3JM Company Inc.

Published Articles by David Balovich

Published in: Creditworthy News
Date: 1/14/99
This is the 7th installment of a continuing series on financial statement analysis.

Long Term Assets

All assets the firm has that are not current fall into the general category of long term assets. Long  erm assets are divided into two categories, real property and personal property. Real property would be land and all other assets are personal.

Prominent among the long term assets are fixed assets, which include property, plant and equipment used to process or produce the firm's product or service. Other long term assets might include fixtures, vehicles or investments if the firm had marketable securities they intended to keep for longer than one year.

Long term assets are those that could be reduced within a one year period but generally are held for a longer period as they are needed by the firm to operate their business.

With the exception of land, real property, personal property is recorded on the balance sheet at its cost less depreciation.

Depreciation is an account function (remember GAAP?). The matching principle of accounting requires that firms use depreciation. Personal property is considered to have a useful life, this means how long will the asset be useful to the firm in generating revenue. If the firm buys equipment that has a five year useful life then it should produce product for five years.

The matching principle holds that it would distort the results of operations in all five years if the entire cost of the machine was to be expensed in the year that it was acquired. We would be understating income in the first year and overstating it in subsequent years. Thus instead of expensing the entire cost of the machine in the year it was acquired, we allocate a portion of the original cost over the useful life of the machine. This is known as depreciation.

There are several methods of depreciation that we will not explore in this column. However it may be relevant to know that there are two basic methods of depreciation, straight line and accelerated. Simply stated, straight line would be taking one-fifth of the cost each year from the total cost and expensing it whereas with accelerated a percentage of the cost would be taken over a lessor period of time. An example of accelerated would be 40% of cost the first year, 35% the second year and the remaining balance the third year.

When reviewing the personal property on the balance sheet the following questions need to be addressed.

1. What method of depreciation is being used?
2. What year of depreciation is the asset in?
3. Does the firm of any assets that are fully depreciated?

Once an asset has fully depreciated it generally is removed from the balance sheet. The fact that an asset no longer has a useful life (accounting principle) does not mean it does not have value. It is important that we determine how much asset value the firm has. This is not always reflected on the balance sheet.

I wish you well.

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