Accounting for fixed assets: Definition, Capitalization, Depreciation and More

Definition

Fixed assets are the long-term tangible assets used by the business to generate cash flow and maintain business activities. Usually, these assets are used by the business for the long term and presented in the company’s balance sheet with the name property, plant, and equipment. These assets are also termed capital assets and can be purchased/constructed/developed by the business.

Further, these assets are classified as non-current assets in the balance sheet and are depreciated over the expected life. Following are some of the characteristics of the fixed/capital assets.

1- Long-life/long term financial benefit

Fixed assets usually carry a life of more than a year. It means the business obtains financial benefit from using the assets in a time more than a year. Further, the fixed asset’s life can also be revised based on any changes in the valuation of assets. For instance, if the business carries some renovations in the building, its life increases. On the other hand, if there is some impairment in the assets (maybe due to some natural disaster), the life of the building decreases.

2- Illiquidity

Fixed assets are illiquid, which means they cannot be readily sold or exchanged without substantial loss on the transaction. Further, it’s challenging to locate the buyer for the fixed assets as they are expected to have a lower trading volume.

Examples of fixed assets

The fixed assets include vehicles, buildings, land, production plants, software, furniture, computers, software, patents, etc. These assets carry some specific life. However, their life is more than a year.

Capitalization of fixed assets

Fixed assets need to be capitalized in the balance sheet of the company. That’s because benefits associated with the assets will be obtained in a time more than a year. Hence, related expenses of the assets need to be aligned with the periods of the economic benefit. On the other hand, if expenses on the assets are incurred in the normal course of the business, like maintenance and running expenses, they need to be charged in the income statement.

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Further, the amount of capitalization for the assets includes the cost of acquisition and all the expenses incurred to bring the asset in the useable form. These expenses may include transportation, installation, site preparation, sales tax, and all related expenses.

In addition to this, a business may set its policy threshold for capitalization. For instance, if the business gets $3,000 as a threshold and purchases the asset amounting to $2,000, there is no need to capitalize the asset. On the other hand, if the business purchases an asset amounting to $5,000, it needs to be capitalized.

Similarly, suppose the business develops some assets in-house. In that case, they need to encounter all of the cost components like material, labor, overheads (indirect costs) and cost of interest (if applicable), etc.

Depreciation of the fixed assets

Depreciation is an accounting method that helps allocate the cost of the fixed assets over the asset’s expected life. Further, it helps track how much asset has been consumed by the business and align the expense against the assets and economic benefits obtained from it.

In simple words, depreciation is based on the accrual concept of accounting, which states that expenses for the same period should be charged in the period of occurrence as economic benefit has been obtained in the same period. Hence, depreciation helps to align the expenses incurred for the business via consumption of the assets and economic benefits obtained. So, it helps to satisfy the accrual concept of accounting.

There can be different depreciation or cost allocation methods, including the straight-line method and the reducing balance method. There are some differences in these cost allocation methods; in the reducing balance method, the depreciation is calculated by applying the depreciation rate, and the depreciation amount keeps changing from time to time. On the other hand, in the straight-line method same amount is charged from depreciation period to period.

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Procedure and purpose for recording depreciation

When the business purchases an asset, it’s recorded in the balance sheet without impacting the income statement. A journal entry for the purchase of the assets reflects that the asset is debited and cash/accounts payable is credited. This entry demonstrates that there is only an impact on the balance sheet of the company.

So, when the business consumes assets, it needs to be removed from the balance sheet in line with the usage. Hence, some amount (after calculation) is transferred from the balance sheet to the income statement on depreciation.

Following entries are posted for the purchase of the asset.

DescriptionDebitCredit
Property, plant, and equipment A/CXXX 
Cash/Accounts payable A/C XXX

When depreciation is to be recorded, the following entry is posted in the accounting system,

DescriptionDebitCredit
Depreciation A/CXXX 
Accumulated depreciation A/C XXX

It’s important to note that against the depreciation of the assets, we have created an accumulated depreciation account. It’s a contra account created against the assets of the business. Hence, we keep increasing the balance in the contra account with the usage of assets.

Further, cost and the contra accounts are eliminated from books of accounts when an asset is disposed from accounting books.

Accounting entry for disposal of asset.

Following entry is posted in the books of accounts when an asset is disposed at a profit (Asset is said to be disposed-off at a profit when proceeds from the asset’s sale are higher than net book value).

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DescriptionDebitCredit
Accumulated depreciation A/CXXX 
Cash/bankXXX 
Cost of the asset XXX
Gain on sale of the asset (profit and loss account) XXX

On the other hand, the following entry is posted in the books of accounts when an asset is disposed at a loss (Asset is said to be disposed-off at a loss when proceeds from the asset’s sale are lower than net book value).

DescriptionDebitCredit
Accumulated depreciation A/CXXX 
Cash/bankXXX 
Cost of the asset XXX
Loss on sale of the asset (profit and loss account)XXX 

Netbook value can be calculated with the following formula,

Netbook value = cost of the asset – Accumulated depreciation

Frequently asked questions

What is a contra account associated with the depreciation?

Accumulated depreciation is the contra account associated with the depreciation. When depreciation expenses in debited in the books of account, accumulated accounts as contra entry are credited. It means we do not modify the cost of the asset purchased, but we keep posting in contra account. So, the cost of the assets and accumulated depreciation (contra account) are both removed from the account’s books once an asset is sold.

What is Netbook value, and how do you calculate the loss/gain on the sale of assets?

Netbook value is obtained when we deduct the accumulated depreciation from the cost of the asset. It’s called net book value because we net the accumulated depreciation (contra account) from the asset cost capitalized in the books of account.

To calculate gain/loss, we compare proceeds from the asset’s sale with the net book value. If netbooks value is higher than sale proceeds, it’s a loss and vice versa.

What is the nature of depreciation?

Depreciation is an expense and charged in the income statement. It reduced an accounting profit and added back in the profit during the preparation of the cash flow statement.

Is deprecation a sunk cost?

Once an asset is in usable condition, the business has to charge deprecation in the income statement irrespective of whether the business uses the asset in the operations. So, deprecation is a sunk cost.

Why is depreciation considered a fixed cost?

Depreciation is considered a fixed cost because it does not vary with the activity level. However, there can be some specific limit/capacity of the PPE to support the production.

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