Noncurrent Assets
Recognition and measurement rules for noncurrent assets have major implications for accounting quality. The following general process describes the accounting for most noncurrent assets:
Recognition and measurement rules for noncurrent assets have major implications for accounting quality. The following general process describes the accounting for most noncurrent assets:
- A noncurrent asset is initially recognized when a past transaction or event enables a firm to control probable benefits of the asset.
- A noncurrent asset is initially measured at the fair value sacrificed to obtain the asset or the fair value of the asset obtained if more clearly determinable.
- Changes in noncurrent assets must be evaluated to ensure that periodic income captures any value declines. The accounting rules for noncurrent assets are complex and vary greatly across asset classes. At this point, we consider how the aforementioned parts of the process can yield accounting quality problems in more general terms
Control
The initial recognition of a noncurrent asset emphasizes acquiring control of an asset and its future economic benefits. The issue here concerns the difference between control and ownership. This distinction is critical for SPEs.Historically, the assets of SPEs had not been reported as part of the sponsoring entity’s balance sheet because the sponsoring entity’s ownership of voting common equity shares was minimal. However, recent rules require SPEs to be consolidated as part of a firm’s balance sheet if the firm exerts control in some way over the SPE or the firm is the substantial beneficiary of asset benefits held by the SPE. These new rules improve balance sheet quality.
Probability
Initial recognition of a noncurrent asset also requires that the future economic benefits are probable. Management judgment of what is probable is a potential source of low accounting quality. You should read the accounting policy note to understand what costs are capitalized as part of property, plant, and equipment and intangible assets. Often, standard setters don’t give companies a choice, prohibiting capitalization of items such as R&D and marketing costs as noncurrent assets. On one hand, this improves balance sheet quality by limiting management judgment in some cases. On the other hand, balance sheet quality can be reduced by keeping valuable assets such as brands and intellectual property from research off of the balance sheet
Fair Value
In an arm’s-length exchange of regularly traded assets, the initial fair value measurement is generally easy to determine. However, unique transactions can be difficult to measure and value and thus can lead to low accounting quality. Consider, for example, a company that provides unique consulting or design services in exchange for a longterm note receivable. The note receivable should be reported initially as a noncurrent asset at its fair value. However, if the services are unique and have no established market value, accountants directly determine the fair value of the note and use it as a basis to record the transaction. The fair value is determined by contractual cash inflows (i.e., periodic interest and final maturity value) and an interest rate that is appropriate for the risk level of the note. Considerable management judgment might be necessary in this situation, and errors in judgment, whether intentional or not, could yield a low-quality note valuation. Because financial statements articulate, service revenue is also valued too high or too low if the note is valued too high or too low, and earnings quality is compromised. Companies have controls in place and auditors have incentives to make sure that these transactions are recorded in a reasonable, unbiased way. However, you should also identify if substantial amounts of revenues or asset acquisitions are a result of unique transactions and how the company accounts for these transactions.
Changes in Value
On an ongoing basis, long-lived productive assets such as buildings and equipment must be depreciated over estimated useful lives to an estimated salvage value using a depreciation method. Changing useful life estimates without having an economic reason changes depreciation expense, possibly in a way that could help a company achieve an earnings target. Biased or opportunistic management estimates of depreciation can lead to low earnings quality
When a firm acquires assets such as property, plant, and equipment and intangible assets, it assumes that those assets will generate future benefits. This does not always turn out to be the case, however. The development of new technologies by competitors, changes in government regulations, changes in demographic trends, and other factors may reduce the future benefits originally anticipated from the assets. In an attempt to improve balance sheet quality in the accounting for real noncurrent assets (as opposed to financial assets), standard setters have created a set of tests for asset impairment. The general process is to estimate whether the fair value of a noncurrent asset has declined below its recorded book value.
The initial recognition of a noncurrent asset emphasizes acquiring control of an asset and its future economic benefits. The issue here concerns the difference between control and ownership. This distinction is critical for SPEs.Historically, the assets of SPEs had not been reported as part of the sponsoring entity’s balance sheet because the sponsoring entity’s ownership of voting common equity shares was minimal. However, recent rules require SPEs to be consolidated as part of a firm’s balance sheet if the firm exerts control in some way over the SPE or the firm is the substantial beneficiary of asset benefits held by the SPE. These new rules improve balance sheet quality.
Probability
Initial recognition of a noncurrent asset also requires that the future economic benefits are probable. Management judgment of what is probable is a potential source of low accounting quality. You should read the accounting policy note to understand what costs are capitalized as part of property, plant, and equipment and intangible assets. Often, standard setters don’t give companies a choice, prohibiting capitalization of items such as R&D and marketing costs as noncurrent assets. On one hand, this improves balance sheet quality by limiting management judgment in some cases. On the other hand, balance sheet quality can be reduced by keeping valuable assets such as brands and intellectual property from research off of the balance sheet
Fair Value
In an arm’s-length exchange of regularly traded assets, the initial fair value measurement is generally easy to determine. However, unique transactions can be difficult to measure and value and thus can lead to low accounting quality. Consider, for example, a company that provides unique consulting or design services in exchange for a longterm note receivable. The note receivable should be reported initially as a noncurrent asset at its fair value. However, if the services are unique and have no established market value, accountants directly determine the fair value of the note and use it as a basis to record the transaction. The fair value is determined by contractual cash inflows (i.e., periodic interest and final maturity value) and an interest rate that is appropriate for the risk level of the note. Considerable management judgment might be necessary in this situation, and errors in judgment, whether intentional or not, could yield a low-quality note valuation. Because financial statements articulate, service revenue is also valued too high or too low if the note is valued too high or too low, and earnings quality is compromised. Companies have controls in place and auditors have incentives to make sure that these transactions are recorded in a reasonable, unbiased way. However, you should also identify if substantial amounts of revenues or asset acquisitions are a result of unique transactions and how the company accounts for these transactions.
Changes in Value
On an ongoing basis, long-lived productive assets such as buildings and equipment must be depreciated over estimated useful lives to an estimated salvage value using a depreciation method. Changing useful life estimates without having an economic reason changes depreciation expense, possibly in a way that could help a company achieve an earnings target. Biased or opportunistic management estimates of depreciation can lead to low earnings quality
When a firm acquires assets such as property, plant, and equipment and intangible assets, it assumes that those assets will generate future benefits. This does not always turn out to be the case, however. The development of new technologies by competitors, changes in government regulations, changes in demographic trends, and other factors may reduce the future benefits originally anticipated from the assets. In an attempt to improve balance sheet quality in the accounting for real noncurrent assets (as opposed to financial assets), standard setters have created a set of tests for asset impairment. The general process is to estimate whether the fair value of a noncurrent asset has declined below its recorded book value.
If so, balance sheet quality is improved by writing down the value of the asset and representing the asset at its lower probable future economic benefits. Earnings quality, especially as it relates to earnings persistence, often suffers when noncurrent asset impairment losses are included in current period income from continuing operations, and if those losses should have been recorded in prior periods, the quality of those earnings will have turned out to be low as well. Again, high-quality disclosure can increase earnings quality. If the notes to the income statement clearly designate the nature of the write-down so that analysts can assess when the asset decline occurred and its likely persistence, earnings quality remains high
The FASB cites the following events or circumstances as examples that may signal recoverability problems for a long-lived asset or group of assets:
The FASB cites the following events or circumstances as examples that may signal recoverability problems for a long-lived asset or group of assets:
- A significant decrease in the market price of a long-lived asset
- A significant adverse change in the extent or manner in which a long-lived asset is being used or in its physical conditio
- A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset, including an adverse action or assessment by a regulator
- An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asse
- A current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset
- A current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life
What is particularly noteworthy about this list is that a firm, in effect, must recognize impairment when it anticipates that assets previously acquired will no longer provide the future benefits initially anticipated. This is a valuable disclosure to consider when you attempt to assess a firm’s past strategic decisions. Firms must include impairment losses in income before taxes from continuing operations. Asset impairments do not warrant presentation in a separate section of the income statement, such as that given for discontinued operations or extraordinary gains
What is particularly noteworthy about this list is that a firm, in effect, must recognize impairment when it anticipates that assets previously acquired will no longer provide the future benefits initially anticipated. This is a valuable disclosure to consider when you attempt to assess a firm’s past strategic decisions. Firms must include impairment losses in income before taxes from continuing operations. Asset impairments do not warrant presentation in a separate section of the income statement, such as that given for discontinued operations or extraordinary gainsor losses (discussed later). However, alternative methods for reporting the losses include a separate line item on the income statement or a detailed note that describes what line items on the income statement include the impairment losses
What is particularly noteworthy about this list is that a firm, in effect, must recognize impairment when it anticipates that assets previously acquired will no longer provide the future benefits initially anticipated. This is a valuable disclosure to consider when you attempt to assess a firm’s past strategic decisions. Firms must include impairment losses in income before taxes from continuing operations. Asset impairments do not warrant presentation in a separate section of the income statement, such as that given for discontinued operations or extraordinary gainsor losses (discussed later). However, alternative methods for reporting the losses include a separate line item on the income statement or a detailed note that describes what line items on the income statement include the impairment losses
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