3.3 Long-term assets and liabilities
8 min read•august 20, 2024
Long-term assets and liabilities are crucial components of a company's financial structure. These resources and obligations, expected to last beyond a year, play a vital role in generating future economic benefits and shaping a firm's capital structure.
Understanding the types, acquisition, measurement, and derecognition of long-term assets and liabilities is essential for accurate financial reporting. This knowledge helps in assessing a company's financial health, operational efficiency, and long-term sustainability.
Types of long-term assets
- Long-term assets are resources that a company expects to use for more than one year and are essential for generating future economic benefits
- In Intermediate Financial Accounting, understanding the different types of long-term assets is crucial for accurate financial reporting and decision-making
Tangible vs intangible assets
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- Tangible assets have a physical form and can be touched (machinery, buildings, land)
- lack physical substance but provide value (, , goodwill)
- Accounting treatment differs for tangible and intangible assets due to their nature and useful life
Depreciable vs non-depreciable assets
- Depreciable assets lose value over time due to wear and tear or obsolescence (equipment, vehicles)
- Non-depreciable assets maintain their value or appreciate over time (land)
- Depreciation expense is recognized for depreciable assets to allocate the cost over the useful life
Held for use vs held for investment
- Assets held for use are employed in a company's operations to generate revenue (manufacturing equipment)
- Assets held for investment are not used in operations but are expected to generate income or capital appreciation (rental properties)
- Classification impacts the accounting treatment and presentation on the balance sheet
Acquisition of long-term assets
- Acquiring long-term assets involves determining the cost and properly recording it in the financial statements
- Intermediate Financial Accounting delves into the nuances of asset acquisition, including capitalization of interest and asset retirement obligations
Cost of acquisition
- Cost includes the purchase price, taxes, delivery, installation, and other directly attributable costs
- Discounts or rebates are deducted from the cost
- Proper determination of cost is essential for accurate initial measurement and subsequent depreciation
Capitalization of interest costs
- Interest costs incurred during the construction or acquisition of a qualifying asset are capitalized as part of the asset's cost
- Capitalization begins when expenditures are made, and interest costs are incurred
- Capitalization ends when the asset is substantially ready for its intended use
Asset retirement obligations
- Asset retirement obligations (AROs) are legal obligations associated with the retirement of a long-lived asset
- AROs are recorded at their present value and included in the cost of the related asset
- The liability is accreted over time, and the asset is depreciated over its useful life
Depreciation of long-term assets
- Depreciation is the systematic allocation of an asset's cost over its useful life
- Intermediate Financial Accounting covers various depreciation methods and the factors influencing useful life and salvage value estimates
Depreciation methods
- Straight-line method allocates an equal amount of depreciation expense each period
- Accelerated methods (declining balance, sum-of-the-years' digits) allocate more depreciation expense in earlier years
- The choice of depreciation method should reflect the pattern of economic benefits consumed
Useful life estimation
- Useful life is the period over which an asset is expected to contribute to a company's operations
- Factors influencing useful life include wear and tear, technological obsolescence, and legal or contractual limits
- Useful life estimates are based on judgment and should be reviewed periodically
Salvage value considerations
- Salvage value (residual value) is the estimated amount a company expects to receive from the disposal of an asset at the end of its useful life
- Salvage value is deducted from the depreciable base to determine the total depreciation expense
- Salvage value estimates should be reviewed regularly and updated if necessary
Impairment of long-term assets
- Impairment occurs when the carrying amount of an asset exceeds its recoverable amount
- Intermediate Financial Accounting covers the indicators of impairment, testing process, and measurement of impairment losses
Indicators of impairment
- Significant decline in market value
- Adverse changes in the business environment or asset usage
- Deterioration of financial performance
- Plans to dispose of the asset before the end of its useful life
Impairment testing process
- Identify the asset or cash-generating unit (CGU) to be tested
- Determine the recoverable amount (higher of less costs of disposal and value in use)
- Compare the recoverable amount with the carrying amount
- Recognize an if the carrying amount exceeds the recoverable amount
Measurement of impairment loss
- Impairment loss is the difference between the carrying amount and the recoverable amount
- The loss is recognized in profit or loss and reduces the carrying amount of the asset
- Impairment losses can be reversed in future periods if conditions improve
Derecognition of long-term assets
- Derecognition occurs when a company disposes of or retires a long-term asset
- Intermediate Financial Accounting covers the accounting treatment for disposals and the calculation of gains or losses
Disposal of long-term assets
- Disposal can occur through sale, abandonment, or exchange
- The carrying amount of the asset is removed from the balance sheet
- Any proceeds from the disposal are recognized
Gains or losses on disposal
- Gain or loss is the difference between the net disposal proceeds and the carrying amount of the asset
- Gains are recognized as income, while losses are recognized as expenses
- Proper calculation and presentation of gains or losses are essential for accurate financial reporting
Types of long-term liabilities
- Long-term liabilities are obligations that a company expects to settle beyond one year or the operating cycle
- Intermediate Financial Accounting covers various types of long-term liabilities and their unique characteristics
Bonds payable
- Bonds are debt securities issued by a company to raise capital
- Bonds have a face value (par value), stated interest rate (coupon rate), and maturity date
- Bonds can be issued at par, at a discount, or at a premium
Notes payable
- Notes payable are written promises to pay a specified amount at a future date
- Notes can be secured (backed by collateral) or unsecured
- Interest is typically paid periodically, with the principal due at maturity
Leases
- Leases are contracts that convey the right to use an asset for a specified period in exchange for payments
- Finance leases transfer substantially all the risks and rewards of ownership to the lessee
- Operating leases do not transfer ownership and are treated as rental agreements
Initial recognition of long-term liabilities
- Initial recognition involves measuring the liability at its fair value and recording it on the balance sheet
- Intermediate Financial Accounting covers present value concepts, the effective interest method, and debt issuance costs
Present value concepts
- Present value is the current worth of future cash flows discounted at a specific rate
- The time value of money principle states that money available now is worth more than an identical sum in the future
- Present value techniques are used to measure the initial value of long-term liabilities
Effective interest method
- The effective interest method is used to amortize the discount or premium on a liability over its life
- The method calculates interest expense based on the effective interest rate, which equalizes the present value of cash flows with the initial carrying amount
- The effective interest method results in a constant interest rate over the life of the liability
Debt issuance costs
- Debt issuance costs are incremental costs directly attributable to the issuance of debt (legal fees, underwriting costs)
- These costs are deducted from the initial carrying amount of the liability
- Debt issuance costs are amortized over the life of the liability using the effective interest method
Subsequent measurement of long-term liabilities
- Subsequent measurement involves updating the carrying amount of the liability at each reporting date
- Intermediate Financial Accounting covers the amortization of discounts or premiums, accrual of interest, and modifications or exchanges of debt
Amortization of discount or premium
- Discounts or premiums arise when the face value of a liability differs from its initial carrying amount
- Amortization is the process of allocating the discount or premium over the life of the liability
- The effective interest method is used for amortization, resulting in a constant effective interest rate
Accrual of interest expense
- Interest expense is recognized in each period based on the outstanding liability balance and the effective interest rate
- Accrued interest is recorded as a separate current liability at each reporting date
- Interest payments reduce the accrued interest liability
Modifications or exchanges of debt
- Modifications involve changes to the terms of an existing liability (interest rate, maturity date)
- Exchanges involve replacing an existing liability with a new one
- Accounting treatment depends on whether the modification or exchange is substantial (10% cash flow test)
Derecognition of long-term liabilities
- Derecognition occurs when a company extinguishes or settles a long-term liability
- Intermediate Financial Accounting covers the accounting treatment for extinguishments and the calculation of gains or losses
Extinguishment of debt
- Extinguishment can occur through repayment, legal release, or substantial modification
- The carrying amount of the liability is removed from the balance sheet
- Any consideration paid is recognized
Gains or losses on extinguishment
- Gain or loss is the difference between the carrying amount of the liability and the consideration paid
- Gains are recognized as income, while losses are recognized as expenses
- Proper calculation and presentation of gains or losses are essential for accurate financial reporting
Presentation and disclosure
- Presentation and disclosure requirements ensure that financial statements provide relevant and reliable information to users
- Intermediate Financial Accounting covers the balance sheet classification and notes to financial statements
Balance sheet classification
- Long-term assets and liabilities are presented separately from current items
- Assets are typically classified as current, long-term investments, property, plant, and equipment, or intangible assets
- Liabilities are classified as current or long-term based on their expected settlement date
Notes to financial statements
- Notes provide additional information and explanations to support the amounts presented in the financial statements
- Notes disclose the accounting policies, assumptions, and estimates used in preparing the financial statements
- Specific disclosures are required for long-term assets (depreciation methods, useful lives) and liabilities (maturity dates, interest rates, collateral)
Key Terms to Review (17)
Asset Impairment: Asset impairment occurs when the carrying amount of a long-term asset exceeds its recoverable amount, indicating that the asset is not worth as much as it was originally recorded on the balance sheet. This situation often arises due to changes in market conditions, technological advancements, or physical damage to the asset. Recognizing asset impairment is crucial because it ensures that financial statements accurately reflect the value of a company's assets, which is essential for making informed investment and business decisions.
Bonds Payable: Bonds payable are long-term debt securities issued by corporations or governments to raise capital, which obligate the issuer to repay the principal amount at a specified future date, along with periodic interest payments. They play a critical role in financing activities, appearing on the classified balance sheet as a liability and impacting long-term assets and liabilities within financial statements.
Debt-to-equity ratio: The debt-to-equity ratio is a financial metric that compares a company's total liabilities to its shareholder equity, indicating the proportion of debt used to finance the company's assets. This ratio helps assess the financial leverage and overall risk associated with a company's capital structure, shedding light on how much of the company's financing comes from creditors versus shareholders. A higher ratio may signal increased risk, while a lower ratio may suggest a more conservative approach to financing.
Declining Balance Method: The declining balance method is an accelerated depreciation technique used to allocate the cost of a long-term asset over its useful life, where the asset loses value more quickly in the earlier years. This method allows businesses to match higher depreciation expenses with higher revenue generated in those initial years of an asset's use. It is especially useful for assets that rapidly lose value, enabling more accurate financial reporting and tax management.
Fair Value: Fair value is the estimated price at which an asset or liability could be bought or sold in a current transaction between willing parties, reflecting current market conditions. It connects to the valuation of both long-term and intangible assets, as well as the recognition of changes in value due to impairment or disposition. Understanding fair value is essential for accurate financial reporting, as it affects the presentation of various assets and liabilities on financial statements.
GAAP: GAAP, or Generally Accepted Accounting Principles, is a collection of commonly followed accounting rules and standards for financial reporting. It establishes a framework for consistent financial reporting, ensuring that companies present their financial statements in a way that is understandable and comparable across different organizations. This standardization is crucial for investors, regulators, and other stakeholders who rely on accurate financial information to make informed decisions.
Historical Cost: Historical cost refers to the original monetary value of an asset or liability at the time it was acquired, recorded at the price paid or the fair market value at that time. This concept is crucial in accounting because it establishes a baseline for reporting assets and liabilities, ensuring consistency and comparability over time. Understanding historical cost helps in evaluating long-term and current assets, as well as their implications for financial statements and acquisition costs.
IFRS: International Financial Reporting Standards (IFRS) are accounting standards developed by the International Accounting Standards Board (IASB) that aim to bring transparency, accountability, and efficiency to financial markets around the world. These standards provide a common global language for business affairs so that financial statements are comparable across international boundaries, promoting cross-border investment and economic growth.
Impairment Loss: An impairment loss occurs when the carrying amount of an asset exceeds its recoverable amount, meaning the asset has lost value and can no longer generate expected future cash flows. This concept is crucial for assessing both long-term assets and intangible assets, as it impacts investment decisions, asset valuations, and financial reporting.
Intangible assets: Intangible assets are non-physical assets that provide long-term value to a company, including items such as patents, trademarks, copyrights, and goodwill. These assets play a crucial role in a company's valuation and can significantly impact its financial position and performance over time.
Mortgage Payable: A mortgage payable is a long-term liability that represents a loan secured by real estate, typically used to purchase property. This liability arises when an entity borrows money from a lender and agrees to pay it back over time, usually with interest, while the property serves as collateral. Mortgages payable are classified as long-term liabilities on the balance sheet, as they are generally due in more than one year.
Patents: Patents are exclusive rights granted by a government to an inventor or assignee for a limited period of time, typically 20 years, allowing them to exclude others from making, using, selling, or distributing their invention without permission. This legal protection encourages innovation by ensuring that inventors can reap the financial benefits of their creations, linking patents closely to long-term assets as they can represent significant value on a company's balance sheet.
Return on Assets: Return on Assets (ROA) is a financial metric that indicates how effectively a company utilizes its assets to generate earnings. It is calculated by dividing net income by total assets, showing the percentage of profit generated for each dollar of assets. Understanding ROA helps in evaluating a company's efficiency in managing its long-term assets and can be particularly insightful when considering the depletion of natural resources, as it reflects how well a company is converting these resources into profits.
Secured debt: Secured debt is a type of borrowing where the borrower pledges specific assets as collateral to secure the loan. This means that if the borrower defaults, the lender has the right to seize the collateral to recover the owed amount. Secured debt is often seen as less risky for lenders compared to unsecured debt, leading to potentially lower interest rates and better loan terms for borrowers.
Straight-Line Depreciation: Straight-line depreciation is a method used to allocate the cost of a tangible asset evenly over its useful life. This approach simplifies financial reporting, as the same amount of depreciation expense is recorded each accounting period, allowing for consistent financial analysis and budgeting.
Trademarks: Trademarks are distinctive signs or symbols, such as words, phrases, logos, or designs, that identify and distinguish the source of goods or services of one entity from those of others. They play a crucial role in protecting a company's brand and reputation, making them a significant aspect of long-term assets, particularly intangible assets. Proper management and accounting for trademarks can involve aspects such as amortization and assessing impairment, ensuring that their value is accurately reflected in financial statements.
Unsecured debt: Unsecured debt refers to loans or credit that are not backed by any collateral, meaning there is no specific asset that the lender can claim if the borrower fails to repay. This type of debt typically carries a higher interest rate than secured debt because it poses a greater risk to lenders. In financial contexts, unsecured debt is often associated with consumer loans, credit cards, and certain types of bonds, making it a significant aspect of both long-term liabilities and overall financial management.