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Subject 4. Financial statement disclosures: analysis and disclosure

IAS 16 provides a long listing of disclosure requirements for PP&E. For each class of PP&E, the financial statements must disclose the following:

  • the measurement bases used for determining the gross carrying amount.
  • the depreciation methods and rates or useful lives.
  • the gross carrying amount and the accumulated depreciation (aggregated with accumulated impairment losses) at the beginning and end of the period.
  • the detailed reconciliation of the carrying amount at the beginning and end of the period (showing, for example, additions, depreciation, impairment losses, revaluation information, foreign currency translation impacts, and so on).

The U.S. GAAP requires a company to disclose the depreciation expense for the period, the balances of assets, accumulated depreciation and a general description of the depreciation method(s) used.

Estimates of average age and remaining useful life of a company's assets reflect the relationship between assets accounted for on a historical cost basis and depreciation amounts.

Assume straight-line depreciation and no salvage value:

Estimated total useful life = Time elapsed since purchase (age) + Estimated remaining life
Estimated total useful life = Historical cost / Annual depreciation expense
Historical cost = Accumulated depreciation + Net PPE
Estimated remaining life = Net PPE/Annual depreciation expense

Average age data is useful in comparing the quality of fixed assets across companies. Newer assets are likely to be more efficient. Thus, firms with newer assets are more competitive. An analyst can use average age data to forecast major capital expenditures and the corresponding financing requirements in the future.

However, the average age data are subject to several limitations.

  • Computations are accurate estimates only if straight-line depreciation is used. They are affected by the firm's choices in depreciation lives and salvage values
  • Computations for average age and average depreciable life may be distorted by changes in asset mix (that is, additions with longer or shorter lives than existing assets).

Practice Question 1

Home Furnishings Inc. reported the following amounts in its 2011 annual report (in thousands):

Depreciation expense: $13,792;
Gross property and equipment: $187,113;
Gross property and equipment in 2010: $178,791.

What is the approximate average useful life of Home Furnishings'property and equipment?

A. 26.53 years
B. 13.57 years
C. 12.96 years

Correct Answer: B

The correct computation is $187,113 /13,792 = 13.57 years.

Practice Question 2

An estimation of the average age of a company's asset can be used to assess:

A. mix of assets
B. efficiency of assets
C. changes in acquisitions of assets

Correct Answer: B

Estimating the average age of the assets can help in the assessment of efficiency; however, the estimate may be distorted by unknown changes in the mix of assets or material acquisitions made.

Practice Question 3

ABC Co. has the following accounts:

Current assets: $10,000
Property, plant & equipment: $120,000
Accumulated depreciation: 30,000
Total assets: $100,000
Gross profit: $50,000
Depreciation expense: 10,000
Tax expense: 5,000
Net Income: $35,000

The average age of fixed asset is estimated to be:

A. 1 year.
B. 3 years.
C. 9 years.

Correct Answer: B

Practice Question 4

ABC Co. has the following accounts:

Current assets: $10,000
Property, plant & equipment: $120,000
Accumulated depreciation: 30,000
Total assets: $100,000
Gross profit: $50,000
Depreciation expense: 10,000
Tax expense: 5,000
Net Income: $35,000

The average depreciable life of fixed assets is:

A. 3 years.
B. 9 years.
C. 12 years.

Correct Answer: C

Practice Question 5

Which of the following best explains why the return on assets (ROA) ratio may show distorted increases over time?

A. Net income is affected by inflation and total assets are getting older.
B. A firm acquires many new assets each period.
C. A firm may use replacement cost valuation for plant assets, and repairs and maintenance expense changes each year to correspond to asset replacement costs.

Correct Answer: A

As the assets age, the net asset book value decreases and the return on assets ratio increases. This return ratio does not reflect economic substance, however, since income is measured in current period dollars while the denominator (assets) is measured using historical information rather than replacement information.

Practice Question 6

A recent annual report included the following information:

Note 5: Assets placed in service before January 1, 2009, are depreciated using an accelerated method. Assets placed in service in 2009 will be depreciated using the straight-line method of depreciation. This change in accounting principle is being made to reflect improvements in the design and flexibility of manufacturing machinery and equipment and improvements in maintenance practices. These improvements have resulted in more uniform productive capacities and maintenance costs over the useful life of an asset. Straight-line is preferable in these circumstances. The change is expected to improve 2009 after-tax results by $80 to $100 million. The change was not made for income tax reporting purposes.

Which of the following would generally be true as a result of this change?

A. return on assets would increase.
B. return on assets would decrease.
C. cash flows would increase.

Correct Answer: A

Income will increase because less depreciation is being taken out of income. The assets will gradually decrease. Both effects together will increase the return on assets.

Practice Question 7

A company has property, plant and equipment listed at an original cost of $6,000,000. Land of $1,000,000 is included in this cost. Depreciation expense for the year is $500,000. What is the average life of the firm's fixed assets?

A. 11 years.
B. 10 years.
C. 12 years.

Correct Answer: B

The average life can be calculated by dividing the original cost by the depreciation expense. Land should be deducted, as it is not depreciated. The average life is 10 years [($6,000,000 - $1,000,000)/$500,000].

Practice Question 8

At the end of 2010, a firm has an estimated average age of its fixed assets of 15 years. If the accumulated depreciation for the firm is $300,000, how much is the depreciation expense for 2010?

A. $30,000.
B. $20,000.
C. $300,000.

Correct Answer: B

The average life can be calculated by dividing accumulated depreciation by the current year's depreciation expense. Thus, $300,000 divided by depreciation expense is 15 years. Therefore, depreciation expense is $20,000.

Study notes from a previous year's CFA exam:

4. Financial statement disclosures: analysis and disclosure