Tangible Assets and Inventory
Long-lived assets and inventory are where management's estimates — useful lives, residual values, impairment, cost-flow assumptions — most visibly shape reported earnings. This lesson covers the life of a tangible asset (recognition, depreciation, revaluation, impairment, disposal) and then inventory: what costs go into it, the FIFO / LIFO / weighted-average choice and its effect on COGS and ratios, the LIFO reserve, and write-downs to net realisable value.
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Under IAS 16, an item of property, plant and equipment (PPE) is capitalised at cost — and the art of analysis is separating what genuinely belongs on the balance sheet (an asset) from what should be expensed immediately, because that choice moves both current earnings and future depreciation.
Learning outcomes
- Determine which costs are capitalised into PPE and which are expensed.
- Apply depreciation methods and assess the age of the asset base.
- Account for the IFRS revaluation model, investment property, and impairment under IFRS vs US GAAP.
- Recognise gains/losses on derecognition and classify held-for-sale assets.
- Measure inventory cost and apply FIFO, LIFO and weighted-average, including the LIFO reserve and write-downs.
Initial recognition (IAS 16)
Capitalised into PPE: the purchase price (incl. import duties and non-refundable taxes, net of trade discounts), any cost directly attributable to bringing the asset to the location/condition needed to operate as intended, and the estimated cost of dismantling and site restoration. Expensed in the income statement: costs of opening a new facility, introducing a new product (advertising/promotion), operating in a new location or with new customers (staff training), and general overhead.
Depreciation and the age of the asset base
Depreciation allocates the cost of a non-current asset systematically over its useful life, to match the expense with the revenues it helps generate. (Tangible assets are depreciated, intangibles amortised, natural resources depleted.) Two estimates drive it: the residual value (expected disposal proceeds at end of life) and the useful life (time or output units). Overstating residual value or useful life understates depreciation — and so overstates earnings.
Straight-line schedule
Cost 2,300, residual value 100, useful life 4 years. Find the annual charge and the schedule.
Show solution
Depreciable amount \(=2{,}300-100=2{,}200\); annual charge \(=2{,}200/4=550\). Net book value runs \(2{,}300\to1{,}750\to1{,}200\to650\to100\); accumulated depreciation \(550\to1{,}100\to1{,}650\to2{,}200\). Other methods: declining-balance (accelerated — a % of carrying amount each year) and units-of-production (depreciable cost × output / capacity).
550 per year; NBV ends at the 100 residualAverage age \(\approx\) Accumulated depreciation / Depreciation expense. Remaining life \(\approx\) Net PPE / Depreciation expense, and \(\text{Useful life}=\text{Average age}+\text{Remaining life}\). An old asset base (short remaining life) flags a pressing need to reinvest, and makes asset-turnover/ROE hard to compare across firms. Check whether capex is keeping pace with the depreciation expense. Example: gross PPE 80, accumulated depreciation 45, annual depreciation 5 → average age \(=45/5=\textbf{9 years}\).
The revaluation model and investment property
The revaluation model (offered by IFRS only — not US GAAP) carries an asset at fair value at the revaluation date less subsequent depreciation. It must be applied to a whole class of assets (no cherry-picking) and only where an active market gives a reliable fair value. The accounting routes a revaluation through OCI or income depending on history:
Increase in fair value → OCI (revaluation surplus), unless it reverses a prior decrease charged to income — then to income up to that loss, excess to OCI. Decrease → income (a loss), unless there is a prior surplus in OCI — then to OCI up to the available surplus, excess to income. (Missonier-Piera, 2007: Swiss firms revalue upward to signal borrowing capacity, lift credit ratings and avoid covenant breaches — note banks dominate Swiss funding.)
Investment property (an IFRS-only category — property held to earn rentals/capital appreciation, not used in operations) may be held at cost or at fair value with all changes through net income — distinct from the revaluation model's OCI surplus route.
Impairment
Depreciation is a planned allocation; impairment is an unanticipated decline in an asset's value. The trigger test differs by framework:
Value in use is the discounted expected future cash flows. The write-down reduces the carrying amount and is a loss in income. PPE and finite-life intangibles are tested when there are indications (obsolescence, falling demand, adverse legal/economic change); indefinite-life intangibles are tested at least annually.
Impairments are transitory items — but beware "big baths." A goodwill impairment hints the acquisition was overpriced; a PPE impairment suggests residual value/useful life were overstated, so past depreciation under-matched revenue and past earnings were overstated. Either way it signals an underperforming business. Reversals: IFRS permits reversing an impairment up to the original loss (confirming it was transitory); US GAAP forbids reversals on assets held for use (allowed only for held-for-sale). Under US GAAP a firm cannot revalue up, but impairment is mandatory — with judgment over the timing of the test.
Derecognition
An asset is derecognised when disposed of or expected to yield no further benefit. The gain/loss \(=\text{selling price}-\text{carrying amount}\) is a transitory item. If sale is not imminent but highly probable and the asset is available immediately, reclassify to assets held for sale — depreciation stops (impairment may still apply). A whole cash-generating unit being spun off is shown as held for distribution, with gains/losses from discontinued operations reported after tax — strip these from ROE and the tax-burden ratio. Special cases: abandonment records a non-cash loss equal to carrying value; exchanges record a non-cash gain/loss = carrying value given up − fair value acquired (no gain/loss if fair value is unreliable).
Inventory cost
Inventory is capitalised at all costs of purchase, conversion and bringing it to its present location and condition — purchase price, transport, insurance (net of discounts); and conversion (direct labour, fixed and variable overhead). Excluded (expensed): abnormal waste, storage of finished goods, administrative overhead, selling costs, and overhead on unutilised capacity.
Exeter Power Tools — overhead on idle capacity
Capacity 25,000 drills/yr; ran at 80%; total production overhead £100,000. Overhead capitalised per drill?
Show solution
Only the overhead for capacity used is capitalised: \(80\%\times£100{,}000=£80{,}000\). The idle \(£20{,}000\) is expensed (SG&A). Units produced \(=80\%\times25{,}000=20{,}000\), so per drill \(=£80{,}000/20{,}000=\textbf{£4.00}\). (Transport to customers and finished-goods storage would be SG&A, not inventory; factory-stage storage that is part of production can be capitalised.)
£4.00 per drill; the £20,000 idle-capacity overhead is expensedCost-flow assumptions: FIFO, LIFO, weighted-average
Cost flow rarely matches physical flow. Specific identification suits non-interchangeable items (gemstones). Otherwise: FIFO (first in, first out), LIFO (last in, first out — US GAAP only), or weighted-average cost.
Buy 5, sell 3
Units bought at 10, 10, 12, 12, 13; sell 3, leaving 2. Compute COGS and ending inventory under each method.
Show solution
FIFO (sell the oldest): COGS \(=10+10+12=32\); inventory \(=12+13=25\). LIFO (sell the newest): COGS \(=12+12+13=37\); inventory \(=10+10=20\). Weighted-average: unit cost \(=(2\!\cdot\!10+2\!\cdot\!12+13)/5=11.4\); COGS \(=3\times11.4=34.2\); inventory \(=2\times11.4=22.8\). Total cost is the same; the methods only allocate it between COGS and inventory.
FIFO: COGS 32 / inv 25 · LIFO: 37 / 20 · WAC: 34.2 / 22.8With rising unit costs and stable/growing quantities: COGS: FIFO < WAC < LIFO and Inventory: LIFO < WAC < FIFO. FIFO gives a realistic balance sheet (inventory near replacement cost) but a stale, low COGS; LIFO gives a realistic income statement (COGS near replacement cost) but a stale, low inventory. Days-of-inventory (DOH) is therefore higher under FIFO than weighted-average (higher inventory numerator, lower COGS denominator).
The LIFO reserve and write-downs
When prices rise, LIFO raises COGS → lowers taxable income → lowers tax → raises cash flow. But the US tax code's LIFO conformity rule forces firms using LIFO for tax to use it for reporting too, so over time LIFO leaves inventory, working capital, total assets and retained earnings artificially low. US GAAP requires disclosing the LIFO reserve — the gap to a FIFO inventory — so analysts can convert:
Write-downs. If inventory's recoverable amount falls below cost (spoilage, obsolescence, price falls), it is written down — via COGS, a restructuring line, or an inventory-valuation allowance.
ABC envelopes — net realisable value
Closing inventory carried at £50/pack. Auditors find the selling price is £40, and £15 of repair is needed to make each pack saleable. Write-down?
Show solution
Net realisable value \(=£40-£15=£25\). Since NRV (£25) < cost (£50), write down to £25 — a £25 charge per pack. Under IFRS the test is NRV for all methods, and a later recovery can be reversed (up to the original write-down, through COGS). Under US GAAP, FIFO/weighted-average use NRV while LIFO/retail use market value (replacement cost, bounded by NRV and NRV − normal margin), and reversals are prohibited. With rising costs, LIFO firms are less likely to need write-downs (their inventory already sits at old, low costs).
NRV £25 < cost £50 → write down £25 per packCapitalise PPE at cost (IAS 16), then depreciate over a useful life and residual value the manager estimates — the lever for earnings — and read the age of the asset base to judge reinvestment needs. IFRS adds an optional revaluation model (through OCI) and fair-value investment property; both frameworks force impairment on a decline (recoverable amount under IFRS, undiscounted-then-fair-value under US GAAP), with IFRS allowing reversals and US GAAP not. For inventory, capitalise purchase + conversion, choose a cost-flow assumption (FIFO/LIFO/WAC) that — under rising prices — drives COGS, inventory and DOH in predictable directions, undo LIFO distortions with the LIFO reserve, and write down to net realisable value when cost is not recoverable.