Accounting is funny about big ticket items. If a company buys a car, building, large machine, or other big purchase, the asset starts to lose value immediately. On the books (specifically, under the account “Fixed Assets at Cost”), fixed assets lose value at a hefty linear rate.
In most cases, this “book value” is very unrealistic. A car, for example, will be worth 80% of its value after one year, and 60% after two. You might think this makes sense on a new car, but what about a used one?
This article will define fixed assets, give examples, explain how booking them “at cost” has pros and cons, cover accumulated depreciation, and finish with a way for companies to “get around” losing asset value with the principle of Fair Market Value.
What are fixed assets?
In short, fixed assets are long-term assets (i.e they last more than 1 year) that a company uses to make goods or provide services. They are also known as Tangible Assets, or Property, Plant, and Equipment.
What makes fixed assets special from a financial and accounting perspective is how we have to book them (i.e record them in the financial statements). In short, we book fixed assets on the balance sheet at the original price it cost the company (“at cost”).
As a second step, we decide over what number of years we would like to “charge” them, or depreciate them, on the profit and loss statement.
Whatever that number is, it becomes the denominator in a fraction in which the cost of the asset is the numerator. The quotient of that fraction is the value at which the asset depreciates each year. This usually happens over an unreasonably short period, such as 3 to 5 years. Let’s look at an example.
Fixed Assets Example
Imagine your company buys a truck for $30,000. In your state, accounting principles dictate that you depreciate a truck over 5 years. This means the truck will be booked on the balance sheet at $30,000. Each year, accountants will subtract $6,000 from its value in the accumulated depreciation account. After 5 years, the truck will be valueless on the books.
This is the same process for all fixed assets. What changes, however, is the number of years an item depreciates. This varies by location and accounting principles. A computer, for example, depreciates over a 3 year period in most places, but in some states it can be as little as 1.66 years.
Fixed Asset Examples by Industry
Fixed assets are as diverse as business lines themselves. Each industry has unique needs for fixed assets, but some examples common to many companies include buildings, vehicles, warehouses, and property. Others include:
- Computer equipment. Includes any hardware and physical equipment such as monitors and computer towers.
- Computer software. Includes applications needed to execute work related tasks, such as operating systems and Microsoft Office.
- Furniture and fixtures. Furniture includes chairs and desks. Fixtures includes lights, sinks, washing machines, and other non-furniture, space-related items.
- Intangible assets. Intangible assets include copyrights, patents at cost, and trademarks.
- Large office supplies such as copiers. Dishwashing machines and copiers are good examples of large office supples that need to be capitalized.
- Land improvements. Includes any renovations on land or buildings that are a cost to bring added value to the production of good or services. This one is important for our discussion on fair market value below, so don’t forget it.
- Construction in progress. Construction in progress is similar to land improvements, but it’s the step in which we record improvements as costs but don’t yet capitalize them.
Booking Fixed Assets “At Cost”
By now, you should understand what it means to book at cost: rather than the actual value of the good, you book and continue to hold fixed assets at the value for which they were purchased. Then, to get it’s value, you subtract accumulated depreciation.
To push our understanding of this concept further, think of the last time you wanted to buy a used product. Maybe it was a car, maybe a nice phone, or perhaps it was a washing machine.
Imagine you went online to a wholesale used goods store that recovers used goods from companies for very cheap and resells them to consumers.
You found several washing machines for sale, all older than 3 years, but in top-notch shape. They were priced at $250 on average, which is way less than the original price of $600. You decide to buy one.
What you didn’t realize is that, since these machines were older than 3 years, their book values were all 0. They are technically worth nothing. But you bought one for $250!
This is the difference between values of assets “at cost” and the value of assets at fair market value. Let’s look closer.
“At Cost” vs Fair Market Value
Fair market value is the price that people are willing to pay for a good or service with a given age. In other words, it’s just the normal ol’ price that customers pay.
When you go to the grocery store and think “that’s too expensive,” you’re lowing the fair market value of the food, since the supermarket will sell less of the food at that price. They will thus have to lower the price and take a smaller margin, or discontinue the product.
On the other hand, when you can’t find a product anywhere, because it’s sold out everywhere, you could be increasing it’s fair market value. Because you want it so bad, you would pay more for it. So the seller will up the price. This very exchange alters the fair market value.
You may have heard of these concepts before: supply and demand.
Businesses and their assets work in a very similar way. While consumer goods respond more directly to the forces of supply and demand, businesses’ fixed assets work in a similar way. When a company wants to sell one of its buildings, for example, any and all buyers will determine its price. This is the fair market value (FMV).
FMV stands in direct contrast to book value. When we say book value, we’re actually talking about the net asset value of the fixed asset as recorded on the balance sheet, which is in almost all cases lower. The net asset value is calculated, simply, as the fixed asset at cost minus accumulated depreciation.
When an asset sells for more than its book value (FMV>BV), this is recorded as a gain on the books. When it sells for less (FMV<BV), this is recorded as a loss.
Net Asset Value, Accumulated Depreciation, & Selling Fixed Assets
By now you should have a pretty clear vision of what “fixed assets at cost” are, but no asset discussion is complete without an explanation of net asset value, accumulated depreciation, and what happens when we sell a fixed asset. Let’s look at our example of the truck we bought for $30,000 (example from above).
Value at cost: $30,000
Yearly Depreciation: $5,000
Imagine we sell the truck in year four — two years before it depreciates entirely. Our balance sheet looks like this at the time of the sale:
Truck value at cost… $30,000
Truck accumulated depreciation… $15,000
Truck net asset value… $15,000
Net liabilities… $15,000
Imagine we sell the truck for $20,000 (FMV). Are we making money or losing it? The key thing to remember here is that we’re talking about two different ideas: cash and profitability.
No matter what, we record a net inflow of cash from the sale in year 4. While there was a net outflow in year 1, we’re cash positive on the sale. This means the cash account will increase by $20,000.
What’s more, we are making more on the sale than the current book value of the truck. This is a gain, and we need to record it on the income statement, which will then feed into retained earnings on the balance sheet.
At the same time, we need to “remove” all traces of the assets value and accumulated depreciation. So we credit the truck and debit the accumulated depreciation by their respective balances.
In short, all we’re doing is recording the cash inflow in current assets, the net change in the asset, and the gain/loss in retained earnings.
When net change in asset is more than the cash received, there’s a loss, and the total assets balance decreases. When net change in asset is less than cash received, there’s a gain, and the total assets balance increases.
Here’s what our balance sheet would look like after the sale:
Truck value at cost… $0
Truck accumulated depreciation… $0
Truck net asset value… $0
Total assets… $20,000
Net liabilities… $15,000
Retained earnings… $5,000
Total Liabilities and Equity… $20,000