Accounting for Fixed Assets

Author: Jim Riley Last updated: Sunday 23 September, 2012

Accounting for fixed assets

Introduction

An important distinction is made in accounting between "current assets" and " "fixed assets".

Current assets are those that form part of the circulating capital of a business. They are replaced frequently or converted into cash during the course of trading. The most common current assets are stocks, trade debtors, and cash.

Compare current assets with fixed assets. A fixed asset is an asset of a business intended for continuing use, rather than a short-term, temporary asset such as stocks.

Fixed assets must be classified in a company's balance sheet as intangible, tangible, or investments. Examples of intangible assets include goodwill, patents, and trademarks. Examples of tangible fixed assets include land and buildings, plant and machinery, fixtures and fittings, motor vehicles and IT equipment.

How should the changing value of a fixed asset be reflected in a company's accounts?

The benefits that a business obtains from a fixed asset extend over several years. For example, a company may use the same piece of production machinery for many years, whereas a company-owned motor car used by a salesman probably has a shorter useful life.

By accepting that the life of a fixed asset is limited, the accounts of a business need to recognise the benefits of the fixed asset as it is "consumed" over several years.

This consumption of a fixed asset is referred to as depreciation.

Definition of depreciation

Financial Reporting Standard 15 (covering the accounting for tangible fixed assets) defines depreciation as follows:

"the wearing out, using up, or other reduction in the useful economic life of a tangible fixed asset whether arising from use, effluxion of time or obsolescence through either changes in technology or demand for goods and services produced by the asset.'

A portion of the benefits of the fixed asset will be used up or consumed in each accounting period of its life in order to generate revenue. To calculate profit for a period, it is necessary to match expenses with the revenues they help earn.

In determining the expenses for a period, it is therefore important to include an amount to represent the consumption of fixed assets during that period (that is, depreciation).

In essence, depreciation involves allocating the cost of the fixed asset (less any residual value) over its useful life. To calculate the depreciation charge for an accounting period, the following factors are relevant:

- the cost of the fixed asset;

- the (estimated) useful life of the asset;

- the (estimated) residual value of the asset.

What is the relevant cost of a fixed asset?

The cost of a fixed asset includes all amounts incurred to acquire the asset and any amounts that can be directly attributable to bringing the asset into working condition.

Directly attributable costs may include:

- Delivery costs

- Costs associated with acquiring the asset such as stamp duty and import duties

- Costs of preparing the site for installation of the asset

- Professional fees, such as legal fees and architects' fees

Note that general overhead costs or administration costs would not be included as part of the total
costs of a fixed asset (e.g. the costs of the factory building in which the asset is kept, or the cost of the maintenance team who keep the asset in good working condition)

The cost of subsequent expenditure on a fixed asset will be added to the cost of the asset provided that this expenditure enhances the benefits of the fixed asset or restores any benefits consumed.

This means that major improvements or a major overhaul may be capitalised and included as part of the cost of the asset in the accounts.

However, the costs of repairs or overhauls that are carried out simply to maintain existing performance will be treated as expenses of the accounting period in which the work is done, and charged in full as an expense in that period.

What is the Useful Life of a fixed asset?

An asset may be seen as having a physical life and an economic life.

Most fixed assets suffer physical deterioration through usage and the passage of time. Although care and maintenance may succeed in extending the physical life of an asset, typically it will, eventually, reach a condition where the benefits have been exhausted.

However, a business may not wish to keep an asset until the end of its physical life. There may be a point when it becomes uneconomic to continue to use the asset even though there is still some physical life left.

The economic life of the asset will be determined by such factors as technological progress and changes in demand. For purposes of calculating depreciation, it is the estimated economic life rather than the potential physical life of the fixed asset that is used.

What about the Residual Value of a fixed asset?

At the end of the useful life of a fixed asset the business will dispose of it and any amounts received from the disposal will represent its residual value. This, again, may be difficult to estimate in practice. However, an estimate has to be made. If it is unlikely to be a significant amount, a residual value of zero will be assumed.

The cost of a fixed asset less its estimated residual value represents the total amount to be depreciated over its estimated useful life.

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