Accounting: The Language of Business (Part 57)

“In the beginning God created man…and the costs followed afterwards.” —Unknown

 Fixed Assets and Intangible Assets (Part A)

by

Charles Lamson

Assume that you are a certified flight instructor and you would like to earn a little extra money by teaching people how to fly. Since you don't own an airplane, one of the pilots at the local airport is willing to let you use her car airplane for a fixed fee per year. You will also have to pay your share of the annual operating costs, based on hours flown. In addition, the owner will consider your request for upgrading the plane's equipment. At the end of the year, the owner has the right to cancel the agreement.

One of your friends is an airplane mechanic. He is familiar with the plane and has indicated that it needs its annual inspection. There is some structural damage on the right aileron. In addition to this repair, you would like to equip the plane with another radio and a better navigation system.

Since you will not have any ownership in the airplane, it is important for you to distinguish between normal operating costs and costs that add future value or worth to the airplane. These letter costs should be the responsibility of the owner. In this case, you should be willing to pay for a part of the cost of the annual inspection. The cost of repairing the structural damage and upgrading the navigation system should be the responsibility of the owner.

Businesses also distinguish between the cost of a fixed asset and the cost of operating the asset. In the next several posts, we discuss how to determine the portion of a fixed asset's cost that becomes an expense over a period of time. We also discuss accounting for the disposal of fixed assets and accounting for intangible assets, such as patents and copyrights.

Nature of Fixed Assets

Businesses use a variety of fixed assets, such as equipment, furniture, tools, machinery, buildings, and land. Fixed assets are long-term or relatively permanent assets. They are tangible assets because they exist physically. They are owned and used by the business and are not offered for sale as part of normal operations. Other descriptive titles for these assets are plant assets or property, plant, and equipment.

The fixed assets of a business can be a significant part of the total assets.

Classifying Costs

Exhibit 2 displays questions that help classify costs. If the purchased item is long-lived, then it should be capitalized, which means it should appear on the balance sheet as an asset. Otherwise, the cost should be reported as an expense on the income statement. If the asset is also used for a productive purpose, which involves a repeated use or benefit, then it should be classified as a fixed asset, such as land, buildings, or equipment. An asset need not actually be used on an ongoing basis or even often. For example, standby equipment for use in the event of a breakdown of regular equipment or for use only during peak periods Is included in fixed assets. Fixed assets that have been abandoned or are no longer used should not be classified as a fixed asset.

EXHIBIT 2 Classifying Costs

Fixed assets are owned and used by the business and are not offered for resale. Long-lived assets held for resale are not classified as fixed assets, what should be listed on the balance sheet in a section entitled investments. For example, undeveloped land acquired as an investment for resale would be classified as an investment, not land.

The Cost of Fixed Assets

The costs of acquiring fixed assets include all amounts spent to get the asset in place and ready for use. For example, freight costs and the costs of installing equipment are included as part of the asset's total cost. The direct costs associated with new construction, such as labor and materials, should be debited to a "construction in progress" asset account. When the construction is complete, the costs should be reclassified by crediting the construction in progress account and debiting the appropriate fixed asset account. For growing companies, construction in progress can be significant.

The details of fixed assets are disclosed on the face of the balance sheet or the notes to the financial statements.

Exhibit 3 summarizes some of the common costs of acquiring fixed assets. These costs should be recorded by debiting the related fixed asset account, such as land, building, land improvements, or machinery and equipment.

EXHIBIT 3 Costs of Acquiring Fixed Assets

Only costs necessary for preparing a long-lived asset for use should be included as a cost of the asset. Unnecessary costs that do not increase the asset usefulness are recorded as an expense. For example, the following costs are included as an expense:

• Vandalism

• Mistakes in installation

• Uninsured theft

• Damage during unpacking and installing

• Fines for not obtaining proper permits from governmental agencies

Donated Assets

Civic groups sometimes give land or buildings to a corporation as an incentive to locate or remain in a community. In such cases, the corporation debits the assets for their fair market value and credits a revenue account. To illustrate, assume that on April 28 the Chamber of Commerce of the city of Moraine donates land to Merrick Corporation as an incentive to relocate its headquarters to Moraine. The land was valued at $500,000. Merrick Corporation would record the land as follows:

Nature of Depreciation

As we have discussed in earlier posts, land has an unlimited life and therefore can provide unlimited services. On the other hand, other fixed assets such as equipment, buildings, and land improvements lose their ability, over time, to provide services. As a result, the costs of equipment, buildings, and land improvement should be transferred to expense accounts in a systematic manner during their expected useful lives. Thus periodic transfer of a cost to expense is called depreciation.

The adjusting entry to record depreciation is usually made at the end of each month or at the end of the year. This entry debits Depreciation Expense and credits a contra asset account entitled Accumulated Depreciation or Allowance for Depreciation. The use of a contra asset account allows the original cost to remain unchanged in the fixed asset account.

Factors that cause a decline in the ability of a fixed asset to provide services may be identified as physical depreciation or functional depreciation. Physical depreciation occurs from wear and tear while in use and from the action of the weather. Functional depreciation occurs when a fixed asset is no longer able to provide services at the level for which it was intended. For example, all personal computers made in the 1980s would not be able to provide an internet connection. Such advances in technology have made functional depreciation an increasingly important cause of depreciation.

The term depreciation as used in accounting is often misunderstood because the same term is also used in business to mean a decline in the market value of an asset. However, the amount of a fixed asset's unexpired cost reported in the balance sheet usually does not agree with the amount that could be realized from its sale. Fixed assets are held for use in a business rather than for sale. It is assumed that the business will continue as a going concern. Thus, a decision to dispose of a fixed asset is based mainly on the usefulness of the asset to the business and not on its market value.

Another common misunderstanding is that accounting for depreciation provides cash needed to replace fixed assets as they wear out. This misunderstanding probably occurs because depreciation, unlike most expenses, does not require an outlay of cash in the period in which it is recorded. The cash account is neither increased nor decreased by the periodic entries that transfer the cost of fixed assets to depreciation expense accounts. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 393-397*

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