Accounting for Fixed Assets Accounting for Fixed Assets Second Edition Raymond H. Peterson John Wiley & Sons, Inc. Copyright © 2002 by John Wiley and Sons, Inc. , New York. All rights reserved.
No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744.
Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc. , 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: PERMREQ @ WILEY. COM. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services.
If legal advice or other expert assistance is required, the services of a competent professional person should be sought. This title is also available in print as ISBN 0-471-09210-X. Some content that appears in the print version of this book may not be available in this electronic edition. For more information about Wiley products, visit our web site at www. Wiley. com To a number of people who influenced my life and prepared me for the job of creating this book: First, my mother, who not only taught me to read, but allowed me to experience the enjoyment of reading.
She opened up for me the vast knowledge available in libraries. Dr. Wade Moorehouse, retired Professor of Accounting and former Chairman of the Department of Business and Economics at California State University, Hayward, who many years ago, when I was an undergraduate student in his accounting course, stimulated my excitement about the accounting function. Blessed with classes of fewer than six students in a new university, we spent many class hours discussing the theory of accounting.
These discussions had a large impact on my career direction. Earl Malone, a District Accounting Manager, who early in my career forced me to develop my own thoughts and not just rely on past practice. He also forced me to aquire the skill of dictation, which made the creation of this book a possibility. Dodie Peterson, world’s best secretary, who converted my ramblings into a manuscript. Contents About the Author Preface Chapter 1 What Is Accounting for Fixed Assets?
Introduction Consumption of Benefits Characteristics of Assets Need to Change Chapter 2 What Is an Asset? Introduction Historical Cost Matching Principle Fixed Assets Property Plant Equipment Defining Assets Government Accounting User Fees Not-for-Profit Accounting xv xvii 1 1 3 4 9 11 11 12 13 14 16 17 18 20 22 24 24 vii viii Contents Chapter 3 Classifications of Asset Transactions Introduction Classification Systems Accounting Policy Decisions Coding of Transactions Property Record Coding System 7 27 28 31 33 34 39 39 39 40 44 47 48 49 49 52 52 54 54 55 55 56 57 58 58 59 59 Chapter 4 Determining Base Unit Introduction Definition of Base Unit Purpose of a Base Unit Establishing Base Units Decision Rules Difficulties in Establishment Land Buildings Equipment Criteria for Establishing Base Units Examples Spare Parts Chapter 5 Control of Property, Plant, and Equipment Introduction Asset Accountant Asset Custodian Inventories Property Record System Identification of Assets Farm Owner Applied Numbers Contents ix
Identification of Specific Asset Items to Be Tagged Bar Coded Tags Security Chapter 6 Asset Policies Manual Introduction Purpose Creating the Manual Partial Sample Manual Use of the Manual Property, Plant, and Equipment Custodian’s Responsibilities Responsibilities of Asset Accountant Procedures for Purchase of Physical Assets Approval Limits Minimum Capitalization Level Items Always Charged to Expense Account Transaction Reports Data Definitions Chapter 7 Establishing Value Introduction Historical Cost Other Values Uses of Values Insurance Collateral for a Loan Purchase or Sale of a Complete Business First Creation of Property Record 0 61 64 65 67 67 67 69 69 72 72 73 75 75 75 76 76 77 83 83 84 84 85 86 86 87 87 x Contents
Valuation Techniques Management Information Periodic Assessment of Value Chapter 8 Allocation of Costs to Accounting Periods Introduction Costs of Using up Assets Depreciation Estimated Life Cost Basis Allocation Methods Accelerated Depreciation Other Depreciation Concerns Tax versus Book Depreciation Balance Sheet Disclosure Not-for-Profit Organizations Chapter 9 Regulated Utilities Introduction Differences in GAAP Telecommunications Accounting Basic Property Record Telecommunications Plant in Service Chart of Accounts Railroads Property Accounts Cost of Construction Units of Property List of Units of Property Accounting for Engineering Costs 88 89 90 93 93 94 95 95 96 97 98 99 100 101 101 105 105 106 106 107 109 110 111 111 114 114 115 Contents xi
Common and Contract Motor Carriers of Passengers Carrier Operating Property Depreciation Minor Items Uniform System of Accounts—Tangible Accounts Account Definitions Chapter 10 Government Accounting Introduction Measurement Focus Fund Accounting Funding for Government Assets Accounting Standard Setting Measuring Service Efforts and Accomplishments Current Government GAAP Property Records Infrastructure Assets Measurement of Utilization Establishing Property Record Establishing Property Record Units Infrastructure Property Units Planning Accounting Policies Software Selection Off-the-Shelf Software Chapter 11 Not-for-Profit Accounting Introduction Accounting Definition of Not-for-Profit Organizations 117 117 117 119 119 119 123 123 124 125 126 126 127 128 128 129 130 131 131 131 132 133 134 135 135 136 xii Contents
Accounting Problems of Not-for-Profit Organizations Formal Accounting Standards Need for Change in Not-for-Profit Accounting Accounting for Property, Plant, and Equipment Creating Property Records Property Record System Documentation Chapter 12 Creation and Verification of Property Records Introduction Purpose of Property Record New Concept Requirements for a Physical Asset Database Property Record Units Coding Systems Property Record Codes for Motor Vehicles Other Codes Required Property Record ID Number Maintenance of the Property Record Database Responsibilities of Asset Manager Updating Records Recording Maintenance Costs Verification of Physical Existence Military Commander Approach Foreign Corrupt Practices Act Fully Depreciated Assets Reports from the Property Record System Chapter 13 Computer Programs Introduction Asset Database Software 138 139 140 141 143 145 147 149 149 150 151 152 155 155 156 156 157 158 158 159 160 161 161 163 164 165 167 167 167
One-Write Systems Existing Database Programs Software Selection Off-the-Shelf Property Record Database Packages Review Copies of Software Evaluation of Software Packages Program Review Checklist for Program Review Database Fields Bibliography Index 168 169 169 170 170 171 172 175 176 179 185 xiii About the Author Raymond (Ray) H. Peterson is currently the senior partner of Ray Peterson & Associates, a consulting firm offering business assistance in establishing and changing accounting systems. He has served as the treasurer of a number of nonprofit organizations. He has over thirty years experience as a management accountant with the Bell System. He retired as Director of Financial Accounting with Pacific Bell. Mr. Peterson has managed the design of Pacific Telephone and Telegraph Companies detail property records.
During the three-year breakup of the Bell System, he was appointed to a Federal Communications Commission task force to create a new uniform system of accounts for telephone companies. The proposed system was adopted by the FCC and was installed in all telephone companies. Mr. Peterson served for 12 years on the Institute of Management Accountants Financial Accounting Standards Committee and its predecessor Subcommittee on Management Accounting Statement Promulgation. He received a BS from California State University at Hayward and an MBA from Golden Gate University in San Francisco. He also taught accounting and management information systems at Golden Gate University. xv Preface
Since the first edition of this book in 1994, not much change has occurred to accounting standards for Property, Plant, and Equipment in business. The GAAP promulgated by the Financial Accounting, FASB, has been to further the concept of identifying the cost of an asset and spreading that cost over the accounting periods that benefit. Accounting for contributions, impairments, and financing of assets have been addressed by the FASB. In contrast, much has happened in the areas of Not-for-Profit and Government accounting for fixed assets. FASB ordered the capitalization of assets and charging of depreciation by Not-for-Profits. The government Accounting standards Board was created as an equal to the FASB with the authority and responsibility to promulgate GAAP for governments.
They replaced the Government Finance Officers Association and its “Blue Book”, Governmental Accounting, Auditing, and Financial Reporting as the “official” accounting rules for State and Local government. An early step by the new GASB was to suspend depreciation for “government” not-for-profit accounting. There was a determination of jurisdiction between FASB and GASB which are outlined in Chapter 10, “Government Accounting” and Chapter 11, “Not-For-Profit Accounting. ” Then the GASB issued concept papers that moved government accounting toward the practices long held as appropriate for businesses. These concept papers state that assets should be placed on the books at acquisition cost and that cost spread over the accounting periods they benefit. This is a major change in accounting for these groups.
Past practice was for assets to be purchased and expensed in the current period, if purchased with general revenue, or not even recorded if purchased with bonds or other special revenue sources. There was considerable argument that these changes were not appropriate for governments. Implementation of GASB statement 33 and xvii xviii Preface 34 were delayed, but are now being implemented. The accounting for governments is not the subject of this book and government accountants are referred to GASB and GFOA publications in the bibliography for the details. However, some discussion is included because it will be of interest to the business accountant that is establishing accounting policy for business and not-for-profit organizations.
There has been considerable argument that fixed assets of businesses should be recorded on the books at something different than depreciated original cost, that adjustments should be made to reflect the market value up as well as down, and that book asset accounting should be changed from cost allocation to reflect some measurement of value. The public review and promulgation process of the GASB provide rebuttals to all of those arguments. I urge any accountant that holds those views to research the process that GASB statements 33 and 34 followed, much of which is available on the web site at http://www. gasb. org. This book is designed for accountants and managers who want to get the most from the physical assets of their organizations. Most readers are already familiar with the oncepts and practical application of total quality management (TQM) zero defects, and the other procedures that describe a continued process of improvement. Having made the process and management changes that brought about easy improvements in quality and cost reduction they are ready to answer the following questions: How are you applying the principles of continuous improvement to the management of property, plant, and equipment? Do you have a process in place that allows you to monitor the status of maintenance (or deferred maintenance) on your property, plant, and equipment? What is the age of the oldest piece of your production equipment? Do you have a plan in place for replacement of production facilities?
Are there any quality problems in your production or service delivery system caused by property, plant, and equipment failures? What is the utilization percentage of the property, plant, and equipment? Can you determine the utilization of your most expensive piece of equipment? Do you have service or production problems attributable to equipment not being available at the place needed? Are all of your property, plant, and equipment being utilized to their fullest? Preface xix Do you have in place a process that monitors the current condition, evaluates the future need for replacement, and brings to your attention needs to modify that plan? Do you manage your physical assets or do you put them in place, use them, and replace them when they are worn out?
Do your plans include having the necessary cash to purchase replacement physical assets or will you have to do an extraordinary financing or fund-raising when you are surprised by their failure? Is there a plan in place for overall management or do you simply hope your assets will continue to allow you to produce your product or provide your service? The purpose of providing this book on accounting for property, plant, and equipment, is to provide the framework for you to install in your organization accounting processes and procedures that will allow you to manage long-term physical assets. How can a book on assets help answer these questions? All accounting students learn the basics bout assets within various accounting courses, however, there really is not much definitive information available on fixed assets in the accounting literature. The Accounting Principles Board and the Financial Accounting Standards Board are both silent on the subject of accounting standards for fixed assets. Lacking a primary source for accounting standards, it is necessary to look to secondary sources, which also contain very little information on the handling of assets. Most accounting textbooks devote only a single chapter to capitalization of assets, and do not cover the subject in depth. Accounting periodicals have focused on valuation of assets, but offer little on specific concepts of capitalization.
The issue of valuing at historical cost versus current market price has received considerable interest over the years. Now the FASB has issued statement 93 requiring not-for-profits to use historical cost less depreciation asset accounting. GASB has issued statements 33 and 34 that require that accounting for all but a few assets. It is even more important to have this single reference to bring all these prospectives together. A number of organizations including the American Institute of Certified Public Accountants, the Institute of Management Accountants, and the Government Finance Officers Association offer courses on capitalization of assets. Most of these courses, however, cover either the tax implications of assets or the valuation question.
Little in these courses describes how to establish asset policies, document them in a manual, and apply them within the company. xx Preface During 1989-1990, the National Association of Accountants (now the Institute of Management Accountants) replaced their original Statement on Management Accounting (SMA) on Fixed Assets with two statements relating to accounting for property, plant, and equipment. SMA 4J, published in 1989, described the accounting for property, plant, and equipment, and SMA 4L, published in 1990, covers control of property, plant, and equipment. A research issues publication called the Reporting, Control, and Analysis of Property, Plant, and Equipment was published in 1990.
This collection of publications represents the majority of the available information on accounting for fixed assets. As a part of the IMA team coordinating those projects, I became convinced this book was needed. There is a need to emphasize that assets must be managed, not just purchased, used up, and replaced. The objective is to provide not only accounting for assets, but include that accounting in a process that will allow management to get the most out of the company’s investment. It is not always possible to create more debt in order to acquire assets. Therefore, some of our consumption must be sacrificed today in order to provide quality assets for tomorrow.
In today’s complex business best quality and maximum utilization are going to give the best return on investment. Accounting for Fixed Assets contains more than the routine accounting processes. It also has the management framework that must surround the accounting process. The United States economy has been built since World War II as “a paper plate society. ” We rapidly built our economy based on the philosophy of quick production without much concern for quality. We built automobiles that only lasted a few years, and, in fact, are still building houses in the same way that we did in the early 1950s. They require major renovation every fifteen or twenty years.
Many of the houses of the early 1950s are currently the subject of redevelopment districts: they either require major repair or must be ripped out and replaced. We have built a tremendous economy and brought the majority of citizens to the highest standard of living of any culture with this “doit-quick” philosophy. It created many jobs, especially at the unskilled and semiskilled level, and brought the pleasure of accomplishment and the fruits of labor to the largest segment of U. S. citizens quickly. We have done so, however, for the sake of today and at the expense of tomorrow. But tomorrow has arrived, and we cannot continue to use up our assets. Those assets capable of bringing future benefits must be managed in a way that will allow those future benefits to occur. Preface xxi
The European and Japanese economies have grown much more slowly; jobs and the rewards that come from labors are just now reaching many segments of those cultures. However, the infrastructure base there, the assets like roads, houses, and other buildings, constructed in the 1950s is still in use and not in need of major repairs. A complete difference in philosophical approach was used in building the base for their economies. They have not sacrificed tomorrow for today, but in fact sacrificed yesterday for today—and today has arrived. Assets are those things we purchase today that will bring future benefits. But those assets must be managed to get those future benefits.
To compete in a level playing field across the world, instead of in one where we make all the rules, we in the United States must evaluate our present practices. We can no longer afford to put two or three times the percentage of our gross national product into the nation’s dumps each year than competing countries do. We can no longer approach the building and operating of our businesses as we did during World War II. We learned there that we can build things quickly if they are only needed for a few years or are abandoned on the battlefield. Much of our managerial approach to business assets is alarmingly similar: build it, use it, and throw it away.
To many, it is even worse than that; we buy it and don’t think about it again until it is worn out or disrupts the production line. Accounting managers must rethink their accounting processes for assets. To be value-added, accounting information must be simple and understandable, and must provide relevant, timely information to those who make decisions based on it. My goal in producing this book is not just to provide a comprehensive treatment of the details of accounting for fixed assets, but also to provide the management accountant with the processes to provide good relevant decision-making information for the officers of the company. Also, I provide the processes that are necessary to manage those assets.
The book is organized to allow you to skip over the initial processes necessary to the system, and understand the principles and philosophy that are necessary in managing assets. I will also suggest a different approach to management of assets. An asset is current production that is not used up, and instead provides the means for future productivity. A hundred years ago, assets were known by business people as capital goods. Capital goods are something that must be managed for the future, not just to benefit current quarter earnings. Accounting for Fixed Assets 1 What Is Accounting for Fixed Assets? INTRODUCTION Most accounting professionals believe that all there is to be learned about asset accounting occurred in the introductory course on principles of accounting.
Therefore, although this subject can become quite complex, it has not been explored in the accounting literature. In 1984 when the Federal Communications Commission (FCC) called for the rewriting of the uniform system of accounts for telephone companies, public utilities had not been following generally accepted accounting principles (GAAP) as outlined by the Financial Accounting Standards Board (FASB) and its predecessors, but instead used procedures that had been outlined in 1934 by the FCC. The team responsible for making recommendations on the rewriting of the system of accounts established a basic policy that what was to be recommended would comply with current GAAP.
The subcommittee responsible for reviewing and recommending procedures for property, plant, and equipment was frustrated by the lack of definitive information on accounting for assets. The primary sources are very limited. The Accounting Principles Board (APB) and the later FASB have been nearly silent on the subject beyond defining depreciation and historical costs. Accounting Research Bulletin (ARB) 43 was issued in 1953 to summarize all previous GAAP. It requires that depreciation be calculated 1 2 What Is Accounting for Fixed Assets? and disclosed. Most of the additional discussion on tangible assets involved explaining why depreciation is appropriately calculated using historical costs.
It is true that management must take into consideration the probability that plant and machinery will have to be replaced at cost much greater than those of the facilities now in use; however, depreciation must not be calculated on the basis of this expected inflation. ARB 43 in paragraph C5 goes on to state: The cost of a reproductive facility is one of the costs of the services it renders during its useful economic life. Generally accepted accounting principles require that this cost be spread over the expected useful life of the facility in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the facility.
This procedure is known as depreciation accounting, a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational matter. It is a process of allocation, not of valuation. After formation of the Accounting Principles Board, APB 6 was issued in 1964 continuing the authority outlined in ARB 43. The Board continued to support the use of historical cost as opposed to inflation accounting: The Board is of the opinion that property, plant, and equipment should not be written up by an entity to reflect appraisal, market or current values which are above cost to the entity. APB 12, issued in 1967, requires the disclosure of depreciable assets and depreciation.
In addition to total depreciation expense and the major classes of depreciable assets, it also requires disclosure of: • Depreciation expense for the period. • Balances of major classes of depreciable assets by nature of function, at the balance sheet date. • Accumulated depreciation, either by major classes of depreciable assets or in total, at the balance sheet date. Consumption of Benefits • A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets. CONSUMPTION OF BENEFITS 3 In 1984, the FASB issued Concept Statement 5, which included additional discussion of assets. However, it was also limited in scope, as one would expect in a concept statement.
The discussion emphasized the recognition assumption of assets, clearly indicating that assets are consumed by their use and the cost should be recognized in the accounting periods of their life. Consumption of economic benefits during a period may be recognized either directly or by relating it to revenues recognized during the period. Some expenses such as depreciation and insurance are allocated by systematic and rational procedures to the period during which the related assets are expected to provide benefits. “Any expense or loss (in future benefits) is recognized if it becomes evident that previously recognized future economic benefits of an asset have been reduced or eliminated. Since its creation, the FASB has entertained considerable discussion about assets, but the only statements issued cover specific assets: • • • • • Expensing versus capitalizing research and development The accounting for software Depreciation in not-for-profit organization financial statements Impairment of Assets Involuntary Conversions FASB Concept Statement 6, Elements of Financial Statements, has more material than any other on the accounting for long-term tangible assets. However, it addresses itself primarily to the definition, the purpose of accrual accounting, and the characteristics of an asset. In 1985, Concept Statement 6 added a definition of assets: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. 4 What Is Accounting for Fixed Assets?
CHARACTERISTICS OF ASSETS Concept Statement 6 continues, enumerating the three essential characteristics of an asset: • It embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to combine directly or indirectly to future net cash in flows. • A particular entity can obtain the benefit and control others’ access to it. • The transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred. This is the first discussion in promulgated accounting rules discussing the definition and characteristics of an asset. The major thrust is that probable future benefit is the definition of an asset.
To reflect it on the balance sheet, the entity must be able to obtain benefit from the asset and control others’ access to the asset. This statement also reviews the concept of future economic benefit and service potential as it relates to not-for-profit organizations. It states: In a not-for-profit organization, the service potential or future economic benefit is used to provide desired or needed goods or services to beneficiaries or other constituents, which may or may not directly result in net cash inflows to the organizations. Some not-for-profit organizations rely significantly on contributions or donations of cash to supplement selling prices. . . This discussion introduces the argument that depreciation of tangible assets is an appropriate expense of not-for-profit organizations. In a discussion of accrual accounting, Concept Statement 6 discusses assets under a heading “Recognition, Matching, and Allocation. ” In paragraph 145, it states: Accrual accounting uses accrual, deferral, and allocation procedures whose goal is to relate revenues, expenses, gains, and losses to periods to reflect an entity’s performance during a period instead of merely listing its cash receipts and outlays . . . the goal of accrual accounting is to account in the periods in which they occur for the effects on an entity of transactions and
Characteristics of Assets other events and circumstances, to the extent that those financial effects are recognizable and measurable. 5 There is a discussion of costs and revenues to determine profits for periods. Depreciation and assets are excluded from the matching concept. Paragraph 149 of Concept Statement 6 explains: However, many assets yield their benefit to an entity over several periods, for example, prepaid insurance, buildings, and various kinds of equipment. Expenses resulting from their use are normally allocated to the periods of the estimated useful lives (the periods over which they are expected to provide benefits) by a rational allocation procedure, for example, by recognizing depreciation or other amortization.
Although the purpose of expense allocation is the same as that of other expense recognition—to reflect the using up of assets as a result of transactions or other events or circumstances affecting an entity—allocation is applied if causal relations are generally, but not specifically, identified. For example, wear and tear from use is known to be a major cause of the expense called depreciation, but the amount of depreciation caused by wear and tear in a period normally cannot be measured. This discussion appears to make the distinction between the matching principle for revenues and expenses and the allocation of the cost of using up future benefits. Although this distinction is subtle, it is the point of basic disagreement between those who argue for inflation accounting and the depreciating of assets based on current market value and those who argue for depreciating using a lesser historical cost.
Appendix B of Concept Statement 6 further discusses characteristics of assets, defining assets as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. ” Most of this discussion relates to intangible or nonphysical assets. The FASB, in issuing its Statement 2, Accounting for Research and Development Costs, also gives us some information on what makes up tangible physical assets. In their concern for the appropriate accounting for research and development costs, they conclude that all should be charged to expense accounts. However, they do give us their thoughts 6 What Is Accounting for Fixed Assets? bout which tangible assets should and should not be included in research and development costs. A prime consideration is that materials, equipment, and facilities that have an alternative future use (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed. However, the costs of such materials, equipment, or facilities that are acquired or constructed for a particular research and development project and have no alternative future uses and therefore no separate economic values are research and development costs at the time the costs are incurred. All research and development costs encompassed by the statement are charged to expense when incurred.
This reflects the concept that research and development costs will be used up during the span of the research project. Tangible assets that have a life beyond the current project, however, should be capitalized and depreciated over their useful lives. The preceding paragraphs summarize the present state of GAAP relating to property, plant, and equipment. Many subjects in accounting have not been covered at length within the promulgated statements. Most with the significance of longterm tangible assets have been covered in more detail in secondary accounting material, but few secondary publications provide any indepth discussion on fixed assets.
Research bulletins and disclosure drafts having to do with inflation accounting have not been allowed to creep into generally accepted accounting principles. Therefore, in determining the details of an accounting system for property, plant, and equipment with the FCC study in 1984 and 1985, the committee felt it necessary to use the secondary documents on assets. The documents were used to establish current practice and to form a model that telecommunications companies should use instead of the 1934 FCC regulations. The only additional definitive document discussing accounting for property, plant, and equipment was issued by the Institute of Management Accountants (IMA, formerly the National Association of Accountants) as Statement on Management Accounting (SMA) 4.
SMA 4 was issued in October 1972 with the title, Fixed Asset Accounting: The Capitalization of Cost. Several concepts outlined in the twenty-four-page statement include the following: Costs through preparation for use Extraordinary repairs Base unit Characteristics of Assets Extended life or increased capacity Written policies Capitalization policy Life greater than one year Self-constructed assets that include direct overhead No initial development cost Depreciation 7 The SMA 4 discusses a number of concepts which were then, and still are, common practice. All Costs to Prepare Item for Use All costs in addition to the invoice price to make an item of property, plant, and equipment ready for use should be capitalized in its historical cost.
Extraordinary Repairs Normal repairs are charged to expense when incurred; however, extraordinary repairs that extend the life, increase the capability, or increase efficiency of the item should be capitalized during its life, the historical cost increased, and depreciation recalculated from that date forward. Base Unit The base unit concept is not dealt with in any other document. It outlines the concept that property units should have a policy determination as to what constitutes the property record entity that is capitalized. The base unit might be a complete machine or the individual components of that machine. This concept is important when establishing a usable property record system for a particular company. For example, entities that use light trucks as maintenance vehicles may wear out a number of trucks during the lives of hydraulic lifts, welding equipment, and utility beds.
Written Policies It is important for each company to have an asset manual with written policies. Determinations of appropriate base units and other policies unique to a company must be described and documented. Without written policies, asset accounting will not be consistent over a period of time. 8 What Is Accounting for Fixed Assets? Capitalization Policy A minimum level of capitalization should be identified. Accounting records that cost more than the items are worth are not cost effective. Life Greater than One Year Policy should emphasize that items with a life restricted to one accounting period should be expensed no matter what their cost.
Self-Constructed Assets All costs of preparing assets for use should be capitalized; however, only directly attributable or traceable overhead costs should be included. General and administrative overhead costs should not be capitalized. If a company is not in the business of constructing assets, overhead costs are not likely to be increased by an individual construction project. Therefore, if those costs were capitalized, expenses in the accounting period that the asset was being constructed would be improperly reduced. Additionally, the initial development cost of making a decision on which project to construct should not be included in capitalizable costs. Subsequent costs for a specific project, once the decision has been made, are capitalized.
Depreciation The idea of the relative permanence of assets that are “fixed” is questioned by SMA 4. The statement notes that periods of nonuse should be excluded from the depreciation schedule: “Until these assets can be said to have completely satisfied the purpose for which they are intended— normal or acceptable production capability—they are, for the time being, suspended accounting-wise in a sort of hiatus, not producing income, hence not triggering depreciation against which it is to be set. ” SMA 4 was replaced in 1989 and 1990 by Statements 4J, Accounting for Property, Plant, and Equipment, and 4L, Control of Property, Plant, and Equipment.
These two documents were prepared from a research project published by the IMA Research Committee, reporting control and analysis of property, plant, and equipment. In other documents the discussion of accounting for fixed or physical assets is limited to a chapter, or a few paragraphs in accounting textbooks. No lengthy document has been published that brings all the concepts of accounting for property, plant, and equipment together. Need to Change 9 There are many articles on fixed assets in accounting magazines such as Strategic Finance, published by the Institute of Management Accountants (IMA) and the Journal of Accountancy, published by the American Institute of Certified Public Accountants (AICPA). Most of these articles discuss theoretical issues of inflation accounting and depreciation.
There are a number of accounting courses offered by such organizations as the IMA, AICPA, and the American Management Association, as well as by a number of accounting and appraisal firms. However, these courses are mostly directed toward the tax requirements of accounting for depreciation. Similarly, there are numerous off-the-shelf personal computer programs aimed at fixed asset accounting. Again, the primary purpose is to fulfill tax requirements and generate depreciation entries. Only a few provide for comprehensive property records. NEED TO CHANGE It has become obvious that management must change the manner in which they approach long-term tangible assets. The many production facilities built in the United States are wearing out.
Government infrastructures of roads, sewers, sidewalks, and utilities are all suffering from the concept of “put it in place and forget about it. ” The need is to get the most use out of these tangible assets. Much of the discussion having to do with inflation accounting for assets revolves around the problem that depreciation is not sufficient to cover the replacement costs of assets. The high cost of replacements, the dwindling supply of capital available, and high interest rates all require that new management control systems be put into place. With adequate control, management, and measurement of asset utilization, organizations can maximize the benefits from their investment in long-lived, tangible assets. 2 What Is an Asset?
INTRODUCTION According to the Financial Accounting Standards Board Concepts Statement 6, assets are “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. ” The Institute of Management Accountants’ Accounting Glossary adds a second definition as “any owned physical object (tangible) or right (intangible) having economic value to its owners; an item or source of wealth with continuing benefits for future periods, expressed, for accounting purposes, in terms of its cost, or other value, such as current replacement cost. Future periods refers to the following year or years. ” (SMA 2A) In its broadest sense, an asset is anything that will probably bring future economic benefit.
In looking at assets, the focus will be on longlived tangible assets, sometimes referred to as fixed assets or property, plant, and equipment. Assets are classified into two categories: tangible and intangible. Tangible assets are assets that one can touch, hold, or feel. Typically called fixed assets in accounting literature, tangible assets are the physical things that a business uses in the production of goods and services. They constitute the production facilities, buildings, equipment, and vehicles. These operational assets of a business include furniture, computers, and similar items not used up within a year. Intangible assets are primarily financing items: stocks, bonds, mortgages, etc.
These assets are outside the scope of this book. 11 12 What Is an Asset? Assets that are converted into cash during the normal production cycle are current. Current physical assets are referred to as financial assets. These are physical assets such as raw materials, work-in-progress inventories, finished goods, and goods held for resale. Physical items can be financial assets, held in inventory, in one business, whereas in other businesses or applications they may be fixed assets. An example of such a financial asset would be real estate held in inventory by a real estate investment and sales organization or builder, which would be a fixed asset for everyone else.
Equipment manufacturers have financial assets in finished goods or inventory held for sale, as well as plant and equipment that will be sold to other businesses. The inventory is a financial asset; when sold for use in a production line it becomes a fixed asset to the purchaser. HISTORICAL COST Historically, asset accounting has not stimulated the interest of accountants and managers in the United States. Assets have been analyzed in depth in terms of alternatives and appropriateness of the investment prior to purchase. However, once acquired and put in place, assets such as buildings, furniture, production equipment, and motor vehicles are given little attention.
Where management attention has been focused, it has been in terms of return on investment and major tax benefits, such as investment tax credits and accelerated depreciation expense allowed on tax returns. In fact, these government tax incentives to buy new equipment in order to stimulate the economy have influenced management to replace still-useful assets that have been depreciated on the tax records. But there is a new perspective emerging on the part of managers and accountants with respect to fixed assets. The high initial cost to purchase, as well as the high carrying costs of debt, require a rethinking of the management of fixed assets.
Many of the same factors that are bringing about just-in-time accounting philosophies and zerodefect quality control within the manufacturing process are also influencing managers’ perspectives on asset management. Zero defects and quality circles of employees are aimed to reduce the high cost of lessthan-perfect products and reflect today’s need for greater precision. To accomplish this higher quality production, it is necessary to have highquality production equipment. This requires preventative maintenance to keep closer tolerances and less downtime. Equipment that Matching Principle 13 fails during a production run leads to extremely high cost when the line stops.
Preventative maintenance is being regularly scheduled on either an hours-of-use or calendar basis. This approach has begun to replace the attitude of put it in, use it, if it breaks repair it; if it breaks too many times, discard it and replace it. In addition to the requirements of modern processing, a new perspective on the need to manage assets—those things that you have saved and paid for which will bring future benefits to the business— has come about as a result of the significant debt held by many businesses. The public’s attention has been caught by the high government deficit, which must be financed by acquiring increasingly more debt.
Large existing debt and the threat of higher interest rates on new debt due to the lower financial ratings are causing many managers to reconsider how to manage the assets they already have. Getting the maximum future value out of existing buildings and production equipment has become a more important aspect of management. In addition to process requirements and debt concerns, the cost of disposal is also growing at an alarming rate. Replacing individual parts instead of entire machines will reduce the production of refuse. In the past, accounting records of assets have been kept primarily for the purpose of establishing balance sheet amounts. The historical cost of purchasing or constructing the physical asset is included in the accounting property record.
This amount, less depreciation, provides the basis for a return on investment calculation, the division of net assets (original cost less book depreciation) by net income. MATCHING PRINCIPLE The matching principle of accounting calls for the matching of costs with the accounting period those costs benefit. The purpose of the historical cost record is to ensure that the costs incurred in the purchase of assets in a past accounting period will be spread over the future accounting periods that benefit. The costs recorded for each asset acquired include the purchase price and anything necessary to make it ready for production. All expenditures involved in the acquisition of an asset and getting it ready for use are capitalized as part of original cost.
Included are the invoice price for the asset, transportation charges, and installation costs, including any construction or changes to the building necessary to house it. Other incidental costs are sales or use tax, duties on imported items, 14 What Is an Asset? and testing and initial setup costs. The total costs of acquiring and putting the asset into actual production use should be capitalized. The use in production at a reasonable production rate (as opposed to limited use during testing) is also the point where capitalization stops on the new asset and depreciation begins. The cost of an asset must be spread on a rational, systematic basis over the periods of its useful life. This limited accounting application of historical cost records has led to many incorrect decisions regarding asset management.
Recognizing this limitation, however, does not mean historical costs records are not necessary. Records must be established to provide information on location, maintenance history, and future usefulness of assets. Today’s high costs of debt and the need to safeguard physical assets requires going beyond the matching principle in creating property records. FIXED ASSETS Historically, even the term that accountants use for the long-lived tangible assets of business, that is, fixed assets, expressed the opinion that once purchased it is fixed, long term, and does not require management attention. In the last few years, the more common “property, plant, and equipment” has been used to describe the operational assets of a business.
Managers have found it necessary to provide additional information about property, plant, and equipment and created records separate from the accounting property record. Additional information includes current market value for insurance and security purposes, and utilization and maintenance records. A single accounting record of tangible assets with normal accounting controls is far superior to multiple records. This integrated record with accounting controls has been made much simpler with the advent and widespread use of small computers. For example, recording maintenance expenses for large equipment items is now easy. In a motor vehicle fleet, actual maintenance costs can be recorded in the property record of each vehicle.
This allows review to ensure preventative maintenance is scheduled and also to establish criteria for disposing of older motor vehicles when they are no longer economical to maintain. It then becomes possible to evaluate motor vehicles based on their entire maintenance record, rather than retiring vehicles based on age or mileage alone. What are assets fixed in? Are they fixed in time, space, or value? It is doubtful that they are fixed at all. IMA defines fixed assets as Fixed Assets 15 “noncurrent, nonmonetary tangible assets used in normal operations of a business. ” See property, plant, and equipment in SMA 2A. Past practice has been to handle fixed assets as a “sunk cost,” a past cost which cannot now be reversed and, hence, should not enter into current decisions.
Differential cost is “the cost that is expected to be different if one course of action is adopted as compared with the costs of an alternative course of action; used in decision making. Contrast with sunk costs. ” (SMA 2A) If it is a fixed cost, then it is also a sunk cost. Is it really an asset if you cannot sell it? If you cannot move it, modify it, or maintain it? Those are alternative actions; therefore, historical cost of property, plant, and equipment are differential costs, not sunk costs. The term “fixed” cost implies a sunk cost. This management treatment of fixed costs as sunk costs may encourage hostile takeovers using junk bonds.
If the current management and stockholders ignore the alternative uses of their long-term tangible assets, an outsider may see a much greater short-term value. In a case like this the current managers and owners are treating the fixed assets as a sunk cost instead of a differential cost. Few assets are fixed in any way. Most are mobile, and will disappear if not accounted for or deteriorate if not maintained. Many increase in value just because of inflation. If they do not increase in value, their replacement cost certainly increases. Typically, insurance policies require that coverage be at least 80 percent of replacement cost or recovery is limited to market value prior to the loss.
Even the government is learning that their fixed asset theory for infrastructure assets needs amendment. Roads, bridges, sewer plants, and buildings seem to be in need of replacement at the same time, because they were put in place and ignored. No plan was prepared to manage them, to determine the best maintenance practice. Now they are not assets, but sources of liability. While government has a limited liability from suits due to personal injury resulting from improper maintenance of roads, etc. , businesses do not enjoy this limitation. If an employee or customer is injured by one of your bridges, roads, or other holdings, you are responsible for the costs.
Is that driveway or parking lot really a fixed asset? Or one to be managed so it will not become a liability? It is difficult to imagine something that should be called a fixed asset. Assets are not fixed in any way—not in place, time, or future income 16 What Is an Asset? or expense. The exception might be a work of art or historical treasure; however, even these items, if not protected, will deteriorate. In defining assets, therefore, we shall use the terms property, plant, and equipment and avoid future use of the term fixed assets, which is in reality an obsolete term for property, plant, and equipment. PROPERTY Property includes lands and improvements thereon.
Land is not depreciated and its cost lasts in our theoretical business model forever. The cost of land includes its acquisition cost—costs of appraising, recording, and obtaining title. It also includes the initial costs of making changes to it so that it can be used for the purpose intended. This cost includes removing old buildings, leveling, and perhaps cleaning up any toxic residue. When land is acquired together with buildings, the cost will be apportioned between the land and the buildings in proportion to their appraised value. If the acquisition plan contemplates the removal of the buildings, then the total cost including removal is accounted for as cost of land. Any salvage value of the emoved buildings, when disposed of, is deducted from the cost of the land. Toxic residue cleanup provides a particular problem in accounting for land. If the extent of the toxic cleanup costs are known prior to purchase, it is assumed that the purchase price has been reduced accordingly. Then it is correct to include those cleanup costs in the cost of the land. However, where land is owned and toxic residues from past practice are discovered, the cleanup of these items provides no future value. Cleaning up these toxic wastes is similar to washing a rental car or limousine. You may not be able to generate any rental revenue without a clean and polished automobile, but it does not provide future value beyond that.
Cleaning up toxic wastes makes the property usable; however, it does not provide future benefit: It can only restore the usefulness of the property to its level of use prior to recognizing the toxic problem. Improvements that theoretically have an indefinite life are also added to the cost of land. Grading, drainage, sewers, and utilities are examples. These items are put in once and unless damaged by force or disrupted by plans for new uses of the land, they do not require maintenance. Therefore, their life is assumed to be that of land forever in the accepted business model. The proper treatment of property costs is an area that must be spelled out in the accounting manual for the firm so that all similar Plant 17 transactions are handled in the same way.
The manual should translate these principles into specific accounting practices for the firm. For example, electric and gas utility installation to the meter or distribution point are usually a part of the land cost. Beyond this, location utilities and part of the individual building investment are to be included in the plant category. The acquisition of property may bring about other expenditures which should be added to its historical cost. Some of these are as follows: Contract price Real estate broker commissions Legal fees involved in the transaction Cost of title guaranty insurance policies Cost of real estate surveys Cost of an option that has been exercised Special government assessments Fees harged by government for changes in land use or zoning Cost of removing buildings Cost of cancellation of unexpired lease Cost to move tenant if payable by purchaser Payment of past due taxes if payable by purchaser Cost of easements or rights of way Assessments for the construction of public improvements Deduction of salvage value from buildings removed and sold Toxic waste cleanup Grading land and providing drainage Placing utilities PLANT The term plant has its origin in manufacturing, where the plant is literally used to house the production equipment. This includes buildings and other structures or improvements that have a limited life. Paved parking lots and sprinkler systems, as well as recreational and landscaping improvements, are included.
Also included in plant are fences, roads, and grading and excavation costs necessary to construction of the buildings. The distinction between property (land) and plant is the 18 What Is an Asset? duration of usefulness. Improvements to the property that will have a measurable or estimated life should be depreciated over that life. Therefore, they are charged to the plant account. If they are of indefinite life, they are treated as property. All expenditures directly related to the purchase or construction of buildings or other physical plant are included in plant cost. Land includes the cost of preparation of a construction site. All costs for a specific construction are included in the cost of the product.
Some of the other expenditures that should be added to the capitalized cost of the asset acquired are as follows: Contract price or cost of construction Cost of grading and excavation for the specific building Expenses incurred in removing trees and other foliage for the specific building Costs of remodeling or altering a purchased building to make it ready for use Costs for architect’s fees, plans, and other planning events Cost of government fees and building permits Payment of prior year taxes accrued on the building if payable by purchaser Other costs such as security or temporary fencing, temporary buildings used during construction, or other costs directly attributable to the construction or purchase of the specific building Capitalized interest EQUIPMENT Equipment includes the machinery, computers, office equipment, and all other long-lived items necessary for the operation of the business.
These items require more managerial control because of their portability and general usefulness for other than the purpose intended when acquired. They range in price from a minimum capitalization level to many millions of dollars for complex production machinery. Because of the wide variety of requirements for different items of equipment, we shall discuss them in several categories, including: Tools Building systems (heating, cooling, elevators) Equipment Irrigation equipment Furniture and office equipment Computers Printing presses Automobiles Tractors Trucks Trailers Aircraft Livestock Furniture and Office Equipment 19 Furniture and office fixtures are long-lived assets needed to run a business.
In the service industries, except for buildings, these will be the major tangible assets of the business. The establishment of a reasonable minimum capitalization level has to be weighed against the other factors of managing this class of equipment. Office desks and chairs that are personally used by one manager will receive the attention necessary to safeguard and ensure proper maintenance as required. Many companies establish a $5,000 minimum capitalization level for these items. However, telephone equipment purchased may become obsolete or require significant maintenance after a short period of time. Also, office copiers, fax machines, and computers have a need for greater management and future planning.
It is important that these items not all have a requirement for replacement in the same future year. Inclusion in the property record, which subjects such items to the controls provided in that system, may in fact reduce the dollar value at which it is desirable to maintain capitalization. These items should be included in a detailed policy and outlined in the handbook on asset capitalization or its chapter in the accounting policy manual of the business. When the decision is made to capitalize a particular item of equipment, all costs involved in putting it into a condition ready for use should be included in the asset value. Some of the costs that may be incurred are: Contract price Commissions paid 20 What Is an Asset?
Legal fees and other contract costs Cost of title guaranty insurance policies Cost of transferring title Freight, handling, and storage costs Sales or use tax and other taxes or fees assessed Costs of preparation of the space for installation (foundations, special walls, removal of windows) Use of cranes or other means of installation Installation charges Cost of testing and preparation for use Costs of reconditioning used equipment purchased DEFINING ASSETS Assets are not always easily defined. For example, a Berkeley, California, producer of “baby” vegetables for New York City upscale restaurants could not function without the regular and dependable inexpensive air shuttle of the crop each morning.
The New York restaurants pay a premium for the product, but it must be picked that morning and delivered to New York City by noon for serving in restaurants that evening. Is the transportation link from San Francisco airport to New York an asset of this Berkeley producer? From an accounting sense, it is not; however, it continues to deliver future benefits to the company. Without that transportation link being available, there would be no business; but it would be impossible to establish any value to that transportation link without a sale. If the business were to be sold, it is likely to command as an operating business more than the value of its individual components. This additional value will be included on the purchaser’s balance sheet as goodwill.
Much of that goodwill can be a result of an existing working transportation system from the producer’s garden to the upscale restaurants. Goodwill is an intangible asset. Accounting recognizes it only because there has been an actual payment for it. It must be recognized somehow as its usefulness is used up over future periods. The asset exists whether it is recognized in the book of accounts as goodwill or not. However, this emphasizes the accounting concept of recognizing asset value in accounting systems for the purpose of measuring the decrease in its future usefulness in relationship to its original cost. In this Defining Assets 21 case, it is not a problem in defining the asset, but in establishing the asset’s value. There are other difficulties in defining an asset.
In industries where investment in property, plant, and equipment is low in comparison to return on products, there has been no need to closely manage the investment in assets. Examples are restaurants where investment is limited to leasehold improvements. The concern of restaurant managers is keeping their lease and labor costs down. The investment in fixed assets required to run a substantial restaurant is small in comparison to its gross sales. The investment in leasehold improvements for a restaurant many times are sunk costs. They have value only to the end of the lease. It may also be desirable for marketing purposes to substantially alter them prior to the end of their useful life.
Here the value is easily established based on what they cost to install. However, they might not be providing future benefits and therefore require replacement before their costs have been recognized. A different management problem exists when investment in capital items is large relative to the cost of production or when there are few other opportunities to use the assets for different purposes. Examples are oil refineries and pharmaceutical laboratories. Once the refinery or drug production facilities are constructed, they are not readily usable for any other purpose. There is also little opportunity to make decisions relative to alternative use of these assets.
A grocery store location could be altered to become a restaurant or a hardware store, but an oil refinery would cost more to dismantle than it originally cost to construct. These cases raise the question of the value of alternative uses. The accounting principle of recognizing decline in service value through depreciation takes this into account in the concept of salvage value. Salvage value is the value which the asset has at the end of its useful life. The oil refinery would have a nega