In this video, learn how to evaluate long-term assets. This includes how impairment issues can significantly affect their valuation.
- Long-term assets such as buildings and equipment are reported in the balance sheet at their historical cost. Well, almost their historical cost. Technically, these building and equipment assets are reported at their net cost, net of depreciation. For example, in its 2018 financial statements, ExxonMobil reported that it held property, plant, and equipment with a historical cost of 477 billion dollars. However, ExxonMobil listed this property, plant, and equipment in its balance sheet at 247 billion dollars net. Net of what? Depreciation of 230 billion dollars. Roughly speaking, ExxonMobil had already used up about half of the long-term service potential of its existing property, plant, and equipment. Depreciation is the accountant's rough estimate of the wear and tear on a long-term asset that comes about through normal use. For example, consider the device that you are using right now to watch or listen to this course. Will that device last more than one year? Probably. Will that device last forever? No. The process of the usage potential of that device being consumed year by year is called depreciation. Okay, so how do accountants compute an annual depreciation amount? Well, it's easier than you might think. Assume that you have a piece of equipment that you purchased for say $10,000. You expect to be able to use the equipment for 10 years after which the equipment will be worn out, obsolete, and worthless. The $10,000 cost of that equipment is part of your cost of doing business. And over 10 years, that total cost is $10,000. But you prepare an income statement each year. So how much of that depreciation expense should you report in this year's income statement? For financial reporting purposes, we typically assume that equipment and buildings wear out in a straight line fashion over time. So $10,000 cost depreciated over 10 years works out to be $1,000 per year. This $1,000 would be reported as an operating expense in the income statement. Now yes, this $1,000 depreciation expense number is an estimate. But if we are using long-term assets and want to prepare annual financial statements we have to make some estimates. Now, after three years for example, a total of $3,000 of depreciation will have accumulated. We call that not surprisingly the amount of accumulated depreciation. The equipment after three years would be reported in the balance sheet at its net amount of $7,000, $10,000 cost minus $3,000 of accumulated depreciation after three years. Okay, but what if the equipment declines in value faster? The term that accountants use for this is impairment. If evidence suggests that the equipment is worth only $4,000 after three years instead of the $7,000 amount reported net of depreciation, the equipment is said to be impaired. An impairment loss of $3,000, $7,000 net amount minus the $4,000 value is recorded in the income statement and the equipment is now reported in the balance sheet at the current value of $4,000. All right, what if the equipment has increased in value, say to $12,000? Do we report a gain of $5,000, the $12,000 value minus the $7,000 net amount? No. Accounting's not fair. We report impairment losses but we don't report increases in value of land, buildings, and equipment. Sorry. In summary, long-term assets such as buildings and equipment are typically reported in the balance sheet at their depreciated value. If the asset has declined substantially in value it is said to be impaired. A loss is recorded and the asset is reported in the balance sheet at this lower current value.
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