The Accounting Equation – A Closer Look at Fixed Assets
Fixed assets take more work than other assets, from both a real-life maintenance perspective and from the accounting viewpoint. The more substantial fixed assets, from vehicles to factories, can require a lot of planning, drawn-out purchase arrangements, and the burden of long-term liabilities to go along with them.
Since so much can go into fixed assets, there are a lot of guidelines to help you deal with them for accounting purposes. Some of the guidelines come from the IRS, and you may have to use them when you do your business tax return. Others come from generally accepted accounting principles (GAAP). The combined rules cover everything from what to include in the price of your asset to the method of calculating depreciation to how to write up the journal entry when you eventually dispose of the asset. Broken down, these rules are really pretty straightforward.
Calculating Fixed-Asset Costs
For the more basic fixed assets, such as file cabinets and desks, the costs are easy to determine. When you start adding in things such as down payments and trade discounts, as you would with a fleet vehicle, for instance, the accounting gets just a little trickier. The basics, though, are the same for every fixed asset you have. The accounting rule here is called the cost principle, which means that you will value your fixed assets based on what you paid for them, never on their market value (or how much they are “really” worth). That cost, though, includes absolutely everything you had to pay to get that asset ready for work. Of course, there’s the price tag of the asset itself, but you add to that things such as sales tax, delivery charges, installation, setup fees, and training on how to use the asset (common with equipment).
ESSENTIAL
If you have to do something to your property so the asset will work properly, whatever you pay for that goes into your total asset cost. For example, if a machine needs to be set on concrete and you have a tile floor, the cost to have a concrete slab put in counts as part of your asset cost.
Say your company needs a computer network. The system itself costs $11,000 for all the hardware and software. The installation and network management training tacks another $2,500 onto your bill. The computer company offers you a 5 percent discount on the system if you’ll sign a one- year service contract for $500, which you do. There’s 6 percent sales tax on the system only, and a $100 delivery charge. Before you can take delivery, though, you have to set up a climate-controlled room to house your server, and that costs $3,000. You pay a cash deposit of $300 on the room, another cash deposit of $1,100 on the computer system, the full price of the service contract, and the rest is payable over three years.
All those costs except for the service contract go into the cost of your computer system asset. That makes your asset value equal to $16,677. The system is $11,000 less a 5 percent discount, bringing it to $10,450. Sales tax (at 6 percent) on that comes to $627. You also add on the $2,500 setup fee, the $100 delivery charge, and the $3,000 room work.
Here’s what the general journal entry would look like:
General Journal Entry
| Date | Account & Explanation | Post Ref | Debit | Credit |
|---|---|---|---|---|
| 01/3/06 | Computer System | $16,677.00 | ||
| Prepaid Service Contract | $500.00 | |||
| Cash | $1,900.00 | |||
| Long-Term Loan Payable | $15,277.00 |
Purchased computer network system with cash deposit and three-year loan, plus one-year service contract for cash.
Depreciation Basics
Depreciation is one of the accountant’s favorite expenses: it reduces your taxable income (and your tax bill) without taking up any of your current cash. This expense represents the loss of value over time of your fixed assets. To qualify for depreciation, the asset has to be kept by your business (and not be for resale), and it has to have a useful life of more than one year.
FACT
Land is the one fixed asset that is never subject to depreciation. Whatever you paid for it in the first place is the value that sticks with it until you’re ready to sell. That’s because in the accounting world, land never deteriorates and never declines in value.
There are a few different ways to calculate depreciation, but the journal entry to record it is the same no matter how you’ve come up with the numbers. It always involves a debit to depreciation expense and a credit to accumulated depreciation. The accumulated depreciation account does just what its name implies: accumulates all of the depreciation expense taken from year to year (the expense account itself is temporary and is closed at the end of each accounting period).
When you deduct accumulated depreciation from a fixed asset, the result is that asset’s book value. Book value equals the original cost of the asset minus its current accumulated depreciation and usually bears no resemblance to its market value.
Getting Rid of Assets
You may hold on to some assets for the life of your business; others will come and go. For those assets you don’t keep forever, there are guidelines for figuring out your gain or loss on the disposition. The gain or loss will hap- pen whether you sell the asset or just trash it; either way, the transaction has some impact on your overall bottom line. Part of the resulting journal entry takes the asset and related accumulated depreciation off the books; the rest goes to gain or loss.
ALERT!
Asset sales may involve trades. For example, you might sell your old van to another company for a combination of cash and some equipment. These transactions can be tricky to record, so get advice from your accountant before writing up the journal entry.
When you get rid of an asset, the difference between what you get for it and its book value will be your gain or loss. When you simply trash a fixed asset, its remaining book value will count as a loss. For example, suppose your landscaping company has a broken-down lawn mower that you’ve decided to take to the dump. You bought it for $2,500 and it has $2,200 of accumulated depreciation on the books, giving it a book value of $300. You would debit accumulated depreciation for $2,200 and loss on disposal of equipment for $300, then credit the fixed asset for $2,500.
Selling it, though, could go either way; plus, you have an extra account to work with, the cash account. Say you sell that same lawn mower for $500.
Now you have a gain of $200 ($500 minus $300 book value). Your journal entry would include a $500 debit to cash, the same $2,200 debit to accumulated depreciation, and $2,500 credit to the fixed asset, but now you would also credit the gain on sale of equipment account for $200. On the other hand, if you sold that asset for $100, you would have a loss of $200, and the entry would change again. Now there would be three debits: $100 to cash, $2,200 to accumulated depreciation, and $200 loss on sale of assets; then you still credit the asset account for $2,500.