To recap our previous post covering the basics of the balance sheet, Non current assets are those that will not be converted into cash or used up within one year or one operating cycle. Non current assets represent the strategic and long term investments of the firm whose benefits will accrue over multiple periods and tell us about the investing activities of the firm. Non current liabilities are those that do not meet the criteria to be classified as current liabilities and represent the long term financing activities of the firm.
In the previous post we covered the various types of current assets and liabilities. In this post we will see the various types of non-current assets and liabilities recorded on the balance sheet. We will also learn about the components of shareholder’s or owner’s equity.
Non current Assets examples
Property, Plant and Equipment (PP&E)
Property Plant and Equipment are considered as non current assets as their useful life usually exceeds one year or one operating cycle. PP&E includes land, buildings, furniture and machinery and equipment. PP&E can be valued using the cost method or revaluation method.
Under the cost method, all PP&E except land are recorded at historical cost – accumulated depreciation/amortization/impairment. Land is not depreciated as it has an infinite life. Historical cost includes purchase price plus any costs incurred for making the asset usable such as delivery and installation costs. There are several depreciation methods that can be followed such as straight line, accelerated depreciation, reducing balance depreciation. (Read this article which covers more information on depreciation methods used).
Intangible assets are assets that lack physical form and shape. Intangible assets can be classified as Identifiable intangible assets and Unidentifiable intangible assets. Identifiable intangible assets can be acquired singly and convey rights and privileges that have finite lives. For example, patents, trademarks and copyrights. Unidentifiable intangible assets cannot be acquired singly and have infinite lives. For example, goodwill. They are considered non current assets as their benefits accrue over multiple periods.
Amortization and impairment rules for intangible assets are as follows;
- Intangible assets with finite lives are amortized over their useful lives.
- Intangible assets with indefinite lives are tested for impairment annually.
Goodwill is the purchase price paid in excess over and above the fair value of the identifiable net assets acquired during an acquisition.
Companies may pay excess price for the assets that are not recorded on the balance sheet such as reputation of the firm being acquired, customer loyalty and synergies gained by combining the two companies. These assets definitely have value but are not quantified.
Goodwill is not amortized but must be tested for impairment at least annually. Impairment occurs if carrying value of the asset falls below the recoverable amount. If goodwill is impaired it is reduced by the amount of impairment loss which is recognized on the income statement. Goodwill is considered counted among non current assets as it can remain on the balance sheet forever if it is not impaired.
A distinction needs to be made between accounting goodwill and economic goodwill. Economic goodwill is concerned with future economic performance of the firm while accounting goodwill results from past acquisitions.
To make financial statements comparable, goodwill should be excluded from the balance sheet and goodwill impairment loss should be excluded from the income statement for the purpose of analysis.
A financial instrument can either be an asset or a liability depending on whether the firm has purchased it or issued it. Financial instruments include stocks, bonds, derivatives, loans and receivables.
Financial instruments can be recorded at historical cost, amortized cost or fair value depending on how they are classified. Unquoted stocks (stocks for which fair value cannot be determined), loans and receivables are recorded at cost.
Held to maturity securities
Held to maturity securities are recorded at amortized cost. Held to maturity securities are debt instruments purchased with the intention of being held until maturity. Amortized cost is original issue price minus principal payments plus amortized discount minus amortized premium minus any impairment losses.
When a security is issued at a discount to par it is recorded on the balance sheet at the discounted value. The discount is amortized over its life and amortization expense recognized is added back (as the discount gets amortized discount becomes lesser and lesser and so it is added back) so that at maturity the security is reflected on the balance sheet at par value. Similarly the security issued at a premium to par is recorded on the balance sheet at a premium. The premium is amortized over its life and the amortization expense is reduced (as premium is amortized premium becomes lesser and lesser and so it is reduced) so that at maturity the security is reflected at par value. As a debt security tends to maturity it tends to par.
Held for trading securities
Held for trading securities are debt and equity securities that are purchased with the intention of trading them over the near term. Held for trading securities are recorded at fair value. Unrealized gains and losses are recognized in the Income statement and thus becomes a part of retained earnings which eventually gets added to Owner’s equity.
Available for sale securities
Available for sale securities are purchased with the intention of neither holding them to maturity nor trading them over the near term. Available for sale securities are recorded at fair value. Unrealized gains and losses are reported in the Other Comprehensive Income which forms a part of the Owner’s Equity.
For all three classes of securities, dividends, interest and realized gains are recognized on the Income Statement.
Non current liabilities examples
Long term financial liabilities
One type of non current liabilities is long term financial liabilities. Long term financial liabilities arise from bank loans, notes payable, bonds payable, derivatives, etc. If they are not issued at par, they are recorded on the balance sheet at amortized cost. Amortized cost is original issue price minus principal payments plus amortized discount minus amortized premium.
Amortized discount and premium have already been explained above.
Deferred tax liability
Deferred tax liability can arise when income tax expense recognized is higher than tax payable. For example, when a company uses straight line method of depreciation for financial reporting and accelerated depreciation for tax purposes. In this case the income reported on the income statement will be higher than the taxable income. (Read here more about depreciation methods used by firms). Deferred tax liability is also created when revenues or gains are recognized on the income statement before they become taxable.
Shareholders equity or Owners Equity
Owners equity or shareholders equity is the residual interest of the owner’s in the assets after deducting the liabilities. Owners equity or shareholders equity includes the capital contributed by the common shareholders, preferred stock, treasury stock, retained earnings, minority interest and accumulated other comprehensive income
Capital Contributed by owners
This category of shareholders equity includes capital contributed by common shareholders. Some companies also issue preferred stock. Preferred shareholders enjoy privileges over the common shareholders such as being paid out dividends before common shareholders are paid and a priority claim over the proceeds from the sale of assets of the company in the event of liquidation.
Shares may be issued at par value or they may not have par values at all. If they have been issued at par they are reported separately in stockholder’s equity.
The number of shares authorized, issued and outstanding must be disclosed for each class of stock issued. Authorized shares are the number of shares that may be sold by the company under its articles of association. Issued shares are the shares actually sold. Outstanding shares are the shares issued minus the shares repurchased by the company.
Minority interest/non controlling interest
Minority interest is that category of owners equity that records the minority shareholders’ interest in the subsidiaries of the company that is not wholly owned by the parent.
Retained earnings is the category of shareholders equity that records the net income not paid out to the owner’s as dividends but retained by the company to plough back into the business.
Treasury stock is the stock that has been repurchased by the firm but not yet retired. It reduces the shareholder’s equity and outstanding shares. It has no voting rights and does not receive dividends.
Accumulated other comprehensive income
Other comprehensive income category of owners equity includes items that are not recognized on the income statement but affect the owner’s equity. They are as follows;
- Foreign currency translation gains and losses
- Adjustments for minimum pension liability
- Unrealized gains and losses from hedging using derivatives
- Unrealized gains and losses from available-for-sale securities
Statement of changes in shareholders equity or owners equity or stockholders equity
Statement of shareholders equity or owners equity records all transactions that increase or decrease equity during the accounting period. The beginning and ending balances of each type of stock account should be reconciled and components of accumulated other comprehensive income must be disclosed.
With this we come to the end of this post in which we covered the types of non current assets and non current liabilities and also shareholders equity or owners equity as we call it….embedded below is a ppt summarizing the post…
in the next post we will move on to covering common size balance sheet and balance sheet ratios….stay tuned…
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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