4.5: Fixed and Intangible Assets
Fixed assets are relatively expensive physical items such as equipment, furnishings, vehicles, buildings, and land that typically last for several years. Fixed assets are also called Property, Plant and Equipment .
Equipment and other fixed assets are definitely costs of running a business. However, the company does not debit an expense account such as Equipment Expense for its cost at the time of purchase. If this were done, the income statement for the year of the purchase would have this large expense that reduces net income. The other years’ income statements would show no expense for this equipment, even though the equipment is used during this time. Instead ofan expense account, the company records the purchase of a fixed asset by debiting an asset account for its cost. For equipment, the Equipment account is debited.
The following journal entry records the purchase of equipment for $27,900 cash.
| Date | Account | Debit | Credit | ||
| 1/1 | Equipment | 27,900 | ▲ Equipment is an asset account that is increasing. | ||
| Cash | 27,900 | ▼ Cash is an asset account that is decreasing . | |||
Depreciation is the periodic expiration of a fixed asset, which means its cost is gradually claimed as an expense over its useful life rather than all at once at the time it is purchased. The company recognizes that a portion of the asset is “used up” as time passes or as the asset is used. The value that a fixed asset loses each year becomes an expense.
All fixed assets except Land are depreciated. Land is considered to be permanent property that is not “used up;” therefore it is not depreciated.
4.5.1 Depreciation Terms
Cost is the amount a company pays or the value it exchanges to acquire a fixed asset. The cost includes the price of the asset plus everything it takes to get the asset to the company and up and running, such as transportation, sales tax, insurance in transit, professional fees of attorneys or engineers, site preparation, and installation. The cost of the asset does not include damage or vandalism during shipment or installation.
| Equipment | + | transportation | + | sales tax | + | installation cost | = | depreciable cost of the asset |
| $9,000 | + | $350 | + | $450 | + | $200 | = | $10,000 depreciable cost of the equipment |
Some fixed assets have a residual value . This is a minimal guaranteed amount that someone will pay at any time, even if the asset no longer is functional, to purchase it from the owner. For example, the manufacturer of a piece of equipment may pay a company a minimal amount and haul away an old piece of equipment that it may then disassemble for spare parts or scrap metal.
Years ago, my dad worked in an area where nice cars tended to disappear from their parking spaces. He chose to drive old “clunkers” that did not appeal to car thieves. Each “clunker” would ultimately die in front of our nice suburban home, and my mother would soon be after him to remove it from the premises. Dad would call his “junk dealer,” a man with a tow truck who would pay my father $50 and haul the wreck off. No matter how bad the condition one of those vehicles was in, it was always worth at least the $50 the “junk dealer” was willing to pay for it. Its residual value was $50.
The useful life is the length of time or amount of activity that a fixed asset is expected to last or have value to a company. It is often measured in years of service, but may also be stated in terms of usage, such as miles, hours, or units of output.
Two people may buy the identical cars for the same price on the same day. If depreciation is measured in years, both cars may be expected to last for eight years. However, if one driver is a salesman who is always on the road traveling long distances and the other is a retiree who drives locally and only occasionally, it is likely that the salesman’s car will last fewer years than the retiree’s. It may be more meaningful to state the useful life in miles, such as 150,000 miles, to better track the usage of the vehicles. In fact, automobile warranties are often stated in dual ways, such as “five years or 60,000 miles, whichever comes first.” Similarly, rather than years, the useful life of a light bulb might be number of hours and a photocopy machine might be number of copies.
Depreciation Expense is an expense account on the income statement that is closed at the end of each accounting period. Debit Depreciation Expense rather than Equipment Expense , Building Expense , Truck Expense , etc. for the amount of a fixed asset that has been “used up” during the accounting period.
Although the value of a fixed asset decreases over time or with usage, the cost principle requires that a fixed asset’s ledger balance be the cost of the asset, or what was paid for it. We cannot credit the asset’s debit balance to show that it is losing value—its debit balance in the ledger must always be what it cost. In the previous equipment example it means that we are not allowed to credit the Equipment account to reduce its balance from $27,900. Its balance must stay at $27,900 as long as the company owns it.
Accumulated Depreciation substitutes for the fixed asset account and is credited to complete the entry. Accumulated Depreciation is a contra asset account that appears in the Asset section on the balance sheet just under the particular asset it relates to. It is not closed at the end of the accounting period. Instead, its credit balance increases each year as a fixed asset loses more and more value.
Each fixed asset account has its own Accumulated Depreciation account. The fixed asset account has a debit balance for the cost of the asset. The Accumulated Depreciation has a credit balance that indicates how much value the fixed asset has lost.
The adjusting entry for depreciation is as follows:
| Date | Account | Debit | Credit | ||
| 1/31 | Depreciation Expense | 8,700 | ▲ Depreciation Expense is an expense account that is increasing . | ||
| Accumulated Depreciation | 8,700 | ▲ Acc. Depreciation is a contra asset account that is increasing. | |||
Since the Accumulated Depreciation account was credited in the adjusting entry rather than the Equipment account directly, the Equipment debit account balance in the previous transaction remains at $27,900, its cost.
Here is a sample of how a fixed asset is presented on the balance sheet:
| Equipment | $27,900 |
| Less: Accumulated depreciatio | 8,700 |
| \(\ \overline{$19,200}\) |
The book value of a fixed asset is what it is currently worth. The cost of a fixed asset is what was originally paid to acquire it. The credit balance in Accumulated Depreciation indicates how much of the asset’s cost has been “used up.” Book value is calculated by subtracting an asset’s Accumulated Depreciation credit balance from its cost. This calculation is reported on the balance sheet.
Book value = Cost - Accumulated Depreciation
The following is the book value of equipment that cost $27,900 at the end of each year in its useful life, assuming it depreciates at a rate of $8,700 per year. This is shown on the balance sheet as follows:
| 2012 | 2013 | 2014 | |
| Equipment | $27,900 | $27,900 | $27,900 |
| Less: Accumulated depreciation | 8,700 | 17,400 | 26,100 |
| Book Value | \(\ \overline{$19,200}\) | \(\ \overline{$10,500}\) | \(\ \overline{$1,800}\) |
Accumulated Depreciation increases over time. Book value decreases over time by the same amount.
The adjusting entries for depreciation split the cost of the equipment into two categories. The Accumulated Depreciation account balance is the amount of the asset that is “used up”. The book value is the amount of value remaining on the asset.
It is important monitor the book value of fixed assets since the book value cannot be lower than the residual value. A company must stop depreciating any further once the book value equals the residual value since the asset will always be worth at least what someone will pay to purchase it from the owner, regardless of its condition. However, even there is no longer any remaining value to depreciate, a company may still continue to use a fixed asset.
4.5.2 Depreciation Methods
We will look at three methods of calculating the amount of depreciation on a fixed asset that should be recorded in the adjusting entry at the end of the accounting period. A company will select one method for each of its assets and use that method throughout the useful life of the asset. Each method requires that you know the cost of the asset, any residual value, and its useful life.
Regardless of the method used, the adjusting entry is a debit to Depreciation Expense and a credit to Accumulated Depreciation.
The adjusting entry for depreciation is as follows:
| Date | Account | Debit | Credit | ||
| 1/31 | Depreciation Expense | XXX | ▲ Depreciation Expense is an expense account that is increasing . | ||
| Accumulated Depreciation | XXX | ▲ Acc. Depreciation is a contra asset account that is increasing. |
Straight-Line Method
Full-year straight-line depreciation
The straight-line method of depreciation is the simplest and most commonly used. It takes the depreciable base (cost minus residual amount) of the asset and expenses it off evenly over the useful life of the asset.
The annual depreciation amount is calculated as follows using straight-line:
\(\ \frac{\text{Cost-Residual value}}{\text{Useful life in years}}\)
The asset is fully depreciated when the years in its useful life have passed. At that point the book value equals the residual value.
On January 1, 2012, a company purchases equipment that costs $27,000. It has a residual value of $900, and has a three-year useful life. The company prepares its financial statements once a year on December 31.
Solution
\(\ \frac{$27,000 -$900}{3}=$8,700\ per\ full\ year\)
The company purchased the equipment on January 1, 2012, so it can depreciate the asset for the full calendar year.
12/31/12 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 8,700 | ||
| Accumulated Depreciation | 8,700 |
After the 12/31/12 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 8,700 |
| Book value | \(\ \overline{$18,300}\) |
12/31/13 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 8,700 | ||
| Accumulated Depreciation | 8,700 |
After the 12/31/13 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 17,400 |
| Book value | \(\ \overline{$9,600}\) |
12/31/14 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 8,700 | ||
| Accumulated Depreciation | 8,700 |
After the 12/31/14 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 26,100 |
| Book value | \(\ \overline{$900}\) |
Partial-year straight-line depreciation
Fixed assets may be purchased throughout the calendar year, not only on January 1. They may only be depreciated for the amount of time during the year that a company owns them. For a partial year, the amount of annual depreciation on December 31 must be pro-rated by the number of months the asset was owned during the year. The following ratios may be used to pro-rate annual depreciation amounts to account for partial-year ownership:
| Purchase date | Months owned as of 12/31 | Fraction used to pro-rate annual amount |
| January | 12 | 12/12 |
| February | 11 | 11/12 |
| March 1 | 10 | 10/12 |
| April 1 | 9 | 9/12 |
| May 1 | 8 | 8/12 |
| June 1 | 7 | 7/12 |
| July 1 | 6 | 6/12 |
| August 1 | 5 | 5/12 |
| September 1 | 4 | 4/12 |
| October 1 | 3 | 3/12 |
| November 1 | 2 | 2/12 |
| December 1 | 1 | 1/12 |
On April 1, 2012, a company purchases equipment that costs $27,000. It has a residual value of $900, and has a three-year useful life. The company prepares its financial statements once a year on December 31.
Solution
| \(\ \frac{$27,000-$900}{3} \) | = $8,700 per full year for years 2 and 3 |
| $8,700 per full year x 9/12 |
= $6,525 for year 1 (April through December, inclusive = 9 months) |
| $8,700 per full year x 3/12 |
= $2,175 for year 4 (January through March, inclusive = 3 months) |
12/31/12 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 6,525 | ||
| Accumulated Depreciation | 6,525 |
After the 12/31/12 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 6,525 |
| Book value | \(\ \overline{$20,475}\) |
12/31/13 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 8,700 | ||
| Accumulated Depreciation | 8,700 |
After the 12/31/13 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 15,225 |
| Book value | \(\ \overline{$11,775}\) |
12/31/14 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 8,700 | ||
| Accumulated Depreciation | 8,700 |
After the 12/31/14 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 23,925 |
| Book value | \(\ \overline{$3,075}\) |
12/31/15 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 2,175 | ||
| Accumulated Depreciation | 2,175 |
After the 12/31/15 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 26,100 |
| Book value | \(\ \overline{$900}\) |
Although the useful life of the equipment is three years, there will be four end- of-year adjusting entries because the three years of ownership do not correspond with calendar years (which are January through December). The adjusting entry amount in year 1 is for nine months ($8,700 x 9/12). In years 2 and 3 the amount is for a full year’s depreciation. In year 4 the adjusting entry amount is for the remaining three months that make up the 36-month, or three-year, useful life ($8,700 x 3/12).
Units of Production Method
The units of production method of depreciation is similar to straight-line except that it uses a rate of usage—such as miles, hours, or units of output—rather than years as the basis for determining the amount of depreciation expense. This method takes the depreciable base (cost minus residual amount) of the asset and expenses it off based on usage during the calendar year.
Assume that the unit of usage is machine hours. The depreciation amount per unit of usage is calculated as follows using units of production:
\(\ \frac{\text{Cost - Residual value}}{\text{Useful life in machine hours}}\)
The asset is fully depreciated when the machine has been used the number of hours in its useful life. At that point the book value equals the residual value.
On January 1, 2012, a company purchases equipment that costs $27,000. It has a residual value of $900, and has an 8,700-hour useful life. The company prepares its financial statements once a year on December 31.
Solution
\(\ \frac{$27,000 - $900}{8,700}=$3.00 \text{ per machine hour}\)
The company used the equipment as follows: 2,100 hours in 2012; 2,300 hours in 2013; 2,600 hours in 2014; and 2,400 hours in 2015.
12/31/12 adjusting entry for depreciation:
2,100 x $3.00 = $6,300 Total of 2,100 hours used
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 6,300 | ||
| Accumulated Depreciation | 6,300 |
| Cost | $27,000 |
| Accumulated depreciation | 6,300 |
| Book value | \(\ \overline{$20,700}\) |
12/31/13 adjusting entry for depreciation:
2,300 x $3.00 = $6,900 Total of 4,400 hours used
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 6,900 | ||
| Accumulated Depreciation | 6,900 |
| Cost | $27,000 |
| Accumulated depreciation | 13,200 |
| Book value | \(\ \overline{$13,800}\) |
12/31/14 adjusting entry for depreciation:
2,600 x $3.00 = $6,300 Total of 7,000 hours used
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 7,800 | ||
| Accumulated Depreciation | 7,800 |
After the 12/31/14 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 21,000 |
| Book value | \(\ \overline{$6,000}\) |
12/31/15 adjusting entry for depreciation:
1,700 x $3.00 = $5,100 Total of 8,700 hours used*
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 5,100 | ||
| Accumulated Depreciation | 5,100 |
After the 12/31/15 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 26,100 |
| Book value | \(\ \overline{$900}\) |
*Although the equipment was used for 2,400 hours in 2015, only 1,700 of those hours may be depreciated. That brings the total number of hours depreciated to 8,700, which is the useful life of the equipment. Be sure not to depreciate more than 8,700 hours.
This same process is followed whether the equipment is owned for a full or partial year. In a partial year, the number of hours used will be proportionately fewer to reflect the reduced amount of time available.
Declining Balance Method
Full-year declining balance depreciation
Declining balance is an accelerated method of depreciation that allows businesses to take more depreciation expense in earlier years and less in later years of the asset’s useful life.
The annual depreciation amount using declining balance is calculated by multiplying the asset’s book value at the beginning of the year by a fraction, which is always “2” divided by the number of years in the useful life. This is done for all years except the last year. In the last year, the depreciation amount is the difference between the current book value minus the residual value. This ensures that in the last year you do not depreciate below the residual value.
The asset is fully depreciated when the years in its useful life have passed. At that point the book value equals the residual value. Do not subtract out residual value in the first year (which you do for straight-line.) It is subtracted out instead in the last year.
On January 1, 2012, a company purchases equipment that costs $27,000. It has a residual value of $900, and has a three-year useful life. The company prepares its financial statements once a year on December 31.
Solution
| Book Value | x | Rate | = | Amount of Depreciation Expense | |
| Year 1 |
27,000 \(\ \underline{- 18,000}\) |
x | 2/3 | = | 18,000 |
| Year 2 |
9,000 \(\ \underline{- 6,000}\) |
x | 2/3 | = | 6,000 |
| Year 3 |
- 6,000 \(\ \overline{3,000}\) |
- | 900 | = | 2,100 |
The company purchased the equipment on January 1, 2012, so it can depreciate the asset for the full calendar year.
12/31/12 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 18,000 | ||
| Accumulated Depreciation | 18,000 |
After the 12/31/12 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 18,000 |
| Book value | \(\ \overline{$9,000}\) |
12/31/13 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 6,000 | ||
| Accumulated Depreciation | 6,000 |
After the 12/31/13 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 24,000 |
| Book value | \(\ \overline{$3,000}\) |
12/31/14 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 2,100 | ||
| Accumulated Depreciation | 2,100 |
After the 12/31/14 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 26,100 |
| Book value | \(\ \overline{$900}\) |
Partial-year declining balance depreciation
Fixed assets may be purchased throughout the calendar year, not only on January 1. They may only be depreciated for the amount of time during the year that a company owns them. For a partial year, the amount of annual depreciation on December 31 must be pro-rated by the number of months the asset was owned during the year. The same ratios provided for straight-line partial-year depreciation should be used for declining balance.
On April 1, 2012, a company purchases equipment that costs $27,000. It has a residual value of $600 and a three-year useful life. The company prepares its financial statements once a year on December 31.
Solution
Since the company purchased the equipment on April 1, 2012, it can only depreciate the asset for nine months in year 1.
| Book Value | x | Rate | = | Amount of Depreciation Expense | |
| Year 1 |
27,000 \(\ \underline{- 13,500}\) |
x | 2/3 | = | 18,000 x 9/12 = 13,500 |
| Year 2 |
- 13,500 \(\ \overline{13,500}\) |
x | 2/3 | = | 9,000 |
| Year 3 |
- 9,000 \(\ \overline{4,500}\) |
x | 2/3 | = | 3,000 |
| Year 4 |
- 3,000 \(\ \overline{1,500}\) |
- | 900 | = | 600 |
12/31/12 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 13,500 | ||
| Accumulated Depreciation | 13,500 |
After the 12/31/12 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 13,500 |
| Book value | \(\ \overline{13,500}\) |
12/31/13 adjusting entry for depreciation:
| Account | Debit | Credit | ||
| 12/31 | Depreciation Expense | 9,000 | ||
| Accumulated Depreciation | 9,000 |
After the 12/31/13 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 22,500 |
| Book value | \(\ \overline{$4,500}\) |
12/31/14 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 3,000 | ||
| Accumulated Depreciation | 3,000 |
After the 12/31/14 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 25,500 |
| Book value | \(\ \overline{$1,500}\) |
12/31/15 adjusting entry for depreciation:
| Date | Account | Debit | Credit | |
| 12/31 | Depreciation Expense | 900 | ||
| Accumulated Depreciation | 900 |
After the 12/31/15 adjusting entry:
| Cost | $27,000 |
| Accumulated depreciation | 26,400 |
| Book value | \(\ \overline{$600}\) |