- DepreciationDepreciation is the cost that is allocated to a fixed asset over its useful life.
- Capital Lease AccountingCapital lease accounting refers to the accounting treatment of assets leased by a business under a capital lease agreement.
- Net Book Value (NBV)Net book value is the value of an asset as recorded in the books of accounts of a company.
Fixed assets are company-owned items that are expected to stay within the company for at least a year. Additionally, fixed assets are actively used to help generate income or revenue.
To help you understand the term, focus on ‘fixed.’ Even if the assets are regularly moved from one place to another, they are fixed in the company. In other words, these assets aren’t going anywhere anytime soon.
Fixed assets are reported as Property, Plant, and Equipment (PP&E) on an accountant’s balance sheet. In real-world situations, fixed assets are not always in the form of property used for organizational or productional use, but can also possibly be rental goods as well.
How to Identify Fixed Assets
Some examples of fixed assets include computers, production tools, and buildings owned by a business. Cars can be considered fixed assets, as well, but this is where identifying what is a fixed asset or not can get a bit tricky.
Companies that sell cars do not consider their cars fixed assets. This happens since these businesses do not expect their cars to be sitting out on the lot for long, or specifically, more than a year. In this case, cars are considered inventory. A car rental company, however, just rents their cars, and these cars help the company generate continued revenue. These cars are fixed assets.
When calculating the fixed assets’ value for accounting purposes, you can figure out which historical costs fall under fixed assets by recognizing which company’s spendings contribute to the availability of such assets. To put it simply, the value of fixed assets often does not come exclusively from the total price of bought assets, but also other related expenses.
For instance, when a company purchases a particular amount of computers used for business administration, the underlying fixed assets’ value does not come only from the price of each computer but also possible shipping costs, installation costs as well as other related costs. Why? Because the additional fees are necessary.
On the other hand, potential interest or insurance charges are not taken into account. These costs may exist, but they are not mandatory expenses and don’t directly contribute to the availability of fixed assets. Instead, they are put under a different category.
Depreciation of Fixed Assets
Let’s say you buy a new laptop over a year ago and have used it regularly until now. When you try to sell the laptop, you can’t expect the device to be valued the same as when you buy it brand new. Simply put, your laptop’s value is decreasing over time.
The depreciation of fixed assets follows a similar principle. First, the asset’s initial value is set, which is the value when the asset is purchased. Afterward, the company may apply the accounting convention that lets them implement the write off method for the assets’ value over time. Basically, the asset’s declining value is recorded on the periodical balance sheets.
This is done to ensure a more accurate profit and loss representation to a business’s operation. Furthermore, it also allows the company to spread out the total cost of fixed assets (which is usually expensive) to several years instead of a one time expense.
As part of total expenses, depreciation is also applied to boost the bottom line or net income of the company each year.
Initial value minus depreciation equal to carrying value, i.e., the current value of fixed assets after enforced depreciation are taken into account. Notice that carrying value is not the same as market value. To be fair, we used a laptop sale value or market value as an example before. However, in reality, depreciation works slightly differently.
To determine the value of depreciation, accountants use an established method that would spread out the cost of fixed assets over many years. This could be 5, 8, 10, or any number of years, depending on the expected useful life of the fixed asset.
This way, you can see that depreciation doesn’t directly correlate with market value, which is the real value of an asset on the market. Carrying value may be below, above, or similar to the market value of the assets when the company decides to sell them.
Carrying value brings us to the next concept; salvage value. Salvage value refers to the carrying value of an asset after all of the possible depreciation has been applied. Carrying value would be equal to the salvage value if the asset’s life had reached its end.
For example, let’s say you have a laptop with an expected useful life of seven years. In that case, the carrying value of that laptop would be equal to its salvage value seven years after you initially bought it. You could say that your laptop is ‘salvageable.’
To calculate the depreciation in the long run, normally, a company needs to determine the salvage value of an asset beforehand.
Salvage Value Formula
$$Total\: Depreciation = Initial\: Cost\: –\: Salvage\: Value$$
Using the formula above, an accountant can more easily decide on the value of depreciation for each year. For instance, let’s say that the initial cost of a fixed asset is $100,000, and the salvage value is set to be $10,000. Furthermore, the expected useful life of the asset is ten years.
In this case, the accountant can assign the depreciation expenses of the asset to be $9,000 every year.
Comparing Fixed Assets to Other Indicators
Sometimes, it’s a little difficult to differentiate fixed assets with other indicators such as non-current assets or long-term investments. However, it’s important to recognize which is which. So, let’s take a moment to understand the distinction.
Fixed Assets vs. Non-current Assets
As you may know, assets are a combination of equity plus liabilities. This separation is based on the ownership of total assets. Differently, you can also divide assets into two categories based on their useful lives or liquidity: current assets and non-current assets.
Current or short-term assets are liquid assets that are expected to be turned into cash in 12 months. Differently, non-current or long-term assets are non-liquid assets that are not easily converted into cash and predicted to be used for more than 12 months.
Non-current assets are further divided into four groups; fixed assets, long-term investments, intangible assets, and deferred charges. Fixed assets are a part of non-current assets, but not all long-term assets are fixed assets.
Long-term investments, like bonds, are not considered fixed assets since they are not used for the company’s day-to-day operation. Additionally, long-term intangible assets such as goodwill, copyrights, and trademarks are not fixed assets either since they don’t physically exist but still provide value for the company.
Deferred Charges as Fixed Assets
Deferred charges (a.k.a deferred expenses) happen when a company is paying in advance for services and goods that would only be fully received or consumed in more than a year. In other words, deferred expenses are simply another way to call long-term prepaid expenses. Deferred charges can be in the form of fixed assets, intangible assets, or long-term investments.
Fixed Assets vs. Current Assets
By definition, fixed assets are long-term tangible assets used to run a company’s operation. They are part of non-current assets. In that case, everything that is not expected to be used for a long time are not fixed assets, no matter how ‘tangible’ they are. Some examples include goods ready for sale and raw materials.
For a company to run properly, these physical assets are an essential part. However, they are not expected to stay at the company for a long time. No current asset is subject to periodical depreciation.