Whenever the topic of Fixed Assets comes up many of us cringe anticipating a highly technical and difficult process.
In reality, Fixed Assets (or Property, Plant, & Equipment) for the majority of small businesses can be relatively straightforward.
What is a Fixed Asset?
A Fixed Asset is an item that you can expect to have long-term (more than 1 year) and that is used in the operation of the business to generate income.
For example, a truck purchased to make deliveries is a Fixed Asset since it is expected to be
Long-term -> you can expect a vehicle to last several years
Used in operation to generate income -> used for deliveries to customers
Think of a Fixed Asset as something you must have for your business to run that is costly to purchase, is expected to be used for several years, and is not easily sold or removed.
Why bother using Fixed Assets?
In simplified terms think of Fixed Assets as a way to show an increase in the value of your company and to spread out the cost of a large purchase over time.
Imagine you bought a machine that cost $1 Million to purchase and is expected to last 20 years.
First, you would want to show that the value of your company has increased, since if you sold the entire business this machine would be a part of that sale and so should be reflected in what the business is actually worth.
Second, in regards to the actual expense of the item, you would not want the full cost to show up all at once.
Having a $1M expense would significantly impact your P&L for that year and following years would not reflect the cost as the machine is used over its lifetime.
Basically, imagine that instead of purchasing one $1M machine that will last 20 years, you had to buy a $50,000 machine each year for 20 years.
Fixed Asset Depreciation allows you to spread out the expense over the life of the asset, while also decreasing the asset’s value on the Balance Sheet allowing for decreases to its Fair Market Value. (A used machine is not as valuable as a new one typically).
Isn’t figuring out Depreciation really hard?
No, it does not have to be.
While there are various methods of depreciation, some more complicated than others, the easiest and best to use for most small businesses is the Straight-Line Method.
This method basically takes the Cost of the asset divided by it’s expected life.
Cost - Salvage
------------------ = Yearly Depreciation
For the majority of the time your Salvage value will be 0, unless you have a known amount it will be worth at the end of its life, if you are unsure talk to your accountant or CPA.
What is included in the “Cost” of an asset?
The “Cost” of an asset includes the cost to acquire and put the asset in use.
This means beyond the price of the asset itself, sales tax, shipping, professional fees (architect, inspector), import duties, installation, as well as, any rebates or discounts received.
Does this mean I have to Depreciate my computer keyboard since it will last several years?
No, you would drive yourself crazy!!
You will set a Fixed Asset Threshold, which is the amount at which an item may become an asset.
For example, if you bought a fancy network printer/scanner/fax machine for the office for $10,000 you would want to include it as a Fixed Asset, but if you bought a desktop printer for the docking bay for $500 it would not be worth adding it as an asset, even though it meets the rest of the criteria of a Fixed Asset.
The IRS suggests $2,500 or $5,000, but these thresholds are a bit high for many small businesses. I typically use $1,500, but as long as you and your CPA are following the same rules for Fixed Asset and Depreciation and they are sensible and reasonable you should be fine.
What if I sell a Fixed Asset before it has fully Depreciated?
While this is not relevant with very large or built-in assets, when it comes to smaller items, or especially vehicles, it is quite common to sell or remove an asset before it’s expected lifetime has ended.
When this happens you will need to recognize either a “Gain or Loss From Sale of Asset”.
You would post a Gain if you were to sell the asset for more than it’s Net Book Value, or the difference between its original value minus any accumulated depreciation.
In the example of the vehicle purchased for $50,000, at the beginning of Year 4 it’s Net Book Value would be $20,000, so if you sold it for $25,000 you would recognize a Gain of $5,000.
Conversely, if you sell an asset for less than it’s Net Book Value, you would post a Loss.
Using the vehicle example again, if we sold it for $15,000 we would post a Loss of $5,000 since again it’s Net Book Value is $20,000.
When does Depreciation start?
Depreciation starts once the asset is “placed in service”, or once you can use it as part of your business.
This means that if the asset is being used, regardless of any payment status, Depreciation should begin.
If the asset is not usable, no depreciation should be posted, even if all payments have been made.
For example, I had a client that was having a large machine installed, but there were constant delays and issues. No depreciation was posted during this time since the machine was not usable.
Managing Your Fixed Assets
You may have noticed some machines at your doctor’s office, hospital, or other business that have a tag or bar code on them with a type of serial number.
These are in all likelihood Fixed Asset Tags.
Knowing where your assets are and what condition they are in are important aspects of managing your Fixed Asset.
This is obviously much more relevant to larger organizations, like hospitals or manufacturers, but Fixed Asset tracking can also deter theft and help track Preventive Maintenance, so depending on your business it may or may not be useful to have something in place.
Fixed Assets are one of those things that can become super complicated, but for most of us should be relatively straightforward as long as you stick to the rules you set, are consistent and reasonable, and keep up with them.
Fixed Assets - A Summary
Think of Fixed Assets as items that you need for your business that are costly and have a long life, like machinery, vehicles, etc.
Instead of expensing them in full on the P&L, we add them to the Balance Sheet to show the value they bring to your business.
We then Depreciate them over the life of the item, which allows us to expense the used portion of the item and reflect its lower value as it ages.
For example, let’s say you purchased a vehicle for $50,000 on January 1st of 2000 and expect to get 5 years of use out of it.
Using the Straight-Line Method the Depreciation for the vehicle will be $10,000 each year.
Cost $50,000 - Salvage $0* = Book Value $50,000
-------------------------------------------------------------------- = $10,000
Useful Life = 5 Years
Depreciation will look like this:
Fixed Assets simply need you to maintain them, and to be consistent and reasonable. If you do this they should be straightforward to manage.
*If you know that an item will have a Salvage Value at the end of its life (i.e. the seller agrees to buy the item at $5,000 after 5 years) that amount is subtracted from the Cost during the calculation. So in this example the amount to Depreciation is $45,000, or $9,000 per year.
Cost $50,000 - Salvage $5,000 = Book Value $45,000
-------------------------------------------------------------------- = $9,000
Useful Life = 5 Years