Fixed asset accounting: Dos, don’ts and details

What is fixed asset accounting?

Fixed asset accounting is a crucial aspect of financial management that deals with tangible assets, also known as property, plant and equipment (PP&E). These assets, which appear on the balance sheet, cannot be easily converted into cash. The term “fixed” indicates that these assets will not be used up, consumed or sold in the current accounting year. Understanding what fixed asset accounting entails is essential for businesses, as virtually all companies have a fixed asset investment.

Fixed assets are used in the production of goods and services for customers. This investment can range from a single laptop to a fleet of trucks, an entire manufacturing facility, or an apartment building for rent. The fixed asset life cycle, from acquisition to disposal, plays a significant role in a company’s financial statements and overall financial health.

Fixed asset accounting do’s and don’ts

Here is a short list of fixed asset accounting do’s and don’ts with detailed explanations:

Do:

• Consider all costs at the time of acquisition or construction, including capitalization of sales tax on fixed assets and freight costs.
• Adopt a fixed asset capitalization policy with a clear capitalization threshold.
• 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 of assets on an ongoing basis.
• Keep asset depreciation records in sufficient detail so they can be accurately tracked when physically moved and/or disposed of. This includes maintaining a fixed asset schedule and performing regular fixed asset roll-forwards.
• Consider asset impairment when significant events or changes in circumstances occur.
• Be aware of changes forthcoming with new lease accounting standards, particularly regarding right-of-use assets.

Don’t:

• Expense costs such as sales tax or freight incurred on a fixed asset purchase, as these can typically be capitalized.
• Use depreciable lives based on IRS 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.

Fixed asset accounting rules and policy

For most businesses, fixed assets represent a significant capital investment, so it's 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. Understanding what it means to capitalize an asset is crucial for proper fixed asset accounting.
• Fixed assets should be recorded at the acquisition cost. 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 asset costs below the threshold amount should be expensed. This is part of the criteria for capitalization of fixed assets.
• Assets constructed by the entity should include all components of cost, including materials, labor, overhead, and interest expense, if applicable.
• Additions increasing the service potential of the asset should be capitalized. Additions better categorized as repairs should be expensed when incurred.

Capitalizing fixed asset costs for software

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

Capitalized costs consist of the fees 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 allowing 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 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 the fair value of the contract elements, not necessarily the separate prices for each element stated in the contract, and then capitalized and expensed accordingly.

GAAP fixed asset capitalization rules

GAAP (generally accepted accounting principles) includes specific guidance for accounting for the costs of computer software purchased for internal use. These GAAP fixed asset capitalization rules help ensure consistency in financial reporting across organizations.

Capitalized costs consist of the fees 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 allowing 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 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 the 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 asset 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 assets 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 the cost less the estimated salvage value.

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 the straight-line method is the most commonly used depreciation method, other methods such as units of production, sum of the years’ digits, and declining balance (including the double-declining balance method) 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.

Net fixed assets and the fixed asset turnover ratio

The net fixed assets formula is a crucial concept in fixed asset accounting. Net fixed assets are calculated by subtracting accumulated depreciation from the original cost of all fixed assets. This figure appears on the balance sheet and is used in various financial analyses, including the calculation of the fixed asset turnover ratio.

The fixed asset turnover ratio is a measure of how efficiently a company uses its fixed assets to generate sales. It’s calculated by dividing net sales by average net fixed assets. This ratio is particularly useful for companies with significant investments in property, plant and equipment.

Impairment testing best practices for accounting

Fixed assets should be tested for impairment individually, or as part of a group, when events or changes in circumstances indicate 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 indicate that future ongoing losses associated with the use of the asset will occur

Keep in mind, 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 income statement as depreciation.

Fixed assets accounting entries and journal entry examples

Understanding fixed assets accounting entries is crucial for proper financial reporting. Here are some fixed asset journal entry examples:

1. Acquisition of a fixed asset:
   • Dr. fixed asset
   • Cr. cash or accounts payable
2. Recording depreciation:
   • Dr. depreciation expense
   • Cr. accumulated depreciation
3. Sale of a fixed asset:
   • Dr. cash
   • Dr. accumulated depreciation
   • Cr. fixed asset
   • Cr. gain on sale of asset (if applicable)
4. Asset disposal:
   • Dr. accumulated depreciation
   • Dr. loss on asset disposal (if applicable)
   • Cr. fixed asset

These entries help maintain accurate records in the fixed asset schedule and facilitate the fixed asset roll forward process.

If your business leases fixed assets

Not all fixed assets are purchased by a business. Most businesses use 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).

The current FASB standard for lease accounting is ASC 842 (Leases). This standard was issued to improve financial reporting about leasing transactions and requires organizations that lease assets (referred to as “lessees”) to recognize on the balance sheet the assets and liabilities related to the rights and obligations created by those leases.

Accounting solutions for fixed asset management

Maintaining complete and up-to-date fixed-asset records isn’t easy, and if you are preparing for an audit, fixed-asset management can be an intimidating prospect. But it doesn’t have to be. Professional accounting firms are ready to partner with you to ensure accuracy in the accounting of your fixed assets.

Understanding fixed asset accounting, from initial recognition to depreciation and eventual disposal, is crucial for accurate financial reporting. By following GAAP fixed asset capitalization rules, maintaining a detailed fixed asset schedule, and regularly performing fixed asset roll forwards, businesses can ensure their balance sheet and income statement accurately reflect their fixed asset investments and related expenses.

Learn more about Wipfli’s accounting services and audit and assurance services.