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The Three “D”s of Fixed Asset Accounting: Dos, Don’ts, and Details

The Three “D”s of Fixed Asset Accounting: Dos, Don’ts, and Details

Fixed assets—also known as tangible assets or property, plant, and equipment (PP&E)—is an accounting term for assets and property that cannot be easily converted into cash. The word fixed indicates that these assets will not be used up, consumed, or sold in the current accounting year. Yet there still can be confusion surrounding the accounting for fixed assets.

Virtually all businesses have a fixed asset investment. Fixed assets are used in the production of goods and services to customers. This investment can range from a single laptop to a fleet of trucks to an entire manufacturing facility or an apartment building for rent.

For most businesses, fixed assets represent a significant capital investment, so it is critical that the accounting be applied correctly. Here are some key facts to understand and insights to keep in mind:

  • Fixed assets are capitalized. That’s because the benefit of the asset extends beyond the year of purchase, unlike other costs, which are period costs benefitting only the period incurred.
  • Fixed assets should be recorded at cost of acquisition. Cost includes all expenditures directly related to the acquisition or construction of and the preparations for its intended use. Such costs as freight, sales tax, transportation, and installation should be capitalized.
  • Businesses should adopt a capitalization policy establishing a dollar amount threshold. Fixed assets that cost less than the threshold amount should be expensed. 
  • Assets constructed by the entity should include all components of cost, including materials, labor, overhead, and interest expense, if applicable.
  • Additions that increase the service potential of the asset should be capitalized. Additions that are better categorized as repairs should be expensed when incurred.

Capitalizing Software Costs

GAAP includes specific guidance for accounting for costs of computer software that is purchased for internal use.  

Capitalized costs consist of the fees that are paid to third parties to purchase and/or develop software. Capitalized costs also include fees for the installation of hardware and testing, including any parallel processing phase. Costs to develop or purchase software that allows for the conversion of old data are also capitalized. However, the data conversion costs themselves are expensed as incurred.

Training and maintenance costs, which are often a significant portion of the total expenditure, are expensed as period costs. 

Upgrade and enhancement costs should be expensed unless it is probable that they will result in additional functionality.

When an organization purchases software from a third party, the purchase price may include multiple elements such as software training costs, fees for routine maintenance, data conversion costs, reengineering costs, and costs for rights to future upgrades and enhancements. Such costs should be allocated among all individual elements, with allocations based on objective evidence of fair value of the contract elements, not necessarily the separate prices for each element stated in the contract, and then capitalized and expensed accordingly.

The Ins and Outs of Depreciation

Depreciation is the process of allocating the cost of the asset to operations over the estimated useful life of the asset. For financial reporting purposes, the useful life is an asset’s service life, which may differ from its physical life. An asset’s estimated useful life for financial reporting purposes may also be different than its depreciable life for tax reporting purposes. 

Furthermore, the objectives of financial reporting and tax depreciation are different; generally, tax methods and lives take advantage of rules that encourage investments in productive assets by permitting a faster write-off, whereas depreciation for financial reporting purposes is intended to match costs with revenue.

The service life for financial reporting is an estimate made by management, considering some of the following factors:

  • Type of asset
  • Condition when purchased:  New or used
  • Past experience
  • Expected usage:  Normal or excessive
  • Expected obsolescence

The service life may be based on industry standards or specific to a business based on how long the business expects to use the asset in its operations. Certain assets may be used until they are worthless and are disposed of without remuneration, while others may still have value to the business at the end of their service life. 

If an asset will have a residual value at the end of its service life that can be realized through sale or trade-in, depreciation should be calculated on cost less the estimated salvage value. Remember, the depreciable life is the term that the asset is used by the owner, but if the asset is not worthless at the end of that life, estimated salvage value should be considered. 

For example, most businesses use five years as the useful life for automobiles. In practice, a particular business may have a policy of purchasing and trading in automobiles every three years. In this case, three years, not five, should be the estimated useful life for depreciation, but the trade-in value must be estimated and used in the calculation of depreciation (the cost, less the estimated salvage value, should be depreciated over the three-year service life to the business). As with all accounting rules, materiality should be considered in determining whether the recognition of residual values is needed.

While straight-line depreciation is the method most commonly used, other methods such as units of production, sum of the year’s digits, and declining balance exist.

As estimates, useful lives should be evaluated during an asset’s life, and changes should be made when appropriate. Changes in estimates are accounted for prospectively.

Impairment Testing

Fixed assets should be tested for impairment individually, or as part of a group, when events or changes in circumstances indicate that an asset’s carrying value may exceed its gross future cash flows. Such circumstances include the following: 

  • A significant decrease in the market price of the asset
  • A significant adverse change in the degree or manner in which the asset is being used
  • Significant deterioration in the asset’s physical condition
  • An accumulation of costs significantly exceeding the amount originally expected for the acquisition or construction of the asset
  • An operating loss in the current period and a history of losses, indicating that future ongoing losses associated with the use of the asset will occur

Keep in mind that impairment accounting applies to a situation when a significant asset, or collection of assets, is not as economically viable as originally thought. Isolated incidents when a particular asset may be impaired are usually not material enough to warrant recognition. In those cases, a change in an asset’s estimated life for depreciation may be all that is needed. Impairment is typically a material adjustment to the value of an asset or collection of assets. It is, in essence, an acceleration of depreciation to account for the lower future benefits to be received from the asset; the charge for impairment is recorded as part of income from operations in the same section of the statements as depreciation.

Leasing Fixed Assets

Keep in mind that not all fixed assets are purchased by a business. Most businesses utilize both purchasing and leasing to acquire fixed assets. Under current accounting rules, assets under capital leases are capitalized by the lessee. Depreciable lives of assets under capital leases are generally the asset’s useful life (for leases with a transfer of ownership to the lessee at the end of the lease) or the term of the related lease (for all other capital leases).

Leases of real estate are generally classified as operating leases by the lessee; consequently, the leased facility is not capitalized by the lessee. However, improvements made to the property—termed leasehold improvements—should be capitalized when purchased by the lessee. The depreciation period for leasehold improvements is the shorter of the useful life of the leasehold improvement or the lease term (including renewal periods that are reasonably certain to occur). 

In February 2016, the Financial Accounting Standards Board issued a new accounting standard for lease accounting. The new standard will replace existing classifications of capital and operating leases. Under the new standard, all long-term leases will require capitalization of a right-of-use asset. The effect of the new standard will result in an increased number of assets being capitalized by lessees.

Given all the various principles and criteria surrounding fixed assets, here is a recap of the most important dos and don’ts to remember:

Do:

  • Consider all costs at time of acquisition or construction.
  • Adopt a capitalization policy.
  • Estimate useful life for depreciation based on an asset’s estimated service life.
  • Consider whether the asset will have value at the end of its service life, then base depreciation on cost, less estimated salvage value.
  • Reevaluate estimates of useful lives on an ongoing basis.
  • Keep your depreciation records in sufficient detail so assets can be accurately tracked when physically moved and/or disposed.
  • Consider asset impairment when significant events or changes in circumstances occur.
  • Be aware of changes forthcoming with new lease accounting standards.

Don’t:

  • Expense costs such as sales tax or freight incurred on a fixed asset purchase.
  • Use depreciable lives based on Internal Revenue Service rules for financial reporting purposes.
  • Ignore changes in an asset’s use or service; you may need to consider asset impairment.
  • Automatically depreciate a leased asset over its useful life; consider lease accounting to determine proper life.
  • Forget to consider insurance recordkeeping requirements when recording and tracking fixed assets.

Author(s)

Border_Sheila
Sheila Border, CPA
Senior Manager
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