Purchase of Fixed Assets

When a fixed asset is purchased, it is recognized as an asset on balance sheet by debiting the asset account and crediting cash or accounts payable or notes payable depending on whether it is a cash purchase, credit purchase or deferred payment.

The expenditure incurred on purchase of fixed assets is called capital expenditure which is recorded as an asset initially and charged to income statement over the useful life of the asset through the process of depreciation.

The amount at which a fixed asset is recognized broadly includes all such costs which are necessary so as to put the asset to its intended use. Cost of acquisition includes the purchase price, taxes, transaction costs (commissions, legal fees, etc.), transportation costs, installation costs, cost of test run (minus income from test run production), decommissioning costs (i.e. costs to be incurred in future to remove the asset), etc. Costs which are not included in the acquisition cost of a fixed asset include the ongoing insurance costs, periodic repair and maintenance costs i.e. such maintenance costs which do not result in improvement in the usefulness of the asset, etc.

When a fixed asset is purchased through deferred payment and the purchase price equals the current cash price of the asset, the asset is recorded at the stated purchase price and the periodic interest is recognized as an expense when it is accrued. However, if the deferred payment purchase of fixed asset is such that no purchase price is mentioned, the asset is recorded at the fair value and the difference between total payments (i.e. the sum of purchase price paid in installments) and the fair value is amortized over the life of the asset.

Example

Aqua, Inc. purchased the following assets during the first quarter of 2018:

  • Asset A: land at a price of $10 million, half of which is required to be paid right away and the rest is to be paid after 1-year subject to a 10% interest rate
  • Asset B: a building with a fair value of $40 million requiring a down payment of $10 million and eight quarterly payment of $4.5 million
  • Asset C: machinery with a purchase price of $10 million, custom duties of $1 million, transportation costs of $0.2 million, installation costs of $1.8 million, present value of decommissioning costs (i.e. asset retirement obligation) of $0.7 million, net testing and commissioning costs of $0.5 million, first-year insurance of $0.2 million.

Asset A must be recorded at the given purchase price using the following journal entry:

Land $10 million
Cash $5 million
Notes payable $5 million

After one year, the remaining payment and associated add-on interest shall be recognized as follows:

Notes payable $5 million
Interest expense ($5 million × 10%) $0.5 million
Cash $5.5 million

Asset B must be recorded at its fair value as follows and the difference between the total payment required and the fair value must be recognized as discount on notes payable:

Buildings $40 million
Discount on notes payable $6 million
Notes payable ($4.5 million × 8) $36 million
Cash $10 million

The discount on notes payable is amortized using the effective interest rate method.

Asset C must be recorded at a cost of $14.2 million by debiting equipment account and crediting accounts payable.

Purchase price $10 million
Custom duties 1 million
Transportation costs 0.2 million
Installation costs 1.8 million
Decommissioning costs 0.7 million
Net testing and commissioning costs 0.5 million
Total acquisition cost 14.2 million

The first year insurance cost is not included in the acquisition cost because it is an on-going revenue expenditure.

Written by Obaidullah Jan, ACA, CFA and last modified on