Presentation and Analysis of Property, Plant, Equipment and Natural Resources

A company should disclose the basis of valuation—usually historical cost—for property, plant, equipment, and natural resources, along with pledges, liens, and other commitments related to these assets. It should not offset any liability secured by property, plant, equipment, and natural resources against these assets.

Instead, this obligation should be reported in the liabilities section.

The company should segregate property, plant, and equipment not currently employed as producing assets in the business (such as idle facilities or landed as an investment) from a set used in operations.

When depreciating assets, a company credits a valuation account normally called Accumulated Depreciation.

Using an Accumulated Depreciation account permits the user of the financial statements to see the original cost of the asset and the amount of depreciation that the company charged to expense in past years.

When depleting natural resources, some companies use an Accumulated Depletion account.

Many, however simply credit the natural resource account directly. The rationale for this approach is that the natural resources are physically consumed, making the direct reduction of the cost of the natural resources appropriate.

Because of the significance of the financial statement of the appreciation method used, companies should disclose the following.

1. Depreciation expense for the period.
2. Balances of major classes of depreciable assets by nature and function.
3. Accumulated depreciation, either by major classes of depreciable assets or in total.
4. A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets.

Special disclosure requirements relating to the oil and gas industry. Companies engaged in these activities must disclose the following in their financial statements;

1. the basic method of accounting for those costs incurred in oil and gas producing activities (e.g., full-cost versus successful efforts), and
2. how the company disposes of costs relating to extractive activities (e.g.-, dispensing immediately versus depreciation and depletion).

The 2007 annual report of International Paper Company in Illustration 11-19 shows an acceptable disclosure. It uses condensed balance sheet data supplemented with details and policies in notes to the financial statements.

Analysis of Property, Plant, and Equipment

Analysts evaluate assets relative to activity (turnover) and profitability.

Asset Turnover Ratio

How efficiently a company uses its assets to generate sales is measured by the asset turnover ratio.- I bis ratio divides net sales by average total assets for the period.

The resulting number is the dollars of sales produced by each dollar invested in assets. To illustrate, we use the following data from the Tootsie Roll Industries 2007 annual report. Illustration 11-20 shows the computation of the asset turnover ratio.

Asset turnover = Net Sales / Average total assets = $497.7 = { ( $812.7 + $791.6) / 2} = 0.62 \

The asset turnover ratio shows that Tootsie Roll generated sales of $0.62 per dollar of assets in the year ended December 31, 2007.

Asset turnover ratios vary considerably among industries. For example, a large utility like Ameren has a ratio of 0.32 times. A large grocery chain like Kroger has a ratio of 2.73 times.

Thus, in comparing performance among companies based on the asset turnover ratio, you need to consider the ratio within the context of the industry in which a company operates.

Profit Margin on Sales Ratio

Another measure for analyzing the use of property, plant, and equipment is the profit margin on sales ratio (rate of return on sales).

Calculated as net income divided by net sales, this profitability ratio does not, by itself, answer the question of how profitably a company uses its assets.

But by relating the profit margin on sales to the asset turnover during a period of time, we can ascertain how profitably the company used assets during that period of time in a measure of the rate of return on assets.

Using the Tootsie Roll Industries data shown on page 560, we compute the profit margin on sales ratio and the rale of return on assets as follows.

Profit margin on sates = Net Income / Net Sales = $51.6 / $497.7 = 10.4%

Rate of return on assets = Profit margin on sales x Asset turnover = 10.4% x .62 = 6.4%

Rate of Return on Assets

The rate of return a company achieves through the use of its assets is the rate of return on assets (ROA).

Rather than using the profit margin on sales, we can company it directly by dividing net income by average total assets. Using Tootsie Roll’s data, we compute the ratio as follows.

Rate of return on assets = Net income / Average total assets = $51.6 / { ($812.7 + $791.6) / 2 } = 6.4%

The 6.4 percent rate of return computed in this manner equals the 6.4 percent rate computed by multiplying the profit margin on sales by the asset turnover. The rate of return on assets measures profitability’ well because it combines the effects of profit margin and asset turnover.

Natural Resources

Natural resources consist of standing timber and underground deposits of oil, gas, and minerals. Natural resources, frequently called wasting assets, have two distinguishing;

Characteristics

1. They are physically extracted in operations.
2. They are replaceable only by an act of nature.

1. The acquisition cost of a natural resource is the cash or cash equivalent price necessary to acquire the resource and prepare it for its intended use.

2. The basic accounting issues related to natural resources are whether exploration costs on unsuccessful explorations should be capitalized or expensed.