Assets and Asset Management
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Assets and Asset Management refers to long-lived assets and how these assets are amortized over time.
Contents
The Nature of Assets
This section is a summary of information contained in the book Accounting: Text and Cases by Anthony, Reece and Hertenstein.
The definition of what is considered an asset is based on when the benefit from its purchase will be experienced. If the benefits of an acquisition will be experienced in the current period, the costs of the goods or services are an expense. If the purchase will have benefits in future periods, the costs are considered assets in the current period and the expenditures are capitalized. Inventory and pre-paid expenses are assets since they have expected benefits in future periods. Capital Assets or Fixed Assets typically are long-lived and will provide benefits and service for several years.
A capital asset can be thought of as a bundle of services. When a company builds a building or buys a truck, the benefits of the purchase will be experienced over a number of years. The assets is said to be "in service". While the asset is in service, the cost of these services need to be matched to the revenue obtained from its use. The general name for this process is amortization but there are a number of other names used. The portion of the assets costs that are charged to a period are an expense in that period. Eventually, all costs for the assets will be converted to expenses over a period of years.
Types of Long-Lived Assets
The main distinction in the type of assets is between assets that have a physical presence, like a building or vehicle, and assets, like intellectual property, which don't. Tangible Assets refers to the assets that have a physical presence and Intangible Assets refers to items like intellectual property, patents, and other non-physical assets. The common name of the long-lived assets on balance sheets as "property, plant and equipment" but this is often reduced to "fixed assets" simple because it is shorter.
The methods by which an asset is converted to an expense varies with the type of asset, local accounting laws and with corporate policies which are intended to provide consistency across many periods. The following table provides a list of asset types and amortization methods:
| Type of Asset | Amortization Method | |
|---|---|---|
| Tangible Assets | ||
| Land | Not amortized | |
| Plant and equipment | Depreciation | |
| Natural Resources | Depletion | |
| Intangible Assets | ||
| Goodwill | Amortization | |
| Patents, copyrights, etc | Amortization | |
| Leasehold Improvements | Amortization | |
| Deferred Charges | Amortization | |
| Research and Development Costs | Not-capitalized | |
| Marketable Securities | None | |
| Investments | None | |
Purchasing Assets
There are a number of situations where the purchase of a capital assets is treated as a period expense rather than a capital expense that will be amortized over time:
- Small items where the value of the asset is below some threshold are typically expensed in the the period in which they where purchased regardless of how long a life they may have. Hand tools are a good example where the life of the asset may be years but the dollar value of its purchase is not worth recording as an asset. The value threshold is defined by each company and can be vary depending on the size of the organization from a few dollars to several thousand. Small items are included as assets when larger assets are purchased. For example, the capital cost of a new factory will include the cost of the hand tools required to make it operational. However, the eventual replacement of these tools is treated as an expense.
- Betterments or improvements to an asset that increases its value are treated as a capital acquisition. In comparison, a repair - even if it is expensive - that does not add value is treated as a period expense. The difference is the test of increase in value from the work. A repair that extends the useful life of the asset beyond its expected service life can be capitalized. Repairs to a leaky roof would be a period expense. Replacement of an ancient heating-cooling unit could be considered a capital acquisition betterment as it is extending the life of the building.
- Replacements can be either assets or expenses depending on how the asset is defined. If the replacement is a component of a larger asset, then the replacement may well be considered a maintenance expense. In some cases, companies will define a building as a a collection of assets where the plumbing, electrical systems, structure, heating and cooling, elevators are considered separate assets on their own. A direct replacement of an entire asset involves writing off the old asset and adding the new one. Generally, the broader the definition of an asset, the greater the amount of replacement expense that is considered maintenance.
The items included in the cost of the asset include all expenditures that are necessary to make the asset ready for its intended use. In practice, companies can choose to limit the asset costs to the purchase price because it is easier to do so and may reduce the impact of property taxes. When purchasing a truck, for example, the purchase price is easily identified on the bill of sale. In other cases, there main be many costs associated with the asset that need to be identified and gathered to determine the asset cost. Survey fees, broker fees, engineering drawings, environmental studies, permits and licenses, internal labor costs, demolition of previous structures, landscaping, construction, sales tax, equipment, transportation, installation and setup, and system tests are examples of the myriad costs that are part of a large asset acquisition.
Self-Constructed Assets
When a company builds a building or other asset for its own use, the cost of the asset includes all the costs associated with its construction plus portions of the company's indirect costs during the construction and a calculation of the interest costs associated with the financing of the project. (Check with your local accountant about how this applies in your country.) If there was no financing, the company should estimate the interest costs as if the project were financed. The period for the estimation is from the start of construction to the time the asset was essentially ready for use. The inclusion of interest costs increases the asset's value, decreases current expenses and increases depreciation in future years.
Noncash Costs
If an asset is purchased using something other than cash or cash-equivalents (notes or obligations) the value of the asset may not be clearly identified. The general rule is to record the asset at the fair market value of the consideration offered in exchange - the market value of the common stock offered, for example. If this is not possible, then the fair market value of the asset itself is used.
Fortunate Acquisitions
In general, all assets are recorded at their costs. The market value of the asset, as it varies over time, is not reflected in the accounting of the assets value on the balance sheet. In some rare cases, assets are increased in value when, for example, the company receives land as a donation or oil is discovered on recently purchased property. In such cases, the fair market value of the asset is used as the asset costs.
Basket Purchases
Sometimes, the acquisition of an asset includes items that must be broken down on the balance sheet as separate assets. The purchase of a building, for example, may include land. In accounting for the purchase the asset must be separated into building and land as the building will be depreciated over time but the land will remain at its original value. This may require an appraisal of the asset to determine the values of the components.
Depreciation
Depreciation is the method of converting a tangible asset's value into an expense over a finite number of accounting periods. Apart from land, which is considered to last forever, all assets are expected to have a finite life and a portion of the value of the asset is expensed over future accounting periods. In concept, the process is similar to any prepaid expense where the benefit is received over a long period of time. The difference is that where the prepaid expense may have a simple formula, depreciation costs can be difficult to estimate.
The useful life of a tangible asset is limited by obsolescence or deterioration. Deterioration determines the useful life when the asset ceases to be fit for service due to wearing out or some other physical process. Deterioration determines the physical life of the asset. Obsolescence occurs when the asset ceases to be useful do to the introduction of new or improved processes or equipment. Obsolescence determines the service life of the asset. Its important to note that depreciation does not just refer to the wear and tear of physical deterioration. The service life of an asset is in many cases shorter than its physical life with computers being a good example.
Judgments Required
Before depreciation expenses can be calculated, the following three judgments must be made for each asset:
- The service life of the asset or the number of accounting periods over which the asset will be useful to the company. The GAAP rules are clear that the depreciation should be based on an estimate of a realistic useful life. Companies should make these estimates for each of their assets based on their plans for the asset.
- The residual value of the asset at the end of its service life - or the amount expected to be recovered from the sale, trade-in, or salvage of the asset at the end of its service life. The residual value determines the net cost of the asset and it is the net cost that should be depreciated over the service life of the asset. In many cases, the residual value is negligibly small but it is possible that a company will trade-in assets long-before the physical life expires. Vehicle leases are a good example where the service life may only be two years on a vehicle with a physical life of 10 years. The trade in value of the vehicle would be substantial and would represent the residual value of the asset. (Check with your accountant about special tax rules related to the definition of service life and residual value.)
- The depreciation method is the algorithm that will be used to convert the net cost into an depreciation expense in each period of the asset's service life. There are a wide variety of methods. The key is to pick an arguably relevant method and apply it consistently over the service life of the asset.
As these three items are judgments, there is a fair amount of guess work in their determination. The amount of depreciation that results is only an estimate and has no real scientific or even logical validity. The complexity of the equations that result in depreciation estimates accurate to the fraction of a penny tend to give the estimates more credibility than they deserve. Don't overlook that depreciation expenses are in-exact in nature.
Depreciation Methods
In determining how much of the net value of the asset should be assigned to each future period, there is no way to directly measure the actual amount of the asset that was consumed in each period. An indirect approach is required where an estimate of a portion of the net value is applied in each future period. There are many possible ways of making these estimates and any way that is "systematic and rational" is permitted. In general, GAAP allows for multiple depreciation methods to be used within a company. In this case, different methods would apply to different types of assets. Most companies don't use this complexity and a simple straight-line method is used for all assets. A few examples of depreciation methods follow.
Straight Line Method
The Straight Line method assumes the assets provides its value in a steady stream where the depreciation expense in each period is equal over the service life of the asset. The depreciation calculation in each period is simply the net value divided by the number of periods. A ten year service life would see 1/10th of the net value expensed as depreciation in each year. This gives rise to the term depreciation rate as the reciprocal of the service life. Again, a ten year service life would have a depreciation rate of 10%.
Accelerated Methods
An accelerated method can be rationalized in cases where the benefit of the asset is greatest when it is new and diminishes over time. It can be argued that for certain assets, efficiency may degrade and maintenance costs increase over time resulting in decreased benefits. Newer equipment may become available that will make the current asset obsolete. In these cases, the amount of depreciation expensed should be greater in the earlier periods and decrease over time.
There are a number of possible algorithms to model this decreasing depreciation expense. Two approaches are described below:
Declining-Balance Method
The declining balance method calculates the depreciation expense in a period by applying a rate to the net book value of the asset. The net book value of an asset in a period is the original cost less the accumulated depreciation to that period. The residual value is not considered in this calculation. It is common to describe the declining balance rate as a percentage of a straight line rate. For example, if the straight line rate was 10% (a 10 year service life), a declining-balance rate of 200% would represent an annual rate of 200% * 10% = 20%. The 200% declining-balance rate is also known as the double-declining-balance method as the rate is double the straight-line method.
Initially, the depreciation expense will be higher than the straight-line method but will decrease and at some point will be lower than the equivalent straight line amount. At that point, it is common to switch to a straight-line method for the remainder of the assets service life.
Year's-Digits Method
The year's-digits method uses the sum of the digit sequence (sum of year digits or SYD) from 1 to n where n is the service life of the asset. This is the sum 1+2+3+...+n which can be calculated as the combinatorial of n or SYD = n*(n+1) / 2. For n=10, the SYD is 10*(10+1)/2 = 55. Then sequence 10/55 + 9/55 + 8/55 + ... + 1/55 = 1. The sequence is used to determine the amount of depreciation in each period. In year 1 of ten, the depreciation is 10/55 of the net value. In year two, the depreciation rate is 9/55 and so on.
Units of Production Method
The units of production method is used where the value provided by the asset is not assumed to be time-phased. Rather, the value is associated with the units produced by the asset. The depreciation rate is determined by estimating the total production of the asset and dividing that into the net value of the asset. For a vehicle that cost $50,000 and was expected to last for 250,000 kilometers, the value of a unit of production is $0.20/km. In a year where the vehicle traveled 10,000 km, the depreciation would be $2,000.
Accounting for Depreciation
In each period where depreciation is recorded, it appears as a depreciation expense on the income or profit and loss statement. On the balance sheet, the depreciation expense is balanced by a reduction in the net asset value. Like a liability where the net amount owing is reduced by payments, the net asset value remaining is reduced by depreciation expenses until the net asset value reaches the residual value and the asset is considered fully depreciated. GAAP rules require that that the cumulative amount of depreciation expensed appears on the financial statement or in the attached notes. This is usually done by having a contra-asset account called accumulated depreciation or some other name such as allowance for depreciation where the cumulative amounts of depreciation are maintained.
The amount of the asset value left to be depreciated is called the book value or net book value of the asset. This is different than the original cost which is the gross book value. The term book is highlights that this value is an accounting value as opposed to a market or appraisal value.
If the assumptions that gave rise to a depreciation expense change - for example, the useful life is extended for a few years - the depreciation expense charged for the new remaining life of the asset should change as well to ensure the asset is fully depreciated when the end of the useful life is reached. However, because of all the estimates and uncertainties in depreciation, this rarely happens.
Fully Depreciated Assets
Depreciation ceases to be accumulated when the net asset value reaches zero regardless of whether the asset remains in active use. At that point, the original value of the asset has been fully expensed. It is customary to keep the asset "on the books" and show the asset and its accumulated depreciation until such time as the asset is disposed of.
Partial Year Depreciation
Coming soon ...
Disposing of Assets
When an asset is sold or disposed of, it is said to be "written off the books". The process of writing off the asset removes any trace of the asset from the balance sheet. Both the accumulated depreciation account and the fixed asset value are removed from the accounts with the balance (the residual value or sale price) going to cash or accounts receivable. For example, suppose a vehicle was purchased for $50,000. It was expected to be used for four years and then would be sold at its residual value of $10,000. If the vehicle was sold at after four years, the financial accounts would change something like the following
::Cash....................................... 10,000 ::Accumulated Depreciation................... 40,000 :::Fixed Assets.............................. 50,000
If the vehicle was sold for less than 10,000 - say $5,000 - the difference between the sale price and the expected residual value becomes a loss and appears on the income statement as an expense. The
::Cash....................................... 5,000 ::Accumulated Depreciation................... 40,000 ::Loss on Sale of Asset...................... 5,000 :::Fixed Assets.............................. 50,000
Essentially, the residual value is an estimate of the market value of the asset at the end of its life. The actual sale price is, by definition, the market value of the asset. If there is a difference, then the assumptions about the depreciation expenses were also in error and a correction is required in the period where the sale occurs. This can be either a gain or a loss depending on whether the asset was sold for more or less than the residual value. The effect on the fixed asset account and the accumulated depreciation accounts are the same in that the amounts related to the asset are removed.
