Analysis of Financial Reports

Session 3

Richard Barker
 What is an asset?
What is the value of an asset?

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Identifying and measuring assets
Identify:
• An asset comprises economic benefits over which the
entity has control
• e.g. excludes people or future sales

Measure:
• An asset is not recognised if it cannot be measured
reliably, for example if the asset is not separable or has
no market
• e.g. research, brands, organisational knowledge
• Assets can be measured at cost or at value
• Value can be ‘in-use’ or ‘in-exchange’

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Q1

Why is the market capitalisation of equity different from

its book value?

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 Illustrative Asset Categories

Fixed Property, Plant, Equipment (PPE) 40,000

Intangible Assets 5,000

Current Inventory 15,000

Accounts Receivable 20,000
Held for the
long-term: the
operating Short-term: part of 80,000
‘infrastructure’ the ‘operating cycle’
of the of the business, and
business liquid within 12
months
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Book Values of Assets

1. How is the value of an asset measured when it is first

recognised in the financial statements?
2. How does the value an asset change after initial
recognition?
– Is the asset carried at cost or market value?
– When is there an impairment (i.e. a write-down) of the
asset?
– How is consumption of the asset measured (i.e.
depreciation/amortisation)?
– What happens when the asset is disposed of?

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 Balance Sheet
Assets Goodwill 200,000 Accounts Receivable
Intangible assets 15,000
Initial recognition at amount
Property, Plant, Equipment 140,000 owed by customer.
Investment in Associates 20,000
Carrying amount is reduced
Inventory 35,000
to the extent that amounts
Accounts receivable 25,000
owed are unlikely to be
Financial assets 10,000
received.
Cash 5,000
455,000
Liabilities Bank loan 80,000
Provision 45,000
Accounts payable 14,000
139,000

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Q2

A company with annual revenue of 12,000 takes, on average,

40 days to collect cash after having recognised revenue.
The company assumes that 0.25% of amounts owed by
customers will never be received. What is the book value
of accounts receivable?

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 Balance Sheet
Assets Goodwill 200,000 Inventory
Intangible assets 15,000
Initially recognised as sum
Property, Plant, Equipment 140,000 of all costs required to bring
Investment in Associates 20,000 the asset into current
Inventory 35,000 location and condition.
Accounts receivable 25,000
Carried at cost or net
Financial assets 10,000
realisable value, whichever
Cash 5,000 is the lower.
455,000
Liabilities Bank loan 80,000
Provision 45,000
Accounts payable 14,000
139,000

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 Definition of Inventory

Assets:
(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in the
production process or in the rendering of services.

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Inventory
Fundamental Principle
Inventories are required to be stated at the lower of cost and net
realisable value (NRV).
Measurement of Inventories
Cost should include all:
• costs of purchase (including taxes, transport, and handling)
net of trade discounts received
• costs of conversion (including fixed and variable
manufacturing overheads) and
• other costs incurred in bringing the inventories to their present
location and condition

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Inventory Example
One of the activities of Manufacturing Company (MCo) is to buy model kits (raw
materials) from a supplier, which it then assembles and sells to its customers.
Other products of MCo represent approximately 80% of activity in the factory.
Very little, if any, of the CEO’s time is directly taken up by activity in the factory.
MCo had a finished goods inventory of 200 models at 1 January 2008, with a
book value (i.e. value on the balance sheet) of €2,000. It had no raw materials or
work-in-progress inventory. During 2008, Manufacturing Company purchased
1000 model kits at a wholesale price of €5.00, on which it was given a 20%
discount. Sales tax was paid at 12.5% on the model kits.
During 2008, Manufacturing Company incurred the following costs:
• Transportation of model kits from the supplier, €500.
• Warehouse costs for model kits, €2,000.
• Employee costs for model kit assembly team, €4,000.
• Factory machinery depreciates by €10,000.
• CEO salary, €50,000.
During 2008, Manufacturing Company sold 1,050 units of product at a price of
€15.00 each.
What was Manufacturing Company’s gross profit in 2008, and what is the value
of finished goods inventory at 31 December 2008?

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 Q3

A company purchases inventory for €30,000, of which 80%

is sold during the accounting period. The company has
a gross profit margin of 60% and an operating profit
margin of 10%. What is the company’s revenue?

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 Q4

A retail company has a single supplier of inventory. All inventory is

stored in a warehouse at a cost of 2,000 per year. If amounts
owing to the supplier increase by 6,500 during a period of time,
and if the cost of sales for that period is 84,000, cash payments to
suppliers are 81,000, and closing balances are 14,000 for
accounts payable and 12,000 for inventory, what was the opening
balance of inventory?

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 Balance Sheet
Assets Goodwill 200,000 PPE
Intangible assets 15,000
Initially recognised as sum
Property, Plant, Equipment 140,000 of all costs required to bring
Investment in Associates 20,000 the asset into use.
Inventory 35,000
Can be held at cost or
Accounts receivable 25,000
revalued amount.
Financial assets 10,000
Cash 5,000 Subject to depreciation and
455,000
impairment testing.
Liabilities Bank loan 80,000 Impairment test based on
Provision 45,000 recoverable amount:
Accounts payable 14,000 highest of value-in-use and
139,000 value-in-exchange

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Definition of
Property, Plant and Equipment (PPE)

Tangible assets that:

(a) are held for use in the production or supply of goods or
services, for rental to others, for investment, or for
administrative purposes, and
(b) are expected to be used during more than one period.

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Measurement of PPE on Recognition
PPE should be initially recorded at cost, which includes all
costs necessary to bring the asset to working condition for its
intended use, i.e.
• original purchase price
• costs of site preparation, delivery and handling,
installation and related professional fees for architects
and engineers
• estimated cost of dismantling and removing the asset
and restoring the site

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 Example: Initial Recognition of PPE
Retail Company (RCo) purchased land on 1 January 2009 for €500,000, with
the intention of building a store, trading for 20 years and then selling the site.
The building of the store was completed on 31 December 2009, at which
date RCo had incurred or estimated the following:
• Building construction costs - €850,000 paid in cash, and a further
€150,000 still owing to the building company.
• Architect, legal and other fees, €60,000.
• Fixtures and fittings within the store, €24,000. The estimated useful life
of the fixtures and fittings is 20 years, and their estimated value after 20
years is €4,000.
• Branding and other RCo-specific design features in the store, €30,000.
• Allocation of labour costs of RCo employees assigned to manage the
building of the store, €40,000.
• Annual local property tax, €5,000 per annum.
• Value of inventory held in the store, €200,000.
What was the book value of RCo’s PPE at 31 December 2009?

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 PPE after Initial Recognition
Q. Is the asset carried at cost or market value?
A There is a choice: Cost Model or Revaluation Model
Q When is there an impairment?
A If the recoverable amount falls below the carrying amount
Q How is depreciation measured?
A Allocate depreciable amount (i.e. cost less residual value)
over the useful life of the asset.
Q What happens when the asset is disposed of?
A Book value goes to zero. Investing cash flow increases by
the sales proceeds. There is a gain/loss on disposal (in the
income statement) if the amount received for the asset is
greater/less than the carrying amount.

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Impairment of Assets

If the recoverable amount of an asset is less than the asset’s

carrying amount
• the asset is impaired
• the asset’s carrying amount should be reduced to its
recoverable amount
The recoverable amount of asset is the higher of
1. The net selling price of the asset
2. The asset’s value in use, i.e. the present value of
estimated future cash flows expected to arise from the
continuing use of the asset and disposal at the end of its
useful life

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Impairment example
An asset is purchased on 1 January 2005 for $110,000
Fees and other costs necessary to bring the asset into its
intended use were $20,000
The asset has an expected useful life of 8 years, and an
estimated residual value of $10,000
The company uses straight-line depreciation for the asset.
At 31 December 2008, the estimated market value of the
asset is $60,000. The company would incur costs of $5,000
if it sold the asset.
The estimated value-in-use of the asset at 31 December
2008 is $65,000.
Is the asset impaired at 31 December 2008?
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 Balance Sheet
Assets Goodwill 200,000 Intangible assets
Intangible assets 15,000
Rarely included in the
Property, Plant, Equipment 140,000 balance sheet, and often
Investment in Associates 20,000 only through acquisition.
Inventory 35,000
Subject to amortisation and
Accounts receivable 25,000
impairment testing.
Financial assets 10,000
Cash 5,000
455,000
Liabilities Bank loan 80,000
Provision 45,000
Accounts payable 14,000
139,000

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 Q5

An item of equipment was purchased on 1 January 2005 for

€1,000. The equipment had an estimated useful life of 10 years
and a residual value of €100. Maintenance costs are €50 each
year. The company uses historical cost valuation and straight line
depreciation. The equipment could be sold at 31 December 2007
for €850. What is the net book value of the equipment at 31
December 2007?

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 Q6

A car was purchased three years ago for 15,000, at which time it
had a 5-year useful life and an estimated residual value of 5,000.
The car is worth 7,500 if sold on the open market, although a
company employee has offered to buy it for 8,000. Over the past
three years, 2,500 has been spent on maintenance, 1,500 on
insurance and 1,800 on petrol. What is the current book value of
the car?

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 Q7

What is the impairment test for Property, Plant and Equipment

(PPE), and why does it differ from the impairment test for
inventory?

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 Learning Outcomes

• What is an asset?
• What is the value of an asset at initial
recognition?
• How do book values of assets change
subsequent to initial recognition?
• What is an impairment, and how are assets
tested for impairment?

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