Accountng: The Language of Business (Part 64)

Skill at creating, exploiting, and exiting crucial alliances beats ownership of fixed assets 

Tom Peters

 Fixed Assets and Intangible Assets (Part H)

by

Charles Lamson

Leasing Fixed Assets

You are probably familiar with Lisa's. A lease is a contract for the use of an asset for a stated period of time. Leases are frequently used in business. For example, automobiles, computers, medical equipment, buildings, and airplanes are often leased.

The two parties to a lease contract are the lessor and the lessee. The lessor is the party who owns the asset. the lessee is the party to whom the rights to use the asset are granted by the lessor. The lessee is obligated to make periodic rent payments for the lease term. All leases are classified by the lessee as either capital leases or operating leases.

A capital lease is accounted for as if the lessee has, in fact, purchased the asset. The lessee debits an asset account for the fair market value of the asset and credits a long-term lease liability account. The asset is then written off as expense (amortized) over the life of the capital lease.

A lease that is not classified as a capital lease for accounting purposes is classified as an operating lease. The lessee records the payments under an operating lease by debiting Rent Expense and crediting Cash. Neither future lease obligations nor the future rights to use the leased asset are recognized in the accounts. However, the lessee must disclose future lease commitments in notes to the financial statements.

The asset rentals described in preceding posts were accounted for as operating leases. To simplify, we will continue to treat asset leases as operating leases. 

Internal Control of Fixed Assets

Because of their dollar and long-term nature, it is important to design and apply effective internal controls over fixed assets. Search controls should begin with authorization and approval procedures for the purchase of fixed assets. Controls should also exist to ensure that fixed assets are acquired at the lowest possible costs. One procedure to achieve this objective is to require competitive bids from three approved vendors.

As soon as a fixed asset is received, it should be inspected and tagged for control purposes and recorded in a subsidiary ledger. This establishes the initial accountability for the asset subsidiary. Subsidiary ledgers for fixed assets are also useful in determining depreciation expense and recording disposals. Operating data that may be recorded in the subsidiary ledger, such as number of breakdowns, length of time out of service, and cost of repairs, are useful in deciding whether to replace the asset. The company that maintains a computerized subsidiary ledger may use bar-coded tags, so that fixed asset data can be directly scanned into computer records.

Fixed assets should be insured against theft, fire, flooding, or other disasters. they should also be safeguarded from theft, misuse, or other damage. for example, fixed assets that are highly open to theft, such as computers, should be locked or otherwise protected when not in use. For computers, safeguarding also includes climate controls and special fire extinguishing equipment. Procedures should also exist for training employees to properly operate fixed assets such as equipment and machinery.

A physical inventory of fixed assets should be taken periodically in order to verify the accuracy of the accounting records. Such an inventory would detect missing, obsolete, or idle fixed assets. In addition, fixed assets should be inspected periodically in order to determine their condition.

Careful control should also be exercised over the disposal of fixed assets. All disposals should be properly authorized and approved. Fully depreciated assets should be returned in the accounting records until disposal has been authorized and they are removed from service. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 408-410*

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Accounting: The Language of Business (Part 63)

Your own business growth and success depends on many things, and along that growing path, you are going to have to concede certain responsibilities and activities - whether for your accounting, your production, or day-to-day management.

Michael Gerber

Fixed Assets and Intangible Assets (Part G)

by

Charles Lamson

Exchanging Similar Fixed Assets

Old equipment is often traded in for new equipment having a similar use. In such cases, the seller allows the buyer an amount for the old equipment traded in. This amount, called the trade-in allowance, may be either greater or less than the book value of the old equipment. The remaining balance---the amount owed---is either paid in cash or recorded as a liability. It is normally called boot, which is its tax name.

Gains on Exchanges

Gains on exchanges of similar fixed assets are not recognized for financial reporting purposes. This is based on the theory that revenue occurs from the production and sale of goods produced by fixed assets and not from the exchange of fixed assets. 

When the trade-in allowance exceeds the book value of an open asset traded in and no gain is recognized, the cost recorded for the new asset can be determined in either of two ways:

1. Cost of new asset = List price of new asset - Unrecognized gain

or

2. Cost of new asset = Cash given (or liability assumed) + Book value of old asset 

To illustrate, assume the following exchange: 

Recorded cost of new equipment:

The entry to record this exchange and the payment of cash is as follows:

Not recognizing the $300 gain ($1,100 trade-in allowance - $800 book value) at the time of the exchange reduces future depreciation expense. That is, the depreciation expense for the new asset is based on a cost of $4,700 rather than on the list price of $5,000. In effect, the unrecognized gain of $300 reduces the total amount of depreciation taken during the life of the equipment by $300.

Losses on Exchanges

For financial reporting purposes, losses are recognized on exchanges of similar fixed assets if the trade-in allowance is less than the book value of the old equipment. When there is a loss, the cost recorded for the new asset should be the market (list) price. To illustrate, assume the following exchange: 

The entry to record the exchange is as follows: 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 406-408*

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Accounting: The Language of Business (Part 62)

.

Companies figured out that the easiest way to make money was to reissue records that the accounting department had paid for years ago and already made a profit.

Chris Cornell

 Fixed Assets and Intangible Assets (Part F)

by

Charles Lamson

Disposal of Fixed Assets

Fixed assets that are no longer useful may be discarded, sold, or traded for other fixed assets. The details of the entry to record a disposal will vary. In all cases however, the book value of the asset must be removed from the accounts. The entry for this purpose debits the asset's and accumulated depreciation account for the balance on the date of disposal and credits the asset account for the cost of the asset. 

A fixed asset should not be removed from the accounts only because it has been fully depreciated. If the asset is still used by the business period, the cost in emulated depreciation should remain in the ledger this period. This maintains accountability for the asset in the ledger if the book value of the asset was removed from the ledger, the accounts would contain no evidence of the continued existence of the asset. In addition, the cost and the accumulated depreciation data on such assets are often needed for property tax and income tax purposes.

Discarding Fixed Assets

When fixed assets are no longer useful to the business and have no residual or market value, they are discarded. To illustrate, assume that an item of equipment acquired at a cost of $25,000 is fully depreciated at December 31, the end of the preceding fiscal year. On February 14, the equipment is discarded. The entry to record this is as follows:

If an asset has been fully depreciated, depreciation should be recorded prior to removing it from service and from the accounting records. To illustrate, assume that equipment costing $6,000 is depreciated at an annual straight line rate of 10%. In addition, assume that on December 31 of the preceding fiscal year, the accumulated depreciation balance, after adjusting entries, is $4,750. Finally, assume that the asset is removed from service on the following March 24. The entry to record the depreciation for the three months of the current period prior to the asset's removal from service is as follows:

The discarding of the equipment is then recorded by the following entry:

The loss of $1,100 is recorded because the balance of the accumulated depreciation account ($4,900) is less than the balance in the equipment account ($6,000). Losses on the discarding of fixed assets are nonoperating items and are normally reported in the Other Expense section of the income statement.

Selling Fixed Assets

The entry to record the sale of a fixed asset is similar to the entries Illustrated above, except that the cash or other asset received must also be recorded. If the selling price is more than the book value of the asset, the transaction results in a gain. If the selling price is less than the book value, there is a loss.

To illustrate, assume that equipment is acquired at a cost of $10,000 and is depreciated at an annual straight line rate of 10%. The equipment is sold for cash on October 12 of the eighth year of its use. The balance of the accumulated depreciation account as of the preceding December 31 is $7,000. The entry to update the depreciation for the nine months of the current year is as follows:

After the current depreciation is recorded the book value of the asset is $2,250 ($10,000 - $7,750) .The entries to record the sale, assuming 3 different selling prices, are as follows: 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 404-406*

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Accounting: The Language of Business (Part 61)

The U.S. tax code was written by A students. Every April 15, we have to pay somebody who got an A in accounting to keep ourselves from being sent to jail.

P. J. O'Rourke

Fixed Assets and Intangible Assets (Part E)

by

Charles Lamson

Capital and Revenue Expenditures

The costs of acquiring fixed assets, adding to a fixed asset, improving a fixed asset, or extending a fixed asset's useful life are called capital expenditures. Such expenditures are recorded by either debiting the asset account or its related accumulated depreciation account. Costs that benefit only the current period or costs incurred for normal maintenance and repairs are called revenue expenditures. Such expenditures are debited to expense accounts. For example, the cost of replacing spark plugs in an automobile or the cost of repainting a building should be debited to an expense account.

To properly match revenues and expenses, it is important to distinguish between capital and revenue expenditures. Capital expenditures will affect the depreciation expense of more than one period, while revenue expenditures will affect the expenses of only the current period.

Stages of Acquiring Fixed Assets

The costs incurred for fixed assets can be classified into four stages: preliminary, preacquisition, acquisition or construction, and in-service. These stages are illustrated in Exhibit 7.

EXHIBIT 7 Fixed Asset Project Stages

The preliminary stage occurs before management believes acquiring a fixed asset is probable. During the stage, a company may conduct feasibility studies, marketing studies, and financial analyses to determine the viability of a fixed asset acquisition. These costs are not associated with a particular fixed asset, so must be treated as revenue expenditures.

In the preacquisition stage, acquiring the fixed asset has become probable, but has not yet occurred. Costs that are incurred during this stage, such as surveys, zoning, and engineering studies, can be associated with a specific fixed asset and should be treated as a capital expenditure. As we stated previously, Capital expenditures are the costs of acquiring, constructing, adding, or replacing fixed assets.

During the acquisition or construction stage, the acquisition has occurred or construction has begun, but the fixed asset is not yet ready for use. Costs directly identified with the fixed asset during the stage should be capitalized in the fixed asset account or in a construction in progress account. General and administrative costs should not be allocated to fixed asset acquisition or construction for capitalization. These costs are debited to the appropriate general and administrative expense account. When the fixed asset is ready for use, the capitalized costs should be transferred from construction in progress to the related fixed asset account. 

During the in-service stage, the fixed asset is complete and ready for use. During this stage, the fixed asset should be depreciated as described in the previous section. In addition, normal, recurring, or periodic repairs and maintenance activities related to fixed assets during this stage should be charged to maintenance expense for the period. Costs incurred to either acquire additional components of fixed assets or replace existing components of fixed assets should be capitalized, as described in the next section.

Exhibit 8 summarizes the accounting for capital and revenue expenditures for the four stages of acquiring fixed assets.

EXHIBIT 8 Capital and Revenue Expenditures

Fixed-Asset Components

An in-service stage fixed asset often includes one or more components. A component is a tangible portion of a fixed asset that can be separately identified as an asset and depreciated over its own separate expected useful life. For example, the roof or elevator of a building could be identified as components that are depreciated separately from the building itself. When a company acquires or constructs a new component, the costs should be capitalized as described for the previous project stages. Once installed, the component would be depreciated over its useful service life. For example, on April 1, Boxter Company purchased and installed a new crane within a warehouse for $150,000. This cost would be capitalized as a separate component as follows:

The company can also replace a component. Replacements are accounted for in two steps. First, the book value of the replaced component is debited to Depreciation Expense and credited to Accumulated Depreciation. This treatment is consistent with a change of estimate, that is, the fixed asset component is now recognized as being fully depreciated upon replacement. In addition, any costs to remove the old component should be charged to expense. Second, the identifiable direct costs associated with the new component are then capitalized. To illustrate, assume that Boxter removes a warehouse roof on August 1 at a cost of $1,000. As of August 1, the old roof has a remaining book value ($40,000 initial cost less $31,000 accumulated depreciation) of $9,000. On August 5, the new roof is completed at a cost of $60,000 and is estimated to have a 20-year life, which is the remaining life of the building. First, the cost of removing the old roof must be expensed, and the book value of the replaced roof must be completely depreciated, as follows:

After the preceding entry, the book value of the old roof is 0 ($40,000 cost less $40,000 accumulated depreciation). Since the old roof is being replaced, its cost and related depreciation must now be removed from the accounting records, as shown in the following entry:

Next, the cost of the new roof must be capitalized as a separate component as follows:

Using the straight-line method (from part 58), the new roof will be depreciated over 20 years at $3,000 per year ($60,000 / 20 years).

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 402-404*

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Accounting: The Language of Business (Part 60)

“And God said to accountants: Go forth and multiply.” —Unknown

 Fixed Assets and Intangible Assets (Part D)

by

Charles Lamson

Depreciation for Federal Income Tax

The Internal Revenue code specifies the Modified Accelerated Cost Recovery System (MACRS) for use by businesses in computing depreciation for tax purposes. MACRS specifies 8 classes of useful life and depreciation rates for each class. The two most common classes, other than real estate, are the 5-year class and the 7-year class. The 5-Year class includes automobiles and light-duty trucks, and the 7-year class includes most machinery and equipment. The depreciation deduction for these two classes is similar to that computed using the declining-balance method discussed in part 59.

In using the MACRS rate, residual value is ignored, and all fixed assets are assumed to be put in and taken out of service in the middle of the year. For the 5-year class assets, depreciation is spread over six years, as shown in the following MACRS schedule of depreciation rates:

To simplify its record-keeping, the business will sometimes use the MACRS method for both financial statement and tax purposes. This is acceptable if MACRS does not result in significantly different amounts than would have been reported using one of the three depreciation methods discussed in parts 58 and 59.

Using MACRS for both financial statement and tax purposes may, however, hurt a business. In one case, a business that had used MACRS depreciation for its financial statements lost a $1 million order because its fixed assets had low book values. The bank viewed these low book values as inadequate, so it would not loan the business the amount needed to produce the order.

Revising Depreciation Estimates

Revising the estimates of the residual value and the useful life is normal. When these estimates are revised, they are used to determine the depreciation expense in future periods. They do not affect the amount of depreciation expense recorded in earlier years.

To illustrate, assume that a fixed asset purchased for $130,000 was originally estimated to have a useful life of 30 years and a residual value of $10,000. The asset has been depreciated at $4,000 per year [($130,000 - $10,000) / 30 years] for 10 years by the straight-line method. At the end of 10 years, the asset's book value (undepreciated cost) is $90,000, determined as follows:

During the eleventh year, it is estimated that the remaining useful life is 25 years (instead of 20) and thus the residual value is $5,000 (instead of $10,000). The depreciation expense for each of the remaining 25 years is $3,400, computed as follows:

Composite-Rate Method

Assets may be grouped according to common traits, such as similar useful lives. For example a group might include all delivery trucks with useful lives of less then 8 years. Likewise, a group might include all office equipment or all store fixtures. Depreciation may be determined for each group of assets, using a single composite rate, rather than a rate for each individual asset. The depreciation computations are similar for groups of assets as for individual assets. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 400-402*

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