Fixed assets, also known as property, plant, and equipment (PP&E), are long-term tangible assets held by a company for use in its operations. They are not intended for sale and have a useful life of more than one accounting period.
- Types of Fixed Assets:
- Tangible Fixed Assets: Physical assets like land, buildings, machinery, vehicles, etc.
- Intangible Fixed Assets: Non-physical assets like patents, trademarks, copyrights, goodwill, etc.
- Fixed assets play a crucial role in a company’s operations and can significantly impact its production capacity, efficiency, and competitiveness.
- They are essential for generating revenue and are a significant component of a company’s overall value.
- Acquisition and Cost Allocation:
- Fixed assets are acquired either through purchase, construction, or as part of a business combination. The cost includes the purchase price, any additional costs for bringing the asset into its intended use, and estimates of dismantling and removing the asset.
- Since fixed assets have a limited useful life, they are subject to depreciation. Depreciation allocates the cost of the asset over its useful life, reflecting the wear and tear or obsolescence that occurs over time.
Methods of Depreciation:
- Straight-Line Method: Allocates an equal portion of the asset’s cost as depreciation expense each year.
- Declining Balance Method: Charges a higher depreciation expense in the earlier years, reflecting a faster rate of asset usage.
- Units of Production Method: Charges depreciation based on the actual usage or production of the asset.
- Sum-of-the-Years-Digits Method: Front-loads depreciation, allocating a higher portion in the early years.
Factors Influencing Depreciation:
- Useful Life: The estimated period over which the asset is expected to contribute to the company’s operations.
- Residual Value: The estimated value of the asset at the end of its useful life.
- Depreciation Method: The chosen method impacts the amount of depreciation expense recorded each period.
- Depreciation is recorded as an expense on the income statement, reducing the asset’s carrying amount on the balance sheet.
- Accumulated depreciation is a contra-asset account that accumulates the total depreciation expense recognized to date.
Implications for Financial Statements:
- Income Statement: Depreciation expense is recorded, reducing net income and reflecting the cost of using the fixed assets in generating revenue.
- Balance Sheet: The carrying amount of fixed assets is reduced by the accumulated depreciation, reflecting their net book value.
- Cash Flow Statement: Depreciation is a non-cash expense, so it’s added back to net income when calculating operating cash flows.
- Tax regulations often have specific rules for depreciation that may differ from accounting standards. This can impact a company’s tax liability.
- If there are indications of a decline in the asset’s value below its carrying amount, an impairment test is conducted, and if necessary, the asset’s value is adjusted.
Changes in Useful Life or Residual Value:
- Changes in estimates of an asset’s useful life or residual value may result in adjustments to depreciation expense in future periods.