Fixed assets are those assets that are used in a productive capacity, are tangible (have physical substance), are relatively long-lived, and provide future benefit that is readily measurable, sometimes referred to as property, plant, and equipment [PP&E]. Among the accounting issues that can arise in accounting for fixed assets are: (1) Determination of the amounts at which to initially record the assets, whether acquired through purchase or nonmonetary exchange; or through construction by the reporting entity. Fixed assets can be acquired individually, in groups, or as a part of a business combination. They can also be acquired through foreclosure. (2) Whether management capitalizes discrete assets in groups or separately capitalizes the major individual components of individual assets (unit of account). (3) The proper accounting for postacquisition costs incurred with respect to the assets during their useful lives. (4) The rate and pattern of allocation of amounts capitalized to the proper periods, including, if applicable, periods during which the assets become impaired. (5) Events that cause the assets to be reclassified to or from categories such as held and used, held for sale, or idle. (6) Derecognition—the recording of sale, exchange, retirement and/or disposal of the assets at or before the end of their productive life.
This post addresses some of those accounting issues: It answers questions around fixed asset purchase and costs capitalization. It comes with handy case examples on each of the issues. Enjoy!
Expenses Included in the Capitalized Cost of a Fixed Asset
When a company purchases a fixed asset, it can include several associated expenses in the capitalized cost of the asset. These costs include the sales tax and ownership registration fees (if any). Also, the cost of all freight, insurance, and duties required to bring the asset to the company can be included in the capitalized cost. Further, the cost required to install the asset can be included. Installation costs include the cost to test and break in the asset, which can include the cost of test materials.
Price of a Purchased Fixed Asset
If a fixed asset is acquired for nothing but cash, its recorded cost is the amount of cash paid. However, if the asset is acquired by taking on a payable, such as a stream of debt payments (or taking over the payments that were initially to be made by the seller of the asset), the present value of all future payments yet to be made must also be rolled into the recorded asset cost.
If the stream of future payments contains no stated interest rate, one must be imputed based on market rates when making the present value calculation. If the amount of the payable is not clearly evident at the time of purchase, it is also admissible to record the asset at its fair market value. If an asset is purchased with company stock, assign a value to the assets acquired based on the fair market value of either the stock or the assets, whichever is more easily determinable.
The ABC Motors Company issues 500 shares of its stock to acquire a sheet metal bender. This is a publicly held company, and on the day of the acquisition, its shares were trading for $13.25 each. Since this is an easily determinable value, the cost assigned to the equipment is $6,625 (500 shares times $13.25/ share). A year later, the company has taken itself private and chooses to issue another 750 shares of its stock to acquire a router. In this case, the value of the shares is no longer so easily determined, so the company asks an appraiser to determine the router’s fair value, which she sets at $12,000. In the first transaction, the journal entry was a debit of $6,625 to the fixed asset equipment account and a credit of $6,625 to the common stock account, while the second transaction was to the same accounts, but for $12,000 instead.
Price of a Fixed Asset Obtained through an Exchange
If a company obtains an asset through an exchange involving a dissimilar asset, it should record the incoming asset at the fair market value of the asset for which it was exchanged. However, if this fair value is not readily apparent, the fair value of the incoming asset can be used instead. If no fair market value is readily obtainable for either asset, the net book value of the relinquished asset can be used.
The XYZ Motor Company swaps a file server for an overhead crane. Its file server has a book value of $12,000 (net of accumulated depreciation of $4,000), while the overhead crane has a fair value of $9,500. The company has no information about the fair value of its file server, so XYZ uses its net book value instead to establish a value for the swap. XYZ recognizes a loss of $2,500 on the transaction, as noted in the next entry:
[Debit]. Factory equipment = $9,500
[Debit]. Accumulated depreciation = $4,000
[Debit]. Loss on asset exchange = $2,500
[Credit].Factory equipment = $16,000
Price of a Fixed Asset Obtained with a Trade-in
A company may trade in an existing asset for a new one, along with an additional payment that covers the incremental additional cost of the new asset over that of the old one being traded away. The additional payment portion of this transaction is called “the boot“. When the boot comprises at least 25% of the exchange’s fair value, both entities must record the transaction at the fair value of the assets involved. If the amount of boot is less than 25% of the transaction, the party receiving the boot can recognize a gain in proportion to the amount of boot received.
Case Example-1 (Asset Exchange With At Least 25% Boot)
The XYZ Motor Company trades in a copier for a new one from the Brilliant Copy Company, paying an additional $9,000 as part of the deal. The fair value of the copier traded away is $2,000, while the fair value of the new copier being acquired is $11,000 (with a book value of $12,000, net of $3,500 in accumulated depreciation).
The book value of the copier being traded away is $2,500, net of $5,000 in accumulated depreciation. Because XYZ has paid a combination of $9,000 in cash and $2,500 in the net book value of its existing copier ($11,500 in total) to acquire a new copier with a fair value of $11,000, it must recognize a loss of $500 on the transaction, as noted in the next entry:
[Debit]. Office equipment (new asset) = $11,000
[Debit]. Accumulated depreciation = $5,000
[Debit]. Loss on asset exchange = $500
[Credit]. Office equipment (asset traded away) = $7,500
[Credit]. Cash = $9,000
On the other side of the transaction, Brilliant Copy is accepting a copier with a fair value of $2,000 and $9,000 in cash for a replacement copier with a fair value of $11,000, so its journal entry is:
[Debit]. Cash = $9,000
[Debit]. Office equipment (asset acquired) = $2,000
[Debit]. Accumulated depreciation = $3,500
[Debit]. Loss on sale of asset = $1,000
[Credit]. Office equipment (asset traded away) = $15,500
Example of Asset Exchange With Less Than 25% Boot
As was the case in the last example, the XYZ Motor Company trades in a copier for a new one, but now it pays $2,000 cash and trades in its old copier, with a fair value of $9,000 and a net book value of $9,500 after $5,000 of accumulated depreciation. Also, the fair value of the copier being traded away by Brilliant Copy remains at $11,000, but its net book value drops to $10,000 (still net of accumulated depreciation of $3,500). All other information remains the same. In this case, the proportion of boot paid is 18% ($2,000 cash, divided by total consideration paid of $2,000 cash plus the copier fair value of $9,000). As was the case before, XYZ has paid a total of $11,500 (from a different combination of $9,000 in cash and $2,500 in the net book value of its existing copier) to acquire a new copier with a fair value of $11,000, so it must recognize a loss of $500 on the transaction, as noted in the next entry:
[Debit]. Office equipment (new asset) = $11,000
[Debit]. Accumulated depreciation = $5,000
[Debit]. Loss on asset exchange = $500
[Credit]. Office equipment (asset traded away) = $14,500
[Credit]. Cash = $2,000
The main difference is on the other side of the transaction, where Brilliant Copy is now accepting a copier with a fair value of $9,000 and $2,000 in cash in exchange for a copier with a book value of $10,000, so there is a potential gain of $1,000 on the deal. However, because it receives boot that is less than 25% of the transaction fair value, it recognizes a pro rata gain of $180, which is calculated as the 18% of the deal attributable to the cash payment, multiplied by the $1,000 gain. Brilliant Copy’s journal entry to record the transaction is:
[Debit]. Cash = $2,000
[Debit]. Office equipment (asset acquired) = $8,180
[Debit]. Accumulated depreciation = $3,500
[Credit]. Office equipment (asset traded away) = $$13,500
[Credit]. Gain on asset transfer = $180
Note: In this entry, Brilliant Copy can recognize only a small portion of the gain on the asset transfer, with the remaining portion of the gain being netted against the recorded cost of the acquired asset.
Price of a Group of Fixed Assets
If a group of assets are acquired through a single purchase transaction, the cost should be allocated amongst the assets in the group based on their proportional share of their total fair market values. The fair market value may be difficult to ascertain in many instances, in which case an appraisal value or tax assessment value can be used. It may also be possible to use the present value of estimated cash flows for each asset as the basis for the allocation, though this measure can be subject to considerable variability in the foundation data and also requires a great deal of analysis to obtain.
The XYZ Motor Company acquires three machines for $80,000 as part of the liquidation auction of a competitor. There is no ready market for the machines. XYZ hires an appraiser to determine their value. She judges machines A and B to be worth $42,000 and $18,000, respectively, but can find no basis of comparison for machine C and passes on an appraisal for that item. XYZ’s production manager thinks the net present value of cash flows arising from the use of machine C will be about $35,000. Based on this information, the next costs are allocated to the machines:
Description Value Proportions Costs
Machine A $42,000 44% $35,200
Machine B $18,000 23% $18,400
Machine C $35,000 33% $26,400
Totals $95,000 100% $80,000
Accounting for Improvements to Fixed Assets
Once an asset is put into use, the majority of expenditures related to it must be charged to expense.
- If expenditures are for basic maintenance, not contributing to an asset’s value or extending its usable life, they must be charged to expense.
- If expenditures are considerable in amount and increase the asset’s value, they are charged to the asset capital account, though they will be depreciated only over the predetermined depreciation period.
- If expenditures are considerable in amount and increase the asset’s usable life, they are charged directly to the accumulated depreciation account, effectively reducing the amount of depreciation expense incurred.
- If an existing equipment installation is moved or rearranged, the cost of doing so is charged to expense if there is no measurable benefit in future periods.
- If there is a measurable benefit, the expenditure is capitalized and depreciated over the periods when the increased benefit is expected to occur.
- If an asset must be replaced that is part of a larger piece of equipment, remove the cost and associated accumulated depreciation for the asset to be replaced from the accounting records and recognize any gain or loss on its disposal.
- If there is no record of the subsidiary asset’s cost, ignore this step. In addition, the cost of the replacement asset should be capitalized and depreciated over the remaining term of the larger piece of equipment.
An example of current-period expenditures is routine machine maintenance, such as the replacement of worn-out parts. This expenditure will not change the ability of an asset to perform in a future period and so should be charged to expense within the current period. If repairs are effected in order to repair damage to an asset, this is also a current-period expense. Also, even if an expenditure can be proven to impact future periods, it may still be charged to expense if it is too small to meet the corporate capitalization limit.
- If a repair cost can be proven to have an impact covering more than one accounting period, but not many additional periods into the future, a company can spread the cost over a few months or all months of a single year by recording the expense in an allowance account that is gradually charged off over the course of the year. In this last case, there may be an ongoing expense accrual throughout the year that will be charged off, even in the absence of any major expenses in the early part of the year—the intention being that the company knows that expenses will be incurred later in the year, and chooses to smooth out its expense recognition by recognizing some of the expense prior to it actually being incurred.
- If a company incurs costs to avoid or mitigate environmental contamination, these costs must generally be charged to expense in the current period. The only case in which capitalization is an alternative is when the costs incurred can be demonstrated to reduce or prevent future environmental contamination as well as improve the underlying asset. If so, the asset life associated with these costs should be the period over which environmental contamination is expected to be reduced.
Interest Associated with a Fixed Asset Capitalized
When a company is constructing assets for its own use or as separately identifiable projects intended for sale, it should capitalize as part of the project cost all associated interest expenses. Capitalized interest expenses are calculated based on the interest rate of the debt used to construct the asset or (if there was no new debt) at the weighted-average interest rate the company pays on its other debt.
Interest is not capitalized when its addition would result in no material change in the cost of the resulting asset, or when the construction period is quite short, or when there is no prospect of completing a project. The interest rate is multiplied by the average capital expenditures incurred to construct the targeted asset. The amount of interest expense capitalized is limited to an amount less than or equal to the total amount of interest expense actually incurred by the company during the period of asset construction.
The Lie Dharma Corporation (LDC) is constructing a new launch pad for its suborbital rocket launching business. It pays a contractor $5,000,000 up front and $2,500,000 after the project completion six months later. At the beginning of the project, it issued $15,000,000 in bonds at 9% interest to finance the project as well as other capital needs. The calculation of interest expense to be capitalized is shown next:
Investment Months to Be Interest Interest to Be
Amount Capitalized Rate Capitalized
$5,000,000 6 9%/12 $225,000
2,500,000 0 — 0
There is no interest expense to be capitalized on the final payment of $2,500,000, since it was incurred at the very end of the construction period. LDC accrued $675,000 in total interest expenses during the period when the launch pad was built ($15,000,000 x 9%/12 x 6 months). Since the total expense incurred by the company greatly exceeds the amount of interest to be capitalized for the launch pad, there is no need to reduce the amount of capitalized interest to the level of actual interest expense incurred. Accordingly, LDC’s controller makes the next journal entry to record the capitalization of interest:
[Debit]. Assets (Launch Pad) = $22,500
[Credit]. Interest expense = $22,500
Accounting for a Fixed Asset Disposition
When a company disposes of a fixed asset, it should completely eliminate all record of it from the fixed asset and related accumulated depreciation accounts. In addition, it should recognize a gain or loss on the difference between the net book value of the asset and the price at which it was sold.
Company ABC is selling a machine that was originally purchased for $10,000 and against which $9,000 of depreciation has been recorded. The sale price of the used machine is $1,500. The proper journal entry is to credit the fixed asset account for $10,000 (thereby removing the machine from the fixed asset journal), debit the accumulated depreciation account for $9,000 (thereby removing all related depreciation from the accumulated depreciation account), debit the cash account for $1,500 (to reflect the receipt of cash from the asset sale), and credit the Gain on Sale of Assets account for $500.
Accounting for an Asset Retirement Obligation
There may be identifiable costs associated with an asset disposition that are required by a legal agreement, known as an asset retirement obligation (ARO). For example: a building lease may require the lessee to remove all equipment by the termination date of the lease; the cost of this obligation should be recognized at the time the lease is signed. As another example: the passage of legislation requiring the cleanup of hazardous waste sites would require the recognition of these costs as soon as the legislation is passed.
The amount of ARO recorded is the range of cash flows associated with asset disposition that would be charged by a third party, summarized by their probability weightings. This amount is then discounted at the company’s credit-adjusted risk-free interest rate. The risk-free interest rate can be obtained from the rates at which zerocoupon United States Treasury instruments are selling.
If there are upward adjustments to the amount of the ARO in subsequent periods, these adjustments are accounted for in the same manner, with the present value for each one being derived from the credit-adjusted riskfree rate at the time of the transaction. These incremental transactions are recorded separately in the fixed asset register, though their depreciation periods and methods will all match that of the underlying asset. If a reduction of the ARO occurs in any period, this amount should be recognized as a gain in the current period, with the amount being offset pro rata against all layers of ARO recorded in the fixed asset register.
When an ARO situation arises, the amount of the ARO is added to the fixed asset register for the related asset, with the offset to a liability account that will eventually be depleted when the costs associated with the retirement obligation are actually incurred. The amount of the ARO added to the fixed asset is depreciated under the same method used for the related asset. In subsequent periods, one must also make an entry to accretion expense to reflect ongoing increases in the present value of the ARO, which naturally occurs as the date of the ARO event comes closer to the present date.
The Putra Tire Company installs a tire molding machine in a leased facility. The lease expires in three years, and the company has a legal obligation to remove the machine at that time. The controller polls local equipment removal companies and obtains estimates of $40,000 and $60,000 of what it would cost to remove the machine. She suspects the lower estimate to be inaccurate and so assigns probabilities of 25% and 75% to the two transactions, resulting in the next probability-adjusted estimate:
Cash Flow Assigned Probability-Adjusted
Estimate Probability Cash Flow
$40,000 25% $10,000
$60,000 75% $45,000
She assumes that inflation will average 4% in each of the next three years and so adjusts the $55,000 amount upward by $6,868 to $61,868 to reflect this estimate. Finally, she estimates the company’s credit-adjusted risk-free rate to be 8%, based on the implicit interest rate in its last lease, and uses the 8% figure to arrive at a discount rate of 0.7938. After multiplying this discount rate by the inflation- and probability-adjusted ARO cost of $61,868, she arrives at $49,111 as the figure to add to the machinery asset account as a debit and the asset retirement obligation account as a credit.
In the three following years, she must also make entries to increase the asset retirement obligation account by the amount of increase in the present value of the ARO, which is calculated as:
Year Beginning Inflation Annual Ending
ARO Multiplier Accretion ARO
1 $49,111 8% $3,929 $53,041
2 $53,041 8% $4,243 $57,285
3 $57,285 8% $4,583 $61,868
After three years of accretion entries, the balance in the ARO liability account matches the original inflation and probability-adjusted estimate of the amount of cash flows required to settle the ARO obligation.
Accounting for Donated Assets
If an asset is donated to a company, the receiving company can record the asset at its fair market value, which can be derived from market rates on similar assets, an appraisal, or the net present value of its estimated cash flows.
When a company donates an asset to another entity, it must recognize the fair value of the asset donated, which is netted against its net book value. The difference between the asset’s fair value and its net book value is recognized as either a gain or loss.
The Dharma Company has donated to the local orchestra a portable violin repair workbench from its manufacturing department. The workbench was originally purchased for $15,000, and $6,000 of depreciation has since been charged against it. The workbench can be purchased on the eBay auction site for $8,500, which establishes its fair market value. The company uses the next journal entry to record the transaction:
[Debit]. Charitable donations = $8,500
[Debit]. Accumulated depreciation = $6,000
[Debit]. Loss on property donation = $500
[Credit]. Machinery asset account = $15,000
Accounting for Construction in Progress
If a company constructs its own fixed assets, it should capitalize all direct labor, materials, and overhead costs that are clearly associated with the construction project. In addition, charge to the capital account those fixed overhead costs considered to have ‘‘discernible future benefits’’ related to the project. From a practical perspective, this makes it unlikely that a significant amount of fixed overhead costs should be charged to a capital project.
If a company constructs its own assets, it should compile all costs associated with it into the “construction-in-progress (CIP)“ account. There should be a separate account or journal for each project that is currently under way, so there is no risk of commingling expenses among multiple projects.
The costs that can be included in the CIP account include all costs normally associated with the purchase of a fixed asset as well as the direct materials and direct labor used to construct the asset. In addition, all overhead costs that are reasonably apportioned to the project may be charged to it as well as the depreciation expense associated with any other assets that are used during the construction process.
One may also charge to the CIP account the interest cost of any funds that have been loaned to the company for the express purpose of completing the project. If this approach is used, either use the interest rate associated with a specific loan that was procured to fund the project or the weighted-average rate for a number of company loans, all of which are being used for this purpose. The amount of interest charged in any period should be based on the cumulative amount of expenditures thus far incurred for the project. The amount of interest charged to the project should not exceed the amount of interest actually incurred for all associated loans through the same time period.
Once the project has been completed, all costs should be carried over from the CIP account into one of the established fixed asset accounts, where the new asset is recorded on a summary basis. All of the detail-level costs should be stored for future review. The asset should be depreciated beginning on the day when it is officially completed. Under no circumstances should depreciation begin prior to this point.
Accounting for Leasehold Improvements
When a lessee makes improvements to a property that is being leased from another entity, it can still capitalize the cost of the improvements, but the time period over which these costs can be amortized must be limited to the lesser of the useful life of the improvements or the length of the lease. If the lease has an extension option that would allow the lessee to increase the time period over which it can potentially lease the property, the total period over which the leasehold improvements can be depreciated must still be limited to the initial lease term, on the grounds that there is no certainty that the lessee will accept the lease extension option. This limitation is waived for depreciation purposes only if there is either a bargain renewal option or extensive penalties in the lease contract that would make it highly likely that the lessee would renew the lease.