Assets and Asset Management

From ADempiere
Revision as of 06:07, 2 June 2011 by Red1 (Talk) (Assets and ADempiere)

(diff) ← Older revision | Latest revision (diff) | Newer revision → (diff)
Jump to: navigation, search
This Wiki is read-only for reference purposes to avoid broken links.

Table of Contents{{#if: Table of Contents#Business Features| | Table of Contents#Business Features }}{{#if: | | [[{{{3}}}]] }}{{#if: | | [[{{{4}}}]] }}{{#if: | | [[{{{5}}}]] }} | Assets and Asset Management{{#if: | | [[{{{next}}}]] }} ⇒

Assets and Asset Management refers to long-lived assets and how these assets are amortized over time.

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:

Amortization methods of various long-lived asset types
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 is the method of converting a tangible asset's value into an expense over a finite number of accounting periods. Depreciation is not money - the money the company has is in its cash accounts. It is not tangible. Accumulated depreciation is not a reserve or fund for the future replacement of the asset. It is simply a matching of a portion of the past cost of an asset to future revenue. It is a process of allocation, not valuation.

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:

  1. 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.
  2. 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.)
  3. 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 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

In the periods where the asset is purchased or disposed of, it is common to allocate half of the allotted depreciation expense, regardless of when in the period the asset was actually purchased or disposed. The theory is that the calculation is simple and the number of assets purchased in a year will roughly average together to about the same amount. Given the inexact nature of depreciation, this half-year convention is a justifiably quick way of making the calculation. If you are recording depreciation in other periods than years, such as quarters or months, you can apply the same logic.

Group Depreciation

If each asset in a group of assets is treated individually, the depreciation calculation is called unit depreciation. In some cases where there is a large pool of assets, group depreciation can be used. Group depreciation uses the same processes discussed above but the calculation is based on the value of the entire group of assets.

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 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. The Gain or Loss on Sale of Asset is usually included in other income on the income statement.

The matching concept in accounting requires that any gain or loss be shown in the period that it occurred as an expense. An asset cost that no longer benefits future periods is an expense in the current period. Ideally, there will be no gain or loss - the theory being that companies make money by using their assets not by selling them. The goal is to depreciate the net value of the asset over its service life but the uncertainties involved make that difficult so some gain or loss on disposal is to be expected.

Where the actual sale price defines the market value on disposition, the actual purchase price defined the sale price when the asset was purchased. These two transactions take the market value into account. Between these events, the fluctuations of the market value are ignored. There is one exception in the case of an impaired asset. An impaired asset is one where the future benefit from the asset, as measured by the cash flow it will generate in revenue, is less than the net book value of the asset. In this case the equipment can be written down to its fair market value with the write down being a reduction in income in the current period.

Where assets are traded or exchanged for other assets, the value of the old asset is used in calculating the market cost of the new asset. If the two assets are similar in type or function - an older car traded for a newer car - the value of the trade-in is assumed to be the net book value. If the assets are dissimilar - equipment versus a car - then the value of the trade-in is estimated to be its fair market value. The later case may result in a gain or loss on disposal of the old asset where the former case will have no gain or loss. In both cases, the accumulated depreciation and cost of the asset are removed from the accounts. Also, the list price of the new asset is disregarded.

The difference in these two approaches has to do with the earnings process of the asset. If the asset exchange is similar, there is no change in the earning process. If the assets are dissimilar, then the earning process of the old asset has ended.

If group depreciation methods are being used, no gain or loss on disposal of any single asset is recorded. The asset account is credited with the assets original cost, as described above. The difference between the original cost and the sales proceeds is debited or credited to accumulated depreciation. This process is justified where the gains and losses on the sale of many individual assets are assumed to average out.

Income Tax Considerations

In general, governments, from time to time, provide incentives for companies to invest in fixed assets by allowing substantial tax credits or methods by which the cost of the asset can be used to reduce the income tax payable in an accelerated fashion. The rules around these methods can differ significantly from the rules for reporting on financial statements. Given the complexity of the income tax laws and regulations, it is beyond the scope of this summary to provide examples.

Suffice it to say, corporate income tax laws change frequently so be sure to check with an accountant regarding the current rules.

Leased Assets

In a lease agreement, the owner of property, the lessor, allows the lessee to use the property for a given period of time. The term of this lease or rental agreement can be short compared to the useful life of the asset - in which case the lease is called an operating lease. The lease payments are expenses in the period where they occur. Where the lease term covers a period substantially equal to the useful life of the property, the lease is called a capital lease or financial lease. Assets acquired under a capital lease are treated as if they were purchased and the lease obligation is treated as a long-term liability - a sort of installment loan. The accounting rules state that a lease if a capital lease if one or more of the following four conditions is met:

  1. the ownership of the asset is transferred to the lessee at the end of the lease;
  2. the lessee can purchase the asset for a bargain price;
  3. the lease term is 75% or more of the economic life of the asset; or
  4. the present value of the lease payments is 90% or more of the fair market value of the asset.

Once a capital leased asset has been acquired and the initial entries have been made, the accounting for depreciation and the reduction in the lease obligation are handled as separate, unrelated processes.

Natural Resources

Natural resources such as oil, natural gas, minerals are assets of the company that has the right to extract them. Called wasting assets, the principles for valuing and acquisition cost is the same as for tangible assets: if purchased, the value is the purchase price and any purchasing costs. If the assets are not purchased but discovered there are two differing views on how to account for them. One view is to capitalize all the exploration costs in the year as the value of the reserves. This is called the full-cost method. The other view is to capitalize only the exploration costs that resulting in a find. All other exploration costs are expensed in the period in which they occurred. This is called the successful effort method.

The process by which natural resources are amortized is called depletion. The objective of depletion is the same as for amortization: to amortize current costs over future periods in some systematic manner. The depletion rates are typically based on a units of production method but may also be based on a straight percentage of revenue. Check with an accountant on the details as there are rules related to income tax.

For natural resources that grow (animals, crops, aging products like cheese & wine), the process of value added by growth is called accretion. Normally, since the value is not realized, it is not accounted for in any way. However, the costs of supporting the growth is added to the capital value of the assets just as manufacturing work adds to the value of products.

Appreciation is also recognized in accounting where the value of the asset increases over time. Appreciation is not a process like depreciation and it is only recognized in highly unusual circumstances. Generally, increases in value of an asset are only recognized when revenue is realized and expiration of cost is recognized when it occurs.

Intangible Assets

Intangible long-lived assets - such as goodwill, organization or start-up costs, trademarks and patents - are converted to expenses over a number of periods. The process is simply called amortization and the straight line method must be used unless there is some demonstratively sound reason. The amortization is usually credited directly to the asset account rather than a contra asset account as in depreciation. If the life of the asset is limited by law - as in the case of patents - the amortization period can not be longer.

Intangible assets are either identifiable or unidentifiable. Identifiable intangibles can be individually sold - such as patents or licenses. Unidentifiable intangibles like goodwill, customer loyalty or reputation can't be sold without selling the entire company.

Goodwill is the excess in acquisition cost over the net asset acquired when one company purchases another and occurs only in this type of transaction. As there is no useful way to estimate the life of goodwill and no reliable way to estimate depreciation, companies are free to pick what ever method they want. However, the amortization period can not be longer than 40 years and is typically around 25 years.

Leasehold improvements revert back to the owner at the end of the lease. The amortization period for these improvements can not exceed the length of the lease unless the lease contains renewal agreements and the lessee believes that the extension of the lease is likely.

Deferred charges are expenses that can be capitalized and amortized in future periods. The start-up costs prior to revenue generation may be deferred rather than expensed in periods where there is no revenue. Approaches to this vary widely. In general, deferred charges are amortized quickly usually within five years or less.

Research and Development costs are not capitalized as fixed assets but are expensed in the period in which they occurred. There is a long reason why dating back to 1974. If the R&D was done under a contract, the costs appear as assets in work in progress and are eventually expensed, according to the matching concept, in the period in which the revenue is recognized.

Software Development is a special case and the development costs of the software is considered an expense up to the point where the software is proven technologically feasible as a product. At that point, the costs of preparing the product for market can be capitalized up to the point that the product is released for sale. The amortization rate is typically the greater of the straight line method of the ratio of the years revenue over the total expected revenue for the product.

Assets and ADempiere

So how does all this accounting gobbledegook relate to ADempiere? We shall see. Stay tuned.

See Also