Businesses and not-for-profit entities often invest significant amounts in fixed assets. However, business owners and bookkeepers may struggle with reporting these long-lived assets properly under U.S. Generally Accepted Accounting Principles (GAAP). Here are answers to some frequently asked questions about fixed asset accounting to help you get it right.
What鈥檚 a fixed asset for accounting purposes?
Under GAAP, a fixed asset 鈥 known formally as property, plant and equipment 鈥 is a tangible asset that:
- Has a useful life of more than one year,
- Is used in operations to produce income, and
- Isn鈥檛 intended for resale in the normal course of business.
Importantly, for an item to qualify as a fixed asset, its cost must be 鈥渕aterial鈥 to the entity鈥檚 financial statements. For instance, a stapler wouldn鈥檛 generally qualify, but an office desk likely would be reported under fixed assets, assuming it meets all the other requirements. Additional examples of fixed assets are computers and software, machinery and equipment, company vehicles, buildings, and leasehold improvements.
Accounting Standards Codification Topic 360 requires organizations to capitalize, not expense, such assets when they鈥檙e initially acquired. Special rules apply to leasehold improvements to rental property by a lessee. These fixed assets are capitalized and depreciated over the shorter of 1) the improvement鈥檚 useful life, or 2) the remaining lease term, including reasonably assured renewal periods. Businesses must carefully evaluate a lease agreement when determining the appropriate depreciation period.
Different rules apply for federal tax purposes. Therefore, bookkeepers must maintain separate depreciation schedules for tax and GAAP reporting.
What鈥檚 the capitalization threshold?
Each organization sets a minimum dollar amount 鈥 called a capitalization threshold 鈥 that鈥檚 used to determine whether to capitalize a purchase. For example, if a business sets a threshold of $2,500, it can immediately expense any items costing less than that amount. Items that cost $2,500 or more are recorded as fixed assets on the balance sheet and depreciated over their useful lives, assuming they also meet all the other qualifying criteria. Depreciation appears as an annual expense on the income statement.
Capitalization thresholds vary from organization to organization. Each company sets an appropriate threshold based on its size and financial reporting needs. Businesses should set the capitalization threshold at a level where expensing lower-cost items doesn鈥檛 distort financial results.
What costs are capitalized?
Capitalized costs may include:
- The purchase price, net of any discounts or rebates,
- Sales taxes,
- Shipping and handling,
- Installation and setup costs,
- Legal fees, closing costs, title fees and permits, and
- Site preparation and testing.
Only the costs necessary to prepare the asset for its intended use are capitalizable. Related costs incurred after the asset is ready for use, such as routine maintenance and staff training, must be expensed when incurred. These costs maintain the asset鈥檚 original service level. However, subsequently incurred costs that increase future service potential, such as replacements or improvements, may need to be added to the asset鈥檚 capitalizable costs.
What鈥檚 depreciation?
The term 鈥渄epreciation鈥 refers to the systematic allocation of a fixed asset鈥檚 cost over its useful life. It鈥檚 not a matter of valuation but a means of cost allocation. GAAP requires depreciation to match the expense of using an asset with the periods in which it generates revenue. The matching principle helps present a more accurate picture of financial performance.
Depreciation is calculated using a depreciation base, equal to the asset鈥檚 cost minus its salvage value. Also known as residual value, salvage value is the estimated amount an asset will be worth at the end of its useful life. This is the estimated amount the asset could be sold for when it鈥檚 removed from service. For example, if a $50,000 truck is expected to be worth $5,000 after five years, only $45,000 would be depreciated.
GAAP requires a rational and systematic depreciation approach. Common methods allowed under GAAP include:
- Straight-line depreciation, which allocates equal depreciation each year,
- Double-declining-balance depreciation, an accelerated method that allocates more expense to the early years of the asset鈥檚 life and less in later years, and
- Units-of-production depreciation, based on actual usage, such as machine hours or units produced.
In practice, most small businesses use straight-line depreciation due to its simplicity and consistency.
How is an asset鈥檚 useful life determined?
Useful life is an estimate of how long an asset will be economically productive, not necessarily how long it will physically last. An asset鈥檚 useful life should be based on the following:
- Manufacturer鈥檚 guidelines,
- Industry norms,
- Past experience,
- Technological obsolescence, and
- Expected usage.
There鈥檚 no universal standard for estimating useful lives. However, GAAP requires them to be reasonable and documented. Annual reviews of these estimates can help evaluate whether adjustments are needed for changes in asset usage and technological advances.
How are fixed asset retirements, sales and disposals reported?
When a fixed asset is removed from service 鈥 whether sold, scrapped or fully depreciated 鈥 its cost and accumulated depreciation must be removed from the balance sheet. Any gain or loss is recognized on the income statement. For example, if equipment with a book value of $10,000 is sold for $12,000, a $2,000 gain is recorded. The gain or loss corrects net income for the years during which the fixed asset was used. Ideally, a disposed asset鈥檚 book value would equal its disposal value, but that鈥檚 often not the case.
Bookkeepers should assess at least annually whether:
- Useful lives or salvage values need adjusting,
- Fixed assets are damaged or have become obsolete, or
- Fixed assets are idle or abandoned.
GAAP requires impairment testing when there鈥檚 an indicator that a fixed asset鈥檚 carrying value may not be recoverable. A write-down is required if an asset鈥檚 fair value falls below book value and isn鈥檛 recoverable through future cash flows.
For more information
Proper accounting of fixed assets is essential for transparency and sound decision-making. Bookkeepers must ensure that capitalization policies, depreciation methods and documentation align with U.S. GAAP standards. If you鈥檙e unsure how to account for these assets or encounter special circumstances, contact your CPA.