As noted in “FASB Definitions of Assets, Liabilities, and Owners’ Equity” in the previous section Definitions of Assets, Liabilities, and Owners’ Equity, assets represent “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” Future economic benefits come in many forms. For example, cash is an asset because it represents purchasing power; the firm can use cash to acquire goods and services, to repay debts, or to make distributions to owners. Inventories are assets because they are merchandise intended for sale to customers for cash and other assets. The firm’s buildings and equipment are assets because they enable the firm to perform its operations and to earn profits in the future.
Assets typically represent tangible economic resources, such as cash, buildings, and trucks. On the other hand, some economic resources are intangible, such as patent rights and copyrights to a text or musical score. Assets may also be represented by promises of future payments from customers who bought goods or services on credit. Assets can be created by contract or acquisition of property rights, and yet they may not be visible to the human eye. All assets, however, have a common characteristic in that they represent probable future economic benefits to the firm.
Assets are classified into two overall categories: current assets and noncurrent assets. This distinction is based on the length of time before the asset is expected to be consumed or converted to cash. Current assets include cash and other assets that will typically become cash or be consumed in one year or one operating cycle, whichever is longer. Current assets are used quickly and repeatedly during a firm’s normal operations. This notion of using assets on a cyclical basis corresponds to a concept called turnover. Current assets turn over quickly, anywhere from daily to annually, and are usually generated in the normal course of business operations. The notion of turnover is used to differentiate current assets from other asset categories that are used (turn over) much more slowly over a number of years.
Cash and cash equivalents include currency, bank deposits, and various marketable securities that can be turned into cash on short notice merely by contacting a bank or broker. These amounts are presently available to meet the firm’s cash payment requirements. Note that only securities that are purchased within 90 days of their maturity dates, or are scheduled to be converted to cash within the next 90 days, may be classified as cash equivalents.
Accounts receivable represent credit sales that have not been collected yet. They are converted into cash as soon as the customers or clients pay their bills (their accounts). Accounts receivable should turn over, or be collected, within the firm’s normal collection period, which is usually 30 or 60 days. A slower accounts receivable turnover embodies more risk to the organization because the probability of nonpayment usually increases as turnover decreases. Overdue accounts may imply that the customer is either unable to pay or is unwilling to pay because of disagreement over the amounts billed. Both cases imply that the amount of cash that will ultimately be collected is less than the amount originally billed to the customer. Managers are interested less in the total amount of accounts receivable than in the estimated cash to be generated from collections of the accounts. For this reason, accounts receivable are listed on the balance sheet at the amounts estimated to be actually collectible. This amount is termed the net realizable value of the receivables. For example, if management estimates that some portion of the amounts billed to customers will ultimately be uncollectible, then the estimated uncollectible portion will be deducted in valuing the accounts receivable on the balance sheet. The uncollectible portion of the receivables is termed an allowance account and is discussed in Chapter, “Current Assets.”
Inventory represents items that have been purchased or manufactured for sale to customers. That is, inventory can either be created through the manufacturing and assembly efforts of the organization or be acquired from others and held for resale. Inventory is the “stuff of commerce” dating back to merchants on camels and pirates raiding the high seas looking for bounty. Inventory can be as prosaic as black tea or salt, or it can be as glamorous as gold bullion or silver coins. Today, inventory is often “high tech,”such as silicon wafers, memory chips, or disk drives. Should the company discover that some of its inventory is unsalable, or marketable only at a greatly reduced price, the reported value of the inventory should be reduced accordingly.
The Operating Cycle and Liquidity
Manufacturing and merchandising firms’ operating cycles include turning inventory into cash. Using three of the current assets discussed earlier, the operating cycle evolves from the purchase of inventory, to the exchange of inventory for a promised payment by a customer (an account receivable), and finally to the conversion of the receivable into cash. Operating cycles may vary in length from just a few days (in the case of food retailers) to months (consumer appliance sellers) or even years (defense contractors).
The more quickly this cycle is completed, the more quickly the inventory is turned into cash, and liquidity is higher. When the operating cycle becomes longer, the firm’s liquidity usually is lower. Should the operating cycle become too long, the firm will be forced to incur debt in order to pay its suppliers of inventory. To some extent, the length of the operating cycle is outside management’s control. The length of time permitted customers to pay their accounts, for example, may be governed by industry practice. To attract and retain customers, the firm may need to offer credit terms as liberal as those offered by its competitors. Likewise, the amount of inventory that the firm keeps on hand may be related to the length of its “production pipeline.” Some products require a lengthy production process that entails a substantial investment in inventory at various stages of completion.
On the other hand, the turnover of accounts receivable and inventory may be influenced by management. For instance, managers may have considerable leeway in offering credit terms to customers or in deciding how much inventory to keep on hand. The analyst, in attempting to assess the firm’s liquidity, needs to understand these underlying factors that cause differences in the amounts of accounts receivable and inventories across firms and industries.
Noncurrent assets are long-term assets that are used in the conduct of the business. Whereas current assets are liquid and turn over in relatively short time periods, noncurrent assets usually turn over very slowly, on the order of once in several years. In other words, while the operating cycle for current assets is usually less than a year, the replacement cycle for noncurrent assets is longer than a year. In a high-tech organization, however, some noncurrent assets may be replaced more frequently.
All noncurrent assets are recorded on the balance sheet at their historical acquisition costs. The disadvantage of this is that as time passes the historical costs of many noncurrent assets become out of date relative to their current market values. Consequently, they indicate little about the market value of the organization and about the future resources necessary to replace the assets. However, the historical costs listed on the balance sheet do represent the costs of these assets that will eventually be consumed by future operations.
Property, Plant, and Equipment. For most firms, noncurrent assets consist mainly of property, plant, and equipment.These assets are widely referred to as fixed assets. Property usually represents the land on which the firm’s offices, factories, and other facilities are located. In most cases, property is a relatively minor portion of the total noncurrent assets, yet in some cases, such as firms engaged in mining, logging, or oil and gas exploration, property constitutes a major operating asset. Property is also valued on the balance sheet at its historical acquisition cost, and because property is usually one of the oldest assets held by an organization, its recorded historical cost is often the most out of date in terms of current market values.
Other Noncurrent Assets
In addition to property, plant, and equipment, many firms possess other noncurrent assets such as intangibles. Intangibles are noncurrent assets that lack physical substance and yet are important resources in the regular operations of a business. Intangibles often consist of legal rights, such as patents or copyrights. Such legal rights are vital to the operations of many firms and, in some cases, may be the most valuable resources owned by the organization.
Consider, for example, the importance of copyrights to computer software developers or book publishers. The value of such firms depends almost entirely on the value of the copyrights that protect their legal rights to the products they have developed. Accounting for intangible assets is similar to that of buildings and equipment because the initial costs are systematically recognized as expenses over the years that benefit from the use of the assets. Intangible assets are valued on the balance sheet at their historical costs, minus any amounts subsequently recognized as expenses. The term amortization is used in place of depreciation when referring to the consumption of intangible assets.
Another important type of intangible asset is goodwill. Goodwill is a general label used by accountants to denote the economic value of an acquired firm in excess of the value of its identifiable net assets (assets minus liabilities). Goodwill reflects the adage that “the value of the whole differs from the sum of its parts.”This economic value is largely due to factors such as customer loyalty, employee competence and morale, management expertise, and so on. In other words, the value of a successful business firm is usually much greater than the total values of its individual assets.
The balance sheet recognition of goodwill depends on whether the firm’s goodwill is internally generated or externally acquired. Internally generated goodwill evolves gradually as the firm develops a good reputation and customer base. It also evolves as the firm cultivates successful relationships with its suppliers, trains and retains a skilled labor force, and conducts other value-enhancing activities. The costs incurred in generating this goodwill are generally not recorded as assets by the firm and instead are recognized as expenses when incurred. The argument used to support the immediate expensing of these costs is the uncertainty and subjectivity involved in identifying future benefits. Externally acquired goodwill, on the other hand, usually arises when one business firm acquires another. In this case, the amount that the purchaser is paying for the goodwill of the seller can be more objectively determined by appraisers.
Assets: Summary and Evaluation
Before leaving the asset side of the balance sheet, it is helpful to summarize the conventions used by accountants to define and value the firm’s assets. We also identify here some of the limitations faced by analysts who must use asset values shown in the balance sheet to evaluate the firm’s liquidity and productive capacity.
As we have seen, accountants classify assets into two broad groups: current and noncurrent. In reporting current assets, the focus is on liquidity. For this reason, current assets are generally valued at the lower of their acquisition costs or present resale values. An exception to this rule is made for investments in the securities of other firms, as we discuss in Chapter, “Current Assets”. These practices are useful to the analyst concerned with the ability of the firm to meet its short-term cash needs.
Noncurrent assets, on the other hand, are generally valued at their acquisition costs minus amounts that have been recognized as expenses in previous periods. These previously recognized expenses will have been shown as depreciation of buildings and equipment or as amortization of intangibles such as patents or good will. In reporting noncurrent assets, the focus is on the operating capacity of the firm; that is, the firm must focus on the structure of its long-lived assets, both tangible and intangible, which are necessary in order for the firm to produce goods or services. The carrying values of these noncurrent assets represent the portion of their original acquisition costs that will be recognized as expenses in future periods. The carrying values of noncurrent assets rarely reflect their market values because inflation has usually caused asset replacement costs to increase beyond their reported values.
The experienced financial statement analyst is alert to two central issues in examining a firm’s asset structure as reported on the balance sheet:
- Different valuation methods are used for various types of assets (cost, market values, lower of cost or market value).
- Many assets that are critical to the firm’s successful operations are not shown on the balance sheet.
With respect to these “missing”assets, chief executive officers (CEOs) are fond of proclaiming:
- “Our employees are our most important resource.”
- “Research today provides profits tomorrow.”
- “Our reputation for quality ensures our success.”
Regardless of these lofty statements, resources such as employee morale, productivity, research and development expertise, and a loyal and satisfied network of customers and suppliers are absent from the balance sheet. Accountants justify these omissions either because these valuable resources do not meet the conditions stated in the FASB’s definition of assets or because there is no reliable method for measuring or valuing such resources.