Accounting for Fixed

Assets
2012 13, Term VI
CA K.P.Rajendran
kprajen@gmail.com

Long-Term Assets
Long-term assets are resources that
are used to generate operating
revenues (or reduce operating costs)
for more than one period.

Long-Term Assets
Long-term assets can be:
tangible fixed assets such as property,
plant and equipment
Intangible assets (assets lacking physical
substance) such as patents, trade marks,
copyrights, and goodwill or
Long-term financial investments such as
investments in equity or debt securities
issued by other companies.

Accounting for Long-Term Assets

Accounting for long-term assets
involves three distinct activities:
Capitalization
Allocation of cost (Depreciation) and
Impairment

Capitalization
Capitalization is the process of
deferring a cost that is incurred in the
current period, but whose benefits
are expected to extend to one or
more future periods.

Capitalization
It is capitalization that creates an
asset account.
In fact, a long-term asset is created
through the process of capitalization.

Capitalization
Capitalization means putting the
asset in the on the balance sheet
rather than immediately expensing its
cost in the income statement.

Capitalization
Capitalization is relatively simple for
hard assets like Property, Plant and
Equipment (PPE).
The asset is normally recorded at its
purchase price.

Capitalization
For soft assets such as R&D and
advertising capitalization is more
difficult.
It is because it is difficult to reliably
measure their future benefits and
their useful life.

Capitalization
That is why costs of internally
developed soft assets like goodwill
are immediately expensed rather
than included in the balance sheet

Effect of Capitalization
Capitalization affects both balance
sheet as well as income statement.
It also affects different financial ratios
derived from these statements.

Effect of Capitalization
Capitalization postpones recognition
of expenses in income statement of
current year.
This yields higher income in the
acquisition period while lower income
in subsequent periods as compared
with immediate expensing of costs.

Effect of Capitalization
Capitalization also affects Return on
Investment and Solvency Ratios (like
Debt-Equity ratio)

Effect of Capitalization
Capitalization also affects the
operating and investing cash flows.
When costs are immediately
expensed, they are reported as
operating cash flows.
When costs are capitalized, they are
reported as investing cash flows.

Allocation (Depreciation)
Allocation is the periodic assignment
of asset cost to expense over its
expected useful life.

Allocation (Depreciation)
This allocation of costs is called
depreciation when applied to
tangible fixed assets
amortization when applied to
intangible assets and
depletion when applied to natural
resources

Allocation (Depreciation)
Cost allocation is a process of
matching cost of an asset against its
benefits according to matching
principle
It is not a valuation process.

Allocation (Depreciation)
The assets carrying value (capitalized
costs less cumulative cost allocation
to date) need not reflect its fair value.

Allocation
The costs of most of the long-term
assets are allocated as expenses over
the period of time during which they
are expected to provide economic
benefits.

Allocation
The two types of long-term assets
whose costs are not allocated over
time are land, which is not
depreciated, and those intangible
assets with indefinite useful lives.

Allocation
Intangible assets with indefinite lives
are tested periodically for any
reduction in their fair value as
compared to their recorded value,
known as impairment, which is
reflected as an impairment loss on
the income statement.

Allocation (Depreciation)
Four factors determine the amount of
cost allocation:

The
The
The
The

cost of the asset

useful life of the asset
salvage value of the asset and
method of allocation

Allocation (Depreciation)
Each of these factors requires
estimation involving managerial
discretion
This estimation in turn, would be
influenced by the operating, financial
and financial reporting strategy of an
enterprise.

Allocation (Depreciation)
Analyst must carefully consider the
effects of these estimates on the
financial statements, especially when
estimates change.

Impairment
When the expected cash flows
(undiscounted) from an asset are less
than its carrying amount (cost less
accumulated depreciation), the asset
is deemed to be impaired and is
written down to its fair market value
(the discounted amount of expected
cash flows).

Property, Plant and Equipment

Property, plant and equipment are
tangible assets that:
are held for use in the production or
supply of goods or services, for rental
to others, or for administrative
purposes; and
are expected to be used during more
than one period.

Property, Plant and Equipment

These assets are intended for use in
operating activities and are not
acquired for sale in the ordinary
course of business.
Fixed assets are resources that are
used to generate operating revenues
or reduce operating costs for more
than one period.

Property, Plant and Equipment

PPE often comprise a significant portion of
the total assets of an enterprise, and
therefore are important in the presentation
of financial position.
Furthermore, the determination of whether
an expenditure represents an asset or an
expense can have a material effect on an
enterprises reported results of operations.

PPE Recognition of cost

The cost of an item of property, plant
and equipment shall be recognised as
an asset if, and only if:
it is probable that future economic
benefits associated with the item will
flow to the entity; and
the cost of the item can be measured
reliably.

PPE Recognition of cost

These recognition criteria apply to
subsequent expenditure as well as
costs incurred initially.

PPE Separate Items

Spare parts and servicing equipment
are classified as inventory and
expensed to income statement as
consumed.
But if the spare parts and servicing
equipment can be used only in
connection with an item of property,
plant and equipment, they are
accounted for as PPE

PPE Separate Items

Large, specialized and complex items
of PPE might have been made up of
different parts having different useful
lives. For example, in the case of an
aircraft, the fuselage, undercarriage
and engine might have different
useful life. In such case each part is
separately depreciated over their
useful life.

PPE Separate Items

Safety and environment equipment,
although will not directly result in
increasing the future economic
benefit any existing PPE, are
necessary for an entity to obtain
future economic benefit from its other
assets. For this reason they are
recognized as assets.

PPE - Cost
An item of property, plant and
equipment that qualifies for
recognition as an asset shall be
measured at its historical cost.
Historical cost valuation involves
recording the asset initially at
purchase cost

PPE Measurement of Cost

The cost of an item of property, plant
and equipment is the amount of cash
or cash equivalents paid or the fair
value of the other consideration given
to acquire the asset at the time of its
acquisition or construction.

PPE Elements of Cost

The cost of an item of property, plant
and equipment comprises:
its purchase price, including import
duties and non-refundable purchase
taxes, after deducting trade discounts
and rebates.

PPE Elements of Cost

any costs directly attributable to bring
the asset to working condition for its
intended use.

PPE Elements of Cost

Examples of directly attributable
costs are:
The cost of site preparation;
initial delivery and handling costs;
installation cost, such as special
foundations for plant; and
professional fees, for example fees of
architects and engineers.

PPE Elements of Cost

Administration and other general
overhead expenses are usually
excluded from the cost of fixed assets
because they do not relate to a
specific fixed asset.

PPE Elements of Cost

However administration expenses are
included in the cost of a fixed asset if
it is directly attributable to brining an
asset to its working condition for its
intended use. For example,
administration expenses specifically
attributable to a construction project.

PPE Elements of Cost

The expenditure incurred on start-up
and commissioning of the project,
including the expenditure incurred on
test runs and experimental
production, is usually capitalized as
an indirect element of the
construction cost.

PPE Elements of Cost

However, the expenditure incurred
after the plant has begun commercial
production is not capitalized and is
treated as revenue expenditure even
though the contract may stipulate
that the plant will not be finally taken
over until after the satisfactory
completion of the guarantee period.

PPE Recognition of Cost

That is recognition of costs in the
carrying amount of an item of PPE
ceases when the item is in the
location and condition necessary for it
to be capable of operating in the
manner intended by management.

PPE Elements of Cost

If the interval between the date a
project is ready to commence
commercial production and the date
at which commercial production
actually begins is prolonged, all
expenses incurred during this period
are charged to the profit and loss
statement.

PPE Elements of Cost

However, the expenditure incurred
during this period is also sometimes
treated as deferred revenue
expenditure to be amortized over a
period not exceeding 3 to 5 years
after the commencement of
commercial production.

PPE Elements of Cost

The cost of a self constructed asset is
determined using the same principles
as for an acquired asset.

PPE Elements of Cost

Included in the costs are costs of
construction that relate directly to the
specific asset and costs that are
attributable to the construction
activity in general and can be
allocated to the specific asset.
Any internal profits are eliminated in
arriving at such costs.

PPE Elements of Cost

Examples of costs that are not costs
of an item of PPE are:
Costs of opening a new facility
Costs of introducing a new product
including costs of advertising and
sales promotion
Administration and general overhead
costs.

PPE Elements of Cost

When a fixed asset is acquired in
exchange for another asset, its cost is
usually determined by reference to
the fair market value of the
consideration given.

PPE Elements of Cost

When a fixed asset is acquired in
exchange for shares or other
securities in the enterprise, it is
usually recorded at its fair market
value, or the fair market value of the
securities issued, whichever is more
clearly evident.

PPE Measurement of Cost

The cost of an item of property, plant
and equipment is the cash price
equivalent at the recognition date.
If payment is deferred beyond normal
credit terms, the difference between
the cash price equivalent and the
total payment is recognised as
interest over the period of credit.

PPE Initial Measurement

Once an item of property, plant and
equipment qualifies for recognition as
an asset, it will initially be measured
at historical cost.

PPE Subsequent Measurement

An item of property, plant and
equipment may be subsequently
measured by using either the cost
model or revaluation model.

PPE Cost Model

In cost model, the asset is carried at
cost less depreciation and any
accumulated impairment loss.

PPE Measurement of Cost

In revaluation model the asset is
carried at a revalued amount, being
its fair value.

PPE Measurement of Cost

Any increase in value on revaluation
is debited to the asset and credited to
the revaluation surplus account
(which would form part of owners
equity), unless the increase reversing
a previous decrease which was
recognized as an expense. To the
extent that this offset is made, the
increase is recognized as an income.

Depreciation
Depreciation is the allocation of the
costs of plant and equipment over
their useful lives.

Depreciation
Depreciation depends upon four
factors:
The cost of the asset
The useful life of the asset
The salvage value of the asset at the end
of its useful life and
The method or pattern of depreciation
adopted.

Depreciation
The useful life of an asset should be
based on the economic life (in time or
units) of the asset or the period
thereof that the organization plans to
use it.

Depreciation
The useful life of an asset depends
on:
The extend of the usage of the asset
The quality of the maintenance of the
asset and
Technological obsolescence of the
asset.

Depreciation
Salvage value is the estimate of the
amount that will be realized when the
asset is removed from service, less
any removal cost.

Depreciation
And the method or pattern or
depreciation determines what the
depreciation amount will be for each
period or unit of use that the asset is
in service.

Depreciation
Establishing the method or pattern of
depreciation in advance reduces the
ability and temptation for
management to adjust depreciation in
such a way that net income for any
one period during the assets life is
manipulated.

Depreciation
The different methods of depreciation
used are:
Straight line method
Reducing balance method and
Activity or units of production method
and
Depletion