Fixed Assets

by Obaidullah Jan, ACA, CFA

Fixed assets (also called capital assets or property, plant and equipment (PPE)) are operational assets that generate economic benefits for a business over a long-term period.

For an asset to be classified as a fixed asset, it must be fundamental to the company’s operations. For example, an investment in bonds held over long-term can’t be classified as a fixed asset because it is a non-operating asset. Secondly, the asset must not be expected to be consumed during one financial year or during one operating cycle. For example, inventories can’t be classified as fixed assets because they are expected to be converted to receivables and eventually to cash within one operating cycle. Another consideration in deciding whether an asset should be classified as a fixed asset is whether it exceeds the business’ capitalization limit. Businesses form a policy of expensing all items lower than a certain monetary value, say $100,000, even if they otherwise meet the definition of a fixed asset.

Typical fixed assets include land, buildings, plant and machinery, vehicles, furniture, etc.

Cost

Fixed assets are recorded at their historical cost which includes all such costs which are necessary to put the asset to its intended use. Most common components of a fixed asset’s cost include the invoice amount of the asset, transportation cost to the site of installation, insurance during transit, installation and commissioning cost, cost of consultants and engineers which carry out the installation and cost to be incurred on dismantling the asset upon its decommissioning.

Let’s say your company purchased a fleet of 100 buses, each for $1 million (inclusive of cost, insurance during transit and freight). $300,000 was paid to handling of the buses at the port and $1,200,000 for onward delivery to a facility where you company wants to modify the seats and rebrand them with your company logo and stuff, all costing $50,000 per bus. You financed the buses with an auto-loan at 10% per annum inclusive of insurance charge of 2% over the useful life of the buses, which is 8 years. The buses must be driven for at least 2,000 kilometers or 200 hours before putting them in commercial operations. The cost per bus (driver’s salaries, fuel, etc.) during the trial phase amounts to $10,000 per bus.

The total cost at which the 100 buses should be capitalized works out to $107,500,00 (=$1,000,000 × 100 + $300,000 + $1,200,000 + $50,000 × 200 + $10,000 × 200). We excluded the interest expense and insurance over the life of the buses because these expenses are not required for putting the asset to its intended use.

Depreciation

After initial recognition, fixed assets are depreciated, i.e. their cost is written off as depreciation expense over the useful life of the asset. This is in accordance with the matching concept of accounting which requires that revenues must be matched with associated expenses to get a complete and accurate picture of profit and loss.

Even after they run out of their useful lives, fixed assets have a certain residual value (also called salvage value or scrap value). Fixed assets are depreciated only to the extent of their depreciable amount, which equals cost minus the salvage value.

$$ Depreciable\ Amount\ =\ Cost\ -\ Salvage\ Value $$

The buses in the example about have a useful life of 8 years each and their residual value at the end of 8th year will be 15% of the CIF value i.e. $150,000 (=$1,000,000 × 15%). Salvage value of 100 buses will be $15,000,000. Depreciable amount is hence $92,500,000 (=$107,500,000 - $15,000,000).

There are different depreciation methods: straight-line method, declining balance method, units of production, etc. Straight-line method is the simplest in that it charges the cost of a fixed asset equally over the life of the asset. Declining balance method charges higher depreciation in initial years of the asset’s useful life and the depreciation expense declines over time. Units of production method charges depreciation based on the actual usage of the asset.

Under the straight-line depreciation method, the depreciation expense for first year will be $11,562,500.

$$ Straight\ Line\ Depreciation\ Expense\ =\frac{$107,500,000\ -\ $15,000,000}{8}=$11,562,500\ $$

The cumulative depreciation charged on an asset since its commissioning is called accumulated depreciation. It is parked in a contra-account to the relevant asset’s cost account.

The carrying value (also called book value) of an asset on the balance sheet equals its historical cost minus the accumulated depreciation.

$$ Book\ Value\ =\ Cost\ -\ Accumulated\ Depreciation $$

In the above case, accumulated depreciation at the end of 3rd year shall be $34,687,500 (= 3 × $11,562,500) and the carrying value of the buses on balance sheet shall be $72,812,500 (=$107,500,000 - $35,687,500).