CHAPTER 9: BALANCE SHEET – MEASUREMENT OF FINANCIAL HEALTH

CHAPTER 9: BALANCE SHEET – MEASUREMENT OF FINANCIAL HEALTH

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Property, Plant & Equipment (and Depreciation)
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Similar to the income statement, balance sheet has a new terminology – “Statements of Financial Position”. While the income statement shows performance within a period, the balance sheet is a snapshot of the assets and liabilities of a company on a particular day. Thus, the balance sheet is always expressed as “as of” a certain date.
 
Table 1 shows the balance sheet extracted from TexCycle’s 2016 annual report.
 

Table 1: Financials Extracted from TexCycle’s Statements of Financial Position as of 31 December 2016 (in RM)
Non-Current Assets	Notes
Property, plant & equipment	12	31,826,337
Prepaid lease payments	13	13,792,777
Investment property	14	19,229,300
Goodwill on consolidation	16	583,937
	A	65,432,351
Current Assets
Inventories	17	222,293
Trade receivables	18	10,336,728
Other receivables & prepaid expenses	18	1,212,691
Investment in unit trusts	19	6,860,022
Tax recoverable		2,545,783
Cash & bank balances	28	5,666,487
	B	26,844,004
Total assets (A + B)		92,276,355
Equity and Reserves
Issued capital	21	17,079,300
Treasury shares	21	(1,017,881)
Reserves	22	68,795,512
Total equity	C	84,856,931
Non-Current Liabilities
Hire-purchase payables – non-current portion	23	58,970
Term loan – non-current portion	24	3,503,059
Deferred tax liabilities	25	1,164,465
	D	4,726,494
Current Liabilities
Trade payables	26	106,326
Other payables & accrued expenses	26	1,958,779
Hire-purchase payables – current portion	23	137,044
Term loan – current portion	24	451,632
Tax liabilities		39,149
	E	2,692,930
Total Liabilities (D + E)		7,419,424
Total Equity & Liabilities (C + D + E)		92,276,355

 
Let’s run through line by line, starting from Non-Current Assets.
 
Property, Plant & Equipment (and Depreciation)

Property, Plant & Equipment lists down all the fixed assets owned by the company, which includes land, machines, tables, chairs, Xerox machines, etc. In short, these are the assets that are used to run the business and are not for resale. The value captured is the net value, which is the cost of the fixed assets after deducting depreciation.

What is depreciation? Depreciation is a reduction in the value of the fixed assets that is subsequently recognised as an expense in the income statement. Why does depreciation exist? There are a few concepts that support depreciation, being:

1. Asset values decline with time along with usage;
2. As the assets are being used to generate the revenue, the cost of the assets must be recognised in the determination of the profit of a particular period; and
3. To smoothen the earnings of company.

However, the concepts above have their own weaknesses.

Firstly, assets need not decline in value with usage. Prices of assets fluctuate as a function of supply and demand.

For the second point, it is difficult to directly match between the value of the asset used and the revenue generated. This is why depreciation is usually charged at a fixed rate to the cost of the assets. For example, if an asset bought at a cost of RM10 million has an estimated life of 10 years, then we will charge a 10% depreciation every year (straight line method of depreciation). The typical double entry would be to debit the income statement (i.e., recognised as an expense) and credit the accumulated depreciation account in the balance sheet.

Using TexCycle’s 2016 annual report as a reference, the cost of the assets is disclosed under Note 12 in Page 93. Cost of assets and accumulated depreciations are disclosed under Note 12 in page 93 and 94 respectively.

There are other methods of depreciation methodologies and companies are required to disclose the policy that they are adopting in the Notes to the Financial Statements. In TexCycle’s case, the deprecation policy is disclosed in Page 81 of 2016’s annual report.

What if we don’t charge depreciation and instead recognise the cost of purchasing the asset at the onset of the purchase? The only impact is that the profit will be volatile, especially if the company has periodic purchases of assets.

For instance, if a company purchases say printing machines worth RM1 million in Year 1, none in Year 2, and RM3 million in Year 3, if the company directly recognise the machines as an expense in the income statement, the profit in Year 1 and Year 3 will immediately drop by RM1 million and RM3 million respectively.

Thus, to a large extent, recognising depreciation actually helps companies to smoothen their earnings.

In short, when comparing companies, we must take note of the depreciation policies used, and whether the companies that we are comparing have the same depreciation policies. If they do not, then we have to adjust and standardise the policies before we proceed with our comparison, or else we would not be comparing like for like.

In the next posting, we will discuss how should investors look at depreciation.

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