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IFT Notes for Level I CFA® Program

R22 Understanding Balance Sheets

Part 2


 

4.  Non-Current Assets

Instructor’s Note

This material will be covered in detail in the reading on Long-Lived Assets.

Non-current assets include all assets that cannot be classified as current assets. Some common examples of non-current assets are discussed below:

4.1. Property, Plant, and Equipment

Property, plant, and equipment (PPE) are tangible assets that are used in the company’s operations. They are expected to be used over more than one fiscal period. Examples of PPE include land, machinery, equipment, etc. PPE is measured differently under IFRS and US GAAP:

  • IFRS permits companies to report PPE using either a cost model or a revaluation model.
  • US GAAP permits only the cost model for reporting PPE.

4.2. Investment Property

IFRS defines investment property as property that is not used in the regular operations of a company. Instead, it is used to earn rental income or capital appreciation. US GAAP has no separate definition for investment property. Similar to PPE, investment property is valued using either the cost model or the fair value model.

4.3. Intangible Assets

These are long-term assets that lack physical substance. Examples include patents, licenses, and trademarks. IFRS allows companies to report intangible assets using either a cost model or a revaluation model. US GAAP allows only the cost model.

4.4. Goodwill

Goodwill is an unidentifiable intangible asset. It is created when one company is purchased by another company. If the purchase price is greater than fair value at acquisition, then the excess amount is recognized as an asset on the acquirer’s balance sheet and referred to as goodwill.

Let us consider a simple example. Company A buys Company T for $100 million. The book value of Company T’s assets and liabilities are $125 million and $75 million respectively.  The fair value of Company T’s assets and liabilities are $160 million and $75 million respectively. What is the goodwill? In this case, the purchase price is $100 million and the net fair value is $160 – $75 million = $85 million. Hence, goodwill is ($100 million – $85 million) $15 million. Note that the book values of assets and liabilities are not used in the goodwill calculation.

Under both IFRS and US GAAP, goodwill is capitalized (i.e., shown as an asset on the balance sheet). Goodwill is not amortized but is tested for impairment annually. If goodwill is impaired, it is written down and the impairment loss is shown on the income statement.

4.5. Financial Assets

IFRS defines a financial instrument as a contract that gives rise to a financial asset of one company and a financial liability or equity instrument of another entity. Financial assets include stocks and bonds, derivatives, loans and receivables.

Financial assets can be measured either at fair value or amortized cost. The measurement basis depends on how financial asset is categorized. The major categories for financial assets are:

  • Measured at Cost or Amortized Cost: Under IFRS, financial assets are measured at amortized cost if the asset’s cash flows occur on specified dates and consist solely of principal and interest, and if the business model is to hold the asset to maturity. For example, investment in a long-term bond. Unrealized gains and losses are not recorded anywhere.
  • Measured at Fair value through profit or loss (FVTPL) under IFRS or Held-for-Trading under US GAAP: This category of asset is acquired primarily for the purpose of selling in the near term and is likely to be held for only a short period of time. Unrealized gains and losses are shown in the income statement.
  • Measured at Fair value through other comprehensive income (FVTOCI) under IFRS or available-for-sale under US GAAP: This category of asset is expected neither to be held till maturity nor traded in the near term. Unrealized gains and losses are shown in other comprehensive income.

Unlike IFRS, the US GAAP category available-for-sale applies only to debt securities and is not permitted for investments in equity securities.

The table below summarizes where gains and losses associated with the financial asset are recognized in the financial statements of the company.

Asset Category Treatment
Measured at Fair Value through Profit and Loss ·      Measured at fair value.

·      Unrealized gains shown on Income Statement.

Measured at Fair Value through Other Comprehensive Income ·      Measured at fair value.

·      Unrealized gains/losses shown in other comprehensive income (OCI).

Measured at Cost or Amortized Cost ·      Measured at cost or amortized cost.

·      Unrealized gains not recorded anywhere.

Realized gains for all categories are shown on the income statement of the company. An important concept related to these assets is mark-to-market. It is the process whereby the value of a financial instrument is adjusted to reflect current value based on market prices. Let us illustrate the different accounting treatments for each of these categories through a simple example.

Example

Company owners contribute $100,000, which is invested in a 20-year bond with a 5% coupon paid semi-annually. After six months, the company receives the first coupon payment of $2,500. At this stage, the market price has increased to $102,000. Show the balance sheet and income statement treatment under each of the following categorizations: HFT, AFS and HTM.

Solution:

The accounting treatment under the three categories is summarized below:

Measured at Fair Value through Profit and Loss Measured at Fair Value through Other Comprehensive Income Measured at Cost or Amortized Cost
Balance Sheet
Cash $2,500 $2,500 $2,500
Cost of securities $100,000 $100,000 $100,000
Unrealized gains/losses $2,000 $2,000
PIC $100,000 $100,000 $100,000
RE Up by $4,500 Up by $2,500 Up by $2,500
OCI Up by $2,000
Income Statement
Interest income $2,500 $2,500 $2,500
Unrealized gain $2,000

For Measured at Fair Value through Profit and Loss, unrealized gains and cash from coupon payments are shown on the asset side of the balance sheet. On the equity side, paid-in capital remains the same at $100,000. Retained earnings increase by $4,500 (sum of coupon payment of $2,500 and unrealized gain of 2,000). On the income statement unrealized gain of $2,000 and interest income of $2,500 is recognized.

For Measured at Fair Value through Other Comprehensive Income, the accounting treatment is the same as HFT except for unrealized gains. For AFS, the unrealized gain is shown as part of other comprehensive income (OCI). It is not shown on the income statement.

For Measured at Cost or Amortized Cost, the asset is valued at amortized cost. Therefore, the unrealized gain of $2,000 is not shown on the balance sheet or income statement. Only the coupon payment of $2,500 is shown on the balance sheet as cash and on the income statement as interest income.

4.6 Deferred Tax Assets

Deferred tax assets (DTA) arise when income tax payable based on income for tax purposes is temporarily greater than income tax expense based on reported financial statement income. In other words, taxable income is higher than accounting profit. Any deferred tax asset is the result of a temporary difference that is expected to reverse in the future. Deferred tax asset reverses when tax benefits are realized in the future resulting in lower cash outflows.

5.  Non-Current Liabilities

All liabilities that are not classified as current are considered to be non-current or long-term liabilities.

Long-term financial liabilities – Include loans, notes and bonds payable. These are usually reported at amortized cost on the balance sheet.

Deferred tax liabilities – Result from temporary timing difference between a company’s taxable income and reported income. They are defined as the amounts of income taxes payable in future periods in respect of taxable temporary differences.


FRA Understanding Balance Sheets Part 2