Fixed Assets

Objectives of Fixed Asset Accounting

• To give investors, creditors, management, tax and regulatory authorities accurate information about fixed assets

• To account for use and disposal of fixed assets

• To plan for their acquisition through realistic budgeting

Definition

• A fixed asset is an asset that is held for the purpose of producing or supplying goods or services and not for sale in the normal course of business.

Issues involved in Accounting for Property, Plant and Equipment

Categories of Long-Lived Assets

• Plant assets– Tangible– Include land, buildings and equipment

• Intangible assets– Carry special rights without physical substance– Include patents, copyrights and trademarks

Asset AccountsRelated Expense Account

(Balance Sheet) (Income Statement)Plant Assets

Land None

Buildings & Equipment Depreciation

Furniture & Fixtures Depreciation

Land Improvements Depreciation

Natural Resources DepletionIntangibles Amortization

Plant Asset Terminology

Determining the Cost of Acquisition – Valuation rules

Sum of all the costs incurred to bring the asset to its intended use

LandPurchase price,

commissions, survey & legal costs, removal

of old buildings

Buildings Purchase price,

commissions, sales & other taxes, repairs &

renovation for intended use

Land ImprovementsFencing, paving,security systems,

lighting

Machinery & Equipment Purchase price,

Insurance in transit, sales taxes, installation

Incidental Costs must be capitalized

Lump-Sum Purchases

• Companies purchase several assets in a group for one price

• Cost is allocated to individual assets by on their market values

SELF CONSTRUCTED FIXED ASSETS

The cost of a self-constructed fixed asset should comprise those costs that relate directly to the specific asset and those that are attributable to the construction activity in general and can be allocated to the specific asset.

NON MONETARY CONSIDERATION

When a fixed asset is acquired in exchange or in

part exchange for another asset, the cost of the asset acquired should be recorded either at fair market value or at the net book value of the asset given up, adjusted for any balance payment or receipt of cash or other consideration.

For this purpose fair market value may be determined by reference either to the asset given up or to the asset acquired, whichever is more clearly evident.

OTHER CONSIDERATIONSAssets acquired on Hire Purchase: recorded at their cash value with a suitable disclosure, that the enterprise does not have full ownership thereof.Assets owned jointly with others: recorded in the Balance sheet to the extent of the enterprise’s share in such assets, original cost, accumulated depreciation and written down value. Alternatively, the pro rata cost of those assets may be grouped together with similar fully owned assets with an appropriate disclosure.Assets purchased for a consolidated price: Where several assets are purchased for a consolidated price, the consideration is apportioned to the various assets on a fair basis determined by competent valuers.

Capital Expenditure vs. Immediate Expense

Capital Expenditure• Increase capacity or extend life• Examples:

– Major overhaul– Building additions

Immediate Expense• Maintain or restore to working order• Examples:

– Minor repairs– Painting

NOTE: Most companies set a rupee amount to decide if an expenditure should be capitalized or expensed

REVALUATION OF FIXED ASSETS

When a revaluation is made, either an entire class of assets should be revalued, or the selection of assets should be made on a systematic basis. The basis should be disclosed.

The revaluation in financial statements of a class of assets should not result in the net book value of that class being greater than the recoverable amount of assets of that class.

When a fixed asset is revalued upwards, any accumulated depreciation existing at the date of the revaluation should not be credited to the profit and loss account

Measuring Depreciation on Plant Assets

• Plant assets wear out or grow obsolete over time

• The cost of a plant asset is allocated to an expense over its life

• Matches expense of using the asset to the revenues the asset helped produce– Land has an unlimited life and is the only plant

asset not depreciation

Depreciation

Depreciation is NOT:• a process of valuation

– based on market value decline

• a method of setting aside cash to replace assets

Wear and tearTechnological factorsProduct marketRegulatory limitsContractual termsAsset replacement

policies

How to Measure Depreciation

• Three items needed– Cost of the plant asset– Estimated useful life

• How long the company expects to use the asset– Estimated residual value

• Expected cash value of asset at the end of its life• Can be zero

Depreciable Cost = Asset’s cost – Estimated residual value

Accounting for Depreciation, continued

Choosing a depreciation methodStraight-line methodAccelerated methods

Written-down-valueSum-of-the-years’-digits method

Production-units methodComparing the depreciation methods

Comparing the Depreciation MethodsIllustrated

28 June 2011 © PHI Learning Private Limited New Delhi 9

Comparing the Depreciation MethodsIllustrated

28 June 2011 © PHI Learning Private Limited New Delhi 10

Impact of Depreciation

• Each year:– Accumulated Depreciation increases– Book value decreases

• At the end of the asset’s life:

Book value = Cost minus accumulated depreciation

Book value = residual value

Considerations in Selecting aDepreciation Method

MatchingSimplicityRecord-keeping costsTaxManagerial motivesLegal requirements

Depreciation for Tax Purposes

• Most companies use straight-line for external reporting

• Most companies use accelerated depreciation for tax purposes – Modified Accelerated Cost Recovery System

(MACRS)– Larger deductions early in assets’ lives helps

reduce taxes and increase cash flow

Partial Year Depreciation

• Companies purchase plant assets whenneeded–not just at beginning of year

• To compute depreciation for a partial year1. Compute depreciation for a full year2. Multiply by fraction of the year the asset is owned– For example, if an asset is purchased May 1,

multiply by 8/12• Not applicable to units-of-production

– Life is not based on years

Changing Useful Life of Asset

• A company may change useful based on new information or experience

• Called a change in estimate• Depreciation formula needs to be revised

Book value at time of change

Remaining useful life

Special Problems in DepreciationAccounting

Partial accounting periodsAssets of low unit costRevising estimated useful life andresidual valueComponents of an assetFully depreciated assets

Myths about Depreciation

Myth 1: Depreciation is a source ofcash.Myth 2: Depreciation is intended toprovide funds for replacement.Myth 3: Depreciation is a valuationprocess.

Analyze the effect of a plant asset disposal

Disposal of Plant Assets

• When a company is finished using an asset, the asset can be:– Discarded– Sold – Exchanged

• Before accounting for the disposal:– Depreciation is updated – Final book value is determined

Discarding Plant Asset

• Accumulated depreciation and cost of asset removed from records

• Loss recorded (unless asset is fully depreciated and no residual value)

JOURNAL

Date   Accounts   Debit   Credit  Accumulated depreciation

    Loss on disposal of plant asset    Plant asset (equipment, bldg)

Selling a Plant AssetIf cash received > Book value GAIN

If cash received < Book value LOSS

Book value = Cost – Accumulated Depreciation

Income Statement accountSimilar to revenue; increases

net income

Income Statement accountSimilar to an expense; decreases

net income

JOURNALDate Accounts Debit Credit  Cash    

  Accumulated Depreciation  

  Loss on sale of equipment    

  Equipment    Record loss on sale of equipment

  Cash    

  Accumulated Depreciation  

  Equipment      Gain on sale of equipment    

Record gain on sale of equipment

Book value at time of sale:Cost $ 8,700

Accumulated depreciation 2004 ($8,700 x 2/5) $ 3,480

2005 ($8700 - 3480) x 2/5 $ 2,088 January - September x 9 /12 $1,566 $5,046 Book value September 30 $3,654 Cash received $2,500 Loss on sale $1,154

JOURNAL

Date Accounts Debit Credit

  Cash $2,500  

  Accumulated Depreciation $5,046

  Loss on sale of equipment $1,154  

  Equipment   $8,700

Record loss on sale of equipment

ACCOUNTING ON RETIREMENT /DISPOSAL

Any profit/loss arising from retirement or disposal of fixed assets should be dealt as below:

-Losses arising from retirement or gains/losses arising from disposal of a fixed asset which is carried at cost should be recognised in the profit and loss account.

-Where a revalued item of fixed asset is disposed off, any loss or gain should be charged or credited to the profit and loss account. However, to the extent that such loss is related to an upward revaluation which has not been subsequently reversed or utilised, it may be charged directly to that account.

Account for natural resources and depletion

Natural Resources• Come from the earth

– Oil, minerals, coal and timber• Depletion records the expense related to extracting

the natural resource– Similar to units-of-production depreciation

JOURNALDate   Accounts   Debit   Credit

12-31   Depletion Expense   $$,$$$        Accumulated Depletion       $$,$$$              

Account for intangible assets and amortization

Intangible Assets

• Represent special rights and benefits– Have no physical form– Very valuable in today’s information-driven

society– Examples include patents and copyrights

Categories of Intangibles

• Finite lives that can be measured– Amortized using the straight-line method– Intangible asset is reduced by amortization

• No Accumulated Amortization account

• Indefinite Lives– Not amortized– Tested annually for loss in value

Specific Intangibles

PatentsFederal grants that giveholder exclusive right to produce and sell an invention for 20 years

Trademarks & Trade Names

Distinctive identification ofproduct or service; a logo

or catch phrase

CopyrightsExclusive right to sell a

book, music, file or other work of art; lasts for the life

of the author + 70 years

Franchises & LicensesRight to sell a product or

service with specific Conditions, such as chain

restaurants

Goodwill

• Very specific meaning in accounting• Only recorded when an entire business is

purchased– Purchase price exceeds fair value of net assets of

business• Represents earning power of purchased

business• Not amortized

Purchase price of MySpace $18

Fair value of net assets

Current assets $10

Long-term assets $15

Total liabilities ($24) $1

Goodwill $17

JOURNAL

Date Accounts Debit Credit

  Current assets $10  

  Long-term assets $15

  Goodwill $17  

  Total liabilities   $24

  Cash   $18

Research & Development Costs

• Not an intangible asset• Required to be expensed as incurred

– No guarantee expenditures will result in a successful project

Financial Analysis of Fixed Assets

Utilization of fixed assetsFixed asset turnoverCalculating fixed asset turnover ratioBasis of comparisonEvaluating utilization of fixed assets

Report plant asset transactions on the statement of cash flows

Plant Assets and Cash Flow Statement• Operating section

– Depreciation, amortization and depletion are noncash expense

– Added back to net income to determine operating cash flows

• Investing section– Purchases of plant assets and intangibles result in

an outflow of cash– Sales results in inflow of cash

DISCLOSURE

• Gross and net book values of fixed assets at the beginning and end of an accounting period along with additions, disposals, acquisitions and other movements during the year.

- Expenditure incurred in the course of construction or acquisition.

- Revalued amounts substituted for historical costs of fixed assets, the method adopted for revaluation, the nature of indices used, the year of any appraisal made and whether an external valuer was involved in carrying out the revaluation.

• The historical cost each class of assets;

• Total depreciation for the period.

• The related accumulated depreciation;

• Depreciation methods used; and

• Depreciation rates (only if they are different from the principal rates specified in the statute governing the enterprise.)

DISCLOSURE REQUIREMENTS FOR DEPRECIATION

Rates as per Schedule XIV

Provisions of the Income Tax ActRates of depreciation as per Appendix I – Rules 5