Fixed asset accounting is the process of capitalizing the purchase cost, allocating the cost over the asset’s useful life via depreciation, testing the fixed asset for impairment, and removing the fixed asset from the books following a disposal. We go over each in detail and provide examples.
- Fixed assets are long-term assets that are expected to be used for more than one operating cycle. They generate revenue over multiple periods. Therefore, their cost should be deducted against profit over multiple periods.
- Upon purchase of a fixed asset, you need to account for its cost by summing up its price and other costs—such as installation, training, insurance, shipping, and taxes.
- Depreciation happens when you start using the asset, so you need to select a depreciation method that best fits the fixed asset’s usage patterns.
- Disposal of fixed assets happens when the business decides to retire the asset. This involves writing down or removing the fixed asset from the books, including its accumulated depreciation.
- Impairment testing is not mandatory for small businesses that aren’t listed in the stock exchange. However, they may still follow United States Generally Accepted Accounting Principles (US GAAP) rules voluntarily.
- Upward changes in the fixed asset’s value are called revaluations, and the US GAAP explicitly disallowed revaluations for fixed asset valuation.
1. Accounting for the Fixed Asset Cost
The largest chunk of a fixed asset’s cost is its purchase or construction price. However, costs incurred to place the asset in service should also be included in the total cost of the fixed asset. A fundamental bookkeeping task is to determine the total cost of the fixed asset correctly because this amount must be capitalized and placed on the balance sheet as an asset versus being deducted against current earnings.
Here are some examples of expenditures that must be capitalized as the cost of the asset, and you can check out our guide on when to capitalize vs expense to learn more:
Manage your fixed assets using specialized software: Our roundup of the best fixed asset management software recommends leading solutions for managing assets from purchase until disposal.
2. Accounting for Fixed Asset Depreciation
Depreciation is a method of allocating the cost of a fixed asset over the life of the asset. Since fixed assets generate revenue for more than one period, it’s important to deduct the cost of the asset over the same period as the life of the asset.
Common depreciation methods include:
Here’s a quick illustration of depreciation. Let’s assume that we have a fixed asset with a cost of $50,000 and salvage value of $2,000. It has a useful life of five years. By applying the straight line method, our annual depreciation expense would look like this:
Straight line depreciation = ($50,000 – $2,000) ÷ 5 years = $9,600/year
By the end of the asset’s useful life, the book value (cost minus accumulated depreciation) will be its salvage value of $2,000 ($50,000 – $48,000).
You can find additional details about calculating depreciation expense in our article on how depreciation works.
3. Accounting for Impairment
Impairment accounting is a requirement for businesses needing to comply with the US GAAP, such as publicly listed companies. Most small businesses don’t enlist in the stock exchange, so GAAP compliance isn’t mandatory. However, small businesses may freely follow the US GAAP for financial reporting.
US GAAP rules state that companies need to test for impairment when there are signs of impairment. GAAP calls these “triggering events”—which is defined as an event giving rise to the possibility of the asset’s fair value being less than its carrying amount.
Before we proceed to the two-step impairment test, let’s define some accounting terms that will we use repeatedly below:
- Carrying amount is the asset’s cost minus accumulated depreciation. This term is sometimes referred to as book value.
- Fair value is the price of an asset when it is bought or sold in an arm’s length transaction. It is the value that two independent parties (buyer and seller) are willing to pay for to complete the transaction.
- Undiscounted cash flows are cash flows that are not adjusted to incorporate the time value of money.
- Impairment is, in a technical sense, the instance when the asset’s fair value is less than its carrying amount. However, impairment can also be defined as an event that negatively affects a fixed asset value due to severe or total damage, loss of utility, and other external factors.
- Recoverability refers to the fixed asset’s ability to generate substantial future cash flow enough to recover its initial cost.
Step 1: Perform the Recoverability Test
To illustrate the recoverability test, let’s use a sample scenario. Due to continued lockdowns brought by the COVID-19 pandemic, a manufacturing company determined that the pandemic is a triggering event for impairment, especially for its machinery with a carrying amount of $80,000. Based on the company’s best estimates, the machinery can bring only $40,000 undiscounted cash flows if the pandemic continues to paralyze its operations and its supply chain.
Since the undiscounted cash flows of $40,000 is less than the carrying amount of $80,000, the fixed asset is impaired. Hence, we go to the next step.
Step 2: Record Impairment Expense
In our example, we determined that the asset is impaired because it can only generate undiscounted future cash flows of $40,000. We can also say that the future cash flows cannot fully recover the fixed asset’s carrying amount of $80,000. But for impairment computation, we ignore the undiscounted future cash flows and pay attention to the fair value.
Let’s assume that the company determined the fair value of the machinery to be $60,000. Therefore, our impairment expense is $20,000 ($80,000 – $60,000). With this information, we can say that the company is overvaluing the asset at $80,000 when a similar machinery can be purchased for only $60,000—which is why we need to write down the asset to $60,000 to reflect its true value.
The journal entry to record the impairment is:
After posting this journal entry, the new carrying amount of the machinery will be $60,000.
Another concept in fixed asset measurement is revaluation to increase the carrying value of an asset to its fair market value (FMV). Unfortunately, the US GAAP explicitly states that in all instances, fixed assets should not be revalued upward to its FMV. Meanwhile, the International Financial Reporting Standards (IFRS)—the international counterpart of the US GAAP—allows revaluation accounting. This difference makes the IFRS more flexible in fixed asset valuation than the US GAAP.
4. Accounting for a Fixed Asset Disposal
At the end of a fixed asset’s useful life, the business owners can either sell the asset or retire the asset. When we dispose of fixed assets, we need to remove the cost of the asset and its accumulated depreciation from the books. If we sell the asset for more than its book value, we recognize a gain. If we sell it for less than its book value, then we recognize a loss.
By using the preceding example, let’s assume that we sold the asset with a $2,000 book value for $1,100 to a scrap dealer. Our entry to record this disposal transaction would be:
Loss on Sale of Fixed Asset
Read our guide on recording the disposal of fixed assets to learn how to record gains, losses, and exchanges of fixed assets for a variety of disposal scenarios.
Frequently Asked Questions (FAQs)
Fixed assets (technically called as property, plant, and equipment) are comprised of land, buildings, furniture and fixtures, leasehold improvements, computer equipment and software, vehicles, machinery, and tools.
A fixed asset is a noncurrent or long-term asset because of its long life. Current assets, on the other hand, are short-term assets that are expected to be converted into cash within the company’s operating cycle. Our article on assets in accounting has a detailed discussion of long-term vs current assets.
Fixed asset accounting consists of recording the asset’s cost, the periodic depreciation over the asset’s life, impairment testing, and the asset’s eventual disposal. You can get a much better measure of profit and loss if you account for your fixed assets properly versus deducting them when purchased, which is often allowed for federal income tax purposes.