Level 1 CFA® Exam:
Non-Current Assets & Liabilities
In this lesson, we will focus on the non-current assets and liabilities, specifically the following types:
- assets – property, plant, and equipment,
- assets – investment property,
- assets – intangible assets,
- assets – goodwill,
- assets – financial assets,
- assets – deferred tax assets,
- liabilities – long-term financial liabilities,
- liabilities – deferred tax liabilities.
Non-current assets are the ones that are not classified as current assets.
Below, we discuss the most common types of non-current assets:
Property, Plant, and Equipment
The property, plant, and equipment (PP&E, PPE) position on the balance sheet presents the combined value of the company’s real assets such as buildings, machinery, vehicles, land, and natural resources. The major premise behind the classification is that the company foresees that those assets will be used in operation and will generate economic benefits for the period beyond 1 year.
For the vast majority of the industries, this position will be one of the biggest on the balance sheet in terms of value. Because it is a material position, valuation methodologies are of key importance. It is worth remembering that those methodologies vary depending on the accounting standards used.
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Assets such as buildings, land, factories, and warehouses, which are owned by the company and are not being used for the company’s operations but are held to generate additional revenue (e.g., in the form of rental fees), are reported in the balance sheet under investment property.
Depending on the accounting standard the carrying amount of the investment property is recognized as follows:
| IFRS | U.S. GAAP | |
|---|---|---|
| Investment property valuation method | cost model or fair value | no specific method defined |
This position on the balance sheet will be material for companies that do operate in the real estate business, but also financial industry corporates like pension funds and insurance companies.
Intangible assets are assets that do not have a physical form or derive from specific contractual or legal rights (such as patents, royalties, trademarks). A special case of the intangible asset is goodwill (which BTW is not individually identifiable but we will cover that topic in further sections).
Valuation methodologies allowed by the accounting standards mirror those applied to property, plant, and equipment:
| IFRS | U.S. GAAP | |
|---|---|---|
| Intangible assets valuation method | cost model or revaluation model | cost model only |
However, for each intangible asset, the company needs to assess if the useful economic life of the asset is finite or infinite.
Assets with:
- finite useful life are amortized and annually verified if the finite/infinite designation is still valid,
- infinite useful life is not amortized but needs to be annually tested for impairment.
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In this section, we will cover one of the most “tricky” assets on the balance sheet, which is very often an exam topic, namely goodwill.
Goodwill – arises during the corporate merger & acquisition processes when the price paid for the company acquired is higher than the net fair value of identifiable and measurable assets and liabilities
You might ask why the acquirer would pay more for the company than its fair value? It is because there are components that build the value of the target company, but are not appropriately represented by the carrying values of assets and liabilities reported within the balance sheet. Usually, this value is built by a well-known brand, customer base, non-capitalized research and development costs, as well as the value coming from the expected synergies when acquiring and target companies are combined.
The analysts and readers of financial statements need to distinguish between two types of goodwill:
- accounting goodwill, based on accounting standards, and
- economic goodwill, based on the economic performance of the company which should be reflected (in theory) in the stock value.
Both IFRS and U.S. GAAP require companies to capitalize goodwill within the balance sheet. It is not subject to amortization but needs to be annually tested for impairment.
The process to measure goodwill when one company acquires another can be summarized in the following steps:
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Now, let’s do a deep dive into the complex world of financial assets.
Under IFRS:
A financial instrument is 'a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity'. Typical examples of such assets are investments in stock of listed companies, corporate and government bonds that companies invest in, and other fixed-income instruments.
A specific group of financial assets called derivatives might be classified as an asset or a liability depending on current market conditions and the construction of a derivative instrument.
Derivative – an instrument whose value depends on a defined underlying factor or instrument.
Derivatives usually do not require a full amount to be paid at the purchase and therefore can be an efficient tool to hedge risk.
The valuation of financial instruments is a comprehensive process and can be distinguished into two separate sub-processes:
- recognition of the asset at inception,
- subsequent valuation during the life of the asset.
Initial recognition of the assets is done using either:
- fair value, or
- amortized cost (value at inception decreased by repayments, impairment, and amortization of premium or discount).
While IFRS and U.S. GAAP have a lot of similarities as regards the accounting rules applied to financial assets recognition and valuation, there are certain differences. Let’s now compare those two regimes:
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Deferred tax asset (DTA) arises due to differences between tax calculated for the net income using tax regulation and accounting regulation. We recognize DTA in the situations when the actual tax paid to the governmental authorities exceeds the tax due calculated using the accounting methods. Usually, it is driven by the timing difference (certain business activities are recorded as income/cost faster for accounting purposes than tax purposes, e.g., due to the application of the accrual accounting method).
One of the examples is the treatment of warranty costs. For accounting purposes, the cost of the warranty should be estimated and recognized in the current period decreasing the income. For tax purposes, those are not usually treated as costs therefore income and taxes due are higher. As the deferred tax is recognized, in the subsequent period (when the difference between taxes paid and accounting tax due levels) the deferred tax asset is gradually reversed.
It is worth noting that to recognize DTA in the balance sheet, the company needs to expect to generate a taxable income in the subsequent periods, which will allow the company to deduct the 'overpaid' taxes.
Non-current liabilities are the ones that are not classified as current liabilities.
Below, we discuss the most common types of non-current liabilities:
Long-Term Financial Liabilities
Long-term liabilities represent the amounts that the company is due to its lenders and finance providers beyond a period of 1 year. Usually, it consists of long-term loans provided by the banks and debt/bonds issued to finance investments and business growth.
Typically, long-term liabilities are reported and measured using the amortized cost method (for details please see the financial instruments section above). However, we need to bear in mind that certain financial liabilities might be recorded using the fair value method. This includes derivatives (which represent liability) or debt held for trading.
By analogy with the deferred tax asset, a reverse scenario that results in the recognition of deferred tax liability (DTL) may occur.
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- Non-current assets and liabilities are the other balance sheet positions that are not classified as current, meaning that the company plans to use them (for assets) or settle them (for liabilities) in the period exceeding one year from the reporting date.
- Non-current assets include property, plant, and equipment (PPE), investment property, intangible assets, goodwill, financial assets, and deferred tax asset (DTA).
- Non-current liabilities include long-term financial liabilities and deferred tax liabilities (DTL).
- Property, plant, and equipment (PPE) is composed of all the assets that the company uses for its day-to-day operation and are expected to provide economic benefits in the long term. PP&E mainly represents buildings, land, manufacturing plants and vehicles used for the production, and delivery of products or services.
- Under IFRS, PPE is reported using either the cost model or the revaluation model, while U.S. GAAP allows the cost model only. PPE is subject to the depreciation process and appropriate depreciation charges need to be reflected in the income statement and balance sheet.
- Investment property includes assets that are held by the company to invest and generate profits either due to growth in the value of the asset or from the regular cash flows. Investment property is valued using either the cost model or the fair value model.
- Intangible assets are identifiable non-monetary assets that do not have a physical form such as royalties, trademarks, licenses, patents, or other legal rights.
- IFRS allow companies to value intangible assets using the cost model or the revaluation model, while U.S. GAAP allows the cost model only. Depending on whether the intangible asset has a finite or an infinite useful life, it is either amortized on a systematic basis (finite life) or annually tested for impairment (infinite life).
- Recognition of the intangible assets created internally depends on a set of criteria. For IFRS, the company needs to distinguish the costs spent on the research phase (which generally are not capitalized) and the development phase (such costs are capitalized providing the asset meets certain criteria). Under U.S. GAAP, costs spent on internally generated intangibles are expensed.
- Goodwill is the excess amount of the fair value of the net assets (fair value of assets decreased by the fair value of liabilities) of the company acquired over the price paid for the company by the acquirer. Goodwill is not amortized but tested annually for impairment similarly to intangible assets with indefinite economic life.
- Financial assets are financial instruments that give rise to an asset for one side of the transaction and liability for another (e.g., stocks, bonds, derivatives). We distinguish assets that are 'held-to-maturity', 'available-for-sale', or 'held-for-trading'.
- Financial assets 'held-to-maturity' are the ones that the company does not want to sell before the maturity date but wants to collect contractual cash flows from its ownership (e.g., long-term bonds). Those assets are measured using the amortized cost method.
- Other assets (not 'held-to-maturity') are generally measured using the fair value method with the unrealized gains and losses recognized either in the income statement or in the other comprehensive income. When those assets are sold, the unrealized gains and losses are eventually recognized in the income statement (i.e., unrealized gain/loss reported previously in the other comprehensive income is 'recycled' to the income statement).
- Deferred tax assets arise when there is a difference in the way expenses are recognized for accounting and tax purposes. If the tax payable in the current period is higher than the one recognized in the income statement according to the accounting rules, a deferred tax asset arises and vice versa – when the tax paid in the current period is lower than the one that has been reported according to the accounting rules, a deferred tax liability is reported.
- Long-term financial liabilities arise when the company enters into the financial instrument transaction that is expected to generate liabilities. The valuation and treatment are the same as for long-term financial assets.