Inadequate provision for the maintenance of property, plant, and equipment detracts from the long-term earning power of the firm. If obsolete assets are not replaced and repairs not properly made, breakdowns and detracted operational efficiency will result. Failure to write down obsolete fixed assets results in overstated earnings.
So how do I know if my fixed assets are well maintained?
Do the following examination:
- Determine the age and condition of each major asset along with its replacement cost.
- Review the trend in fixed asset acquisitions to total gross assets. This trend is particularly revealing for a technological company that has to keep up-to-date. A decrease in the trend points to the failure to replace older assets on a timely basis. Inactive and unproductive assets are a drain on the firm.
- Review asset efficiency by evaluating production levels, downtime, and discontinuances. Assets that have not been used for a long period of time may have to be written down.
Note: Pollution-causing equipment may necessitate replacement or modification to meet governmental ecology requirements.
Company X presents the following information regarding its fixed assets:
Fixed Assets $120,000 $105,000
Repairs and Maintenance 6,000 4,500
Replacement Cost 205,000 250,000
The company has inadequately maintained its assets as indicated by:
- The reduction in the ratio of repairs and maintenance to fixed assets from 5 percent in 2009 [=6,000/120,000 = 5.0%] to 4.3% percent in 2010 [= 4,500/105,000 = 4.3%]
- The material variation between replacement cost and historical cost
- The reduction in fixed assets over the year
The Use Of Fixed Asset Turnover Ratio
The fixed asset turnover ratio [=net sales to average fixed assets] aids in appraising a company’s ability to use its asset base efficiently to obtain revenue.
A low ratio may mean that investment in fixed assets is excessive relative to the output generated.
When a company’s rate of return on assets [e.g., net income to fixed assets] is poor, the firm may be justified in not maintaining fixed assets. If the industry is declining, fixed asset replacement and repairs may have been restricted.
A company having specialized or risky fixed assets has greater vulnerability to asset obsolescence. For Example: Machinery used to manufacture specialized products and
Having said that, one may adopt the following approach:
- A depreciation method should be used that most realistically measures the expiration in asset usefulness. For example: The “units-of-production” method may result in a realistic charge for machinery. Unrealistic book depreciation may be indicated when depreciation for stockholder reporting is materially less than depreciation for tax return purposes.
- Examine the trend in depreciation expense as a percent of both fixed assets and net sales. A reduction in the trend may point to inadequate depreciation charges for the potential obsolescence of fixed assets. Another indication of inadequate depreciation charges is a concurrent moderate rise in depreciation coupled with a material increase in capital spending.
The following information applies to Y Company:
Depreciation expense to fixed assets 5.3% 4.4%
Depreciation expense to sales 4.0% 3.3%
The above declining ratios indicate improper provision for the deterioration of assets.
A Final Note
- A change in classification of newly acquired fixed assets to depreciation categories different from the older assets (e.g., accelerated depreciation to straight-line) will result in lower earnings quality.
- A vacillating depreciation policy will distort continuity in earnings.
- If there is a reduction in depreciation expense caused by an unrealistic change in the lives and salvage values of property, plant, and equipment, there will be overstated earnings.
- An inconsistency exists when there is a material decline in revenue coupled with a major increase in capital expenditures. It may be indicative of overexpansion and later write-offs of fixed assets.