Accounting for Fixed Assets Explained
Whether recording transactions or preparing annual financial statements, the fixed asset section demands meticulous attention from accountants. Fixed assets play are key to the operations and financial health of a business. This article aims to guide accountants through the essentials of managing the fixed asset section, highlighting what information to gather, pinpointing key risk areas, and specifying necessary documentation.
What are fixed assets?
Fixed assets are owned by the company and utilised in its operations to generate revenue by producing goods or providing services. These assets, typically equipment or property, offer long-term economic benefits and are used by the business for at least a year. The value of fixed assets, except for land, diminishes over time due to use and ageing, allowing for depreciation. At the end of their useful life, fixed assets are usually sold or given away.
In financial reporting, when a business acquires a fixed asset, it records this asset under Property, Plant, and Equipment (PPE) on the statement of financial position. These assets are initially capitalised at cost and then depreciated over time, affecting financial statement figures in the statement of financial position and performance, and the cash flow statement.
Leasing is another common approach for businesses to gain the use of fixed assets without purchasing them outright. How to account for leased assets may differ according to the requirements of the accounting framework applied by the entity.
The Life Cycle of Fixed Assets
The fixed asset life cycle involves stages or actions such as:
1. Acquisition
The acquisition stage marks the beginning of a fixed asset's life cycle. Typically, acquiring fixed assets such as machinery can be achieved through purchase. However, some assets might be constructed internally, in which case the costs associated with labour, specifically the portion of employees’ salaries involved in building the asset, must be accounted for in its capitalisation.
2. Depreciation
As fixed assets such as machinery and office equipment are utilised and age, their value decreases—except for land, which does not depreciate.
During this stage, several factors need to be considered to calculate depreciation accurately, including the asset's useful life, salvage value, and the chosen method of depreciation, such as straight-line, declining balance, units of production, or sum-of-the-years' digits.
3. Maintenance and Repairs
Over time, most fixed assets require maintenance and repairs to ensure operational efficiency. The decision to either capitalise these costs—adding them to the asset's value—or to treat them as expenses depends on the nature of the repairs. If the repairs are significant and increase the asset’s value or extend its useful life, capitalisation may be warranted.
4. Disposal
The final stage of a fixed asset's life cycle involves its disposal, where it may be converted into cash or removed from use. Disposal methods vary; an asset can be sold, donated, or replaced with a newer model. The chosen method impacts both the financial treatment and the strategic management of asset replacement. Tax implications to be considered may include recoupment of wear and tear previous allowed.
Objective of asset management: Optimising asset value
Managing fixed assets effectively means optimising asset value or return on investment (ROI) at each stage of the life cycle. This includes assessing whether the asset is a necessity and potential ROI at acquisition, ensuring operational efficiency and appropriate depreciation during use, and considering the financial and tax implications of disposal. Compliance with accounting standards and maintaining internal controls are essential to accurately reflect the asset's financial aspects. This approach enhances asset utility and financial returns, underpinning strategic financial planning and reporting.
Accounting for fixed assets
The accounting treatment of fixed assets under International Financial Reporting Standards (IFRS) and IFRS for Small and Medium-sized Entities (IFRS for SMEs) is guided by several key principles across the asset life cycle stages—acquisition, use (including depreciation), maintenance and repairs, and disposal. Here's how these are handled:
1. Acquisition
Under IFRS and IFRS for SMEs fixed assets are initially recognised at cost. The cost includes the purchase price, any import duties, and other taxes (that are not recoverable from the taxing authorities), and any directly attributable costs of bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.
When accounting for a client, fixed assets acquired during the financial year (additions) must be identified. Request the invoices for these assets to confirm that they are recorded at the correct values and dates.
2. Use and Depreciation
During the usage stage, fixed assets are carried at cost less accumulated depreciation and any accumulated impairment losses. Depreciation is systematically charged to expense over the asset's useful life. The method used should reflect the pattern in which the asset's future economic benefits are expected to be consumed by the entity. Common methods include straight-line, diminishing balance, and units of production. When there are major differences in the market value and carrying amount, the asset can be revalued which means that its carrying amount will be increased to match the market value.
3. Maintenance and Repairs
Maintenance and repair costs are recorded as expenses unless the costs provide additional future economic benefits, improve the asset, or extend the asset’s life. In this case, the costs are capitalised and added to the asset's carrying amount.
4. Impairment
Fixed asset-carrying amounts and adjustments for impairment losses if there is an indication that an asset may be impaired.
5. Disposal
Upon disposal or retirement, the difference between the asset’s carrying amount and the disposal proceeds is recognised as a gain or loss in profit or loss.
Documentation Required
Fixed assets are documented in financial records at cost when they are acquired, providing for annual depreciation.
Lead Schedule for Fixed Assets: Show the figures that align with the financial trial balance detailing each category of fixed assets, including cost, additions, disposals, accumulated depreciation, and carrying amounts. It's vital to ensure that opening and closing balances are accurate and consistent.
Fixed Asset Register: This comprehensive list shows each assets detailing its life cycle within the organisation by tracking cost, depreciation, revaluations, impairements and net book value. The register should be updated for any changes throughout the year, such as acquisitions or disposals.
Deeds of Ownership and Valuation Certificates: Ownership documentation and current valuation certificates are essential for properties and significant assets. These documents prove legal ownership and provide the value of the assets.
Invoices and contracts: Keep on file all the documents proving the original cost as well as additions, capitalised expenses.
Areas of Risk
1. Depreciation Calculations
Depreciation of fixed assets is a significant area prone to errors that can substantially skew financial statements. Several factors contribute to these risks:
Method Selection: Choosing an inappropriate depreciation method that does not accurately reflect the usage and economic benefits derived from the asset can lead to misstated financial results. For example, using straight-line depreciation for an asset that is heavily used in the early years of its life might understate expenses initially.
Rate Application: Applying incorrect depreciation rates, whether due to miscalculation or misunderstanding of regulatory guidelines, can lead to incorrect depreciation expenses. This is particularly problematic if the rates do not align with the useful life and salvage value of the assets.
Changes in Estimates: Failing to adjust depreciation calculations when there are changes in estimates regarding an asset’s useful life or salvage value can also lead to inaccuracies.
To mitigate these risks, accountants should regularly review the depreciation methods and rates applied to ensure they are appropriate and make adjustments as necessary based on changes in asset usage patterns, asset condition, and relevant regulations.
2. Asset Misclassification
Misclassification between capital and revenue expenditure can significantly distort an entity's financial statements, affecting both the income statement and balance sheet:
Capital vs. Revenue Expenditure: Expenditures that extend an asset’s useful life or enhance its capacity should be capitalised, while routine maintenance costs should be expensed. Misclassification can lead to improper capitalisation of expenses, inflating asset values and understating expenses, which in turn can affect profit margins and tax liabilities.
Lease Classification: Incorrect classification of leases (operating vs. finance) can impact the balance sheet structure and the profit and loss statement. This requires careful consideration of lease terms against the criteria set forth by accounting standards.
Accountants need to establish clear policies for classifying expenditures and conduct regular training to ensure that all accounting personnel understand these distinctions.
3. Inaccurate Asset Valuation
Asset valuation inaccuracies can have several repercussions, particularly in companies where fixed assets play a central role in operations:
Market and Economic Changes: Fluctuations in market values and economic conditions can lead to significant differences between the book value and fair market value of assets. Regular, unbiased valuations are crucial, especially for high-value and specialised assets.
Impairment Risks: Failure to recognize or timely address impairment of assets can lead to overstated asset values and, consequently, financial ratios. This misrepresentation can mislead stakeholders about the financial health of the entity.
Revaluation Practices: If the revaluation model is used, it’s essential to ensure that revaluations are performed regularly and reflect realistic, current values. Inaccurate revaluations can lead to volatility in earnings and affect stakeholders’ decisions.
To address these risks, accountants should ensure adherence to the latest accounting standards for asset valuation, conduct regular training on valuation techniques, and implement strict controls over the valuation process. Additionally, engaging independent valuation experts can provide objectivity, especially for complex or significant valuations.
By addressing these key risk areas diligently, accountants can enhance the reliability of financial reporting and provide stakeholders with a clearer, more accurate view of an organization’s asset base and financial status.
An Example: Accounting for a Fixed Asset
Below you find an example of how to account for a fixed asset from its purchase through its disposal under IFRS and IFRS for SMEs, showing the practical steps and journal entries involved in each stage of the asset's life cycle.
1. Acquisition
A South African company purchased a delivery vehicle on January 1, 2023, to improve its distribution services.
Costs: The purchase price of the vehicle is R300,000. Additional costs include R20,000 for import duties and R10,000 for delivery and installation, totaling R330,000.
Accounting Entry:
o Debit Fixed Assets (Vehicle): R330,000
o Credit Cash/Bank: R330,000
2. Use and Depreciation
Depreciation Method: The company's accounting policy states that vehicles should be depreciated using the straight-line depreciation method.
Useful Life: The expected useful life of the vehicle is estimated to be 5 years. This is in line with the wear and tear allowed by SARS. This is a good thing, as the depreciation and wear and tear allowed will be the same which means that there will be no deferred tax consequences.
Salvage Value: R30,000
Annual Depreciation = (Cost - Salvage Value) / Useful Life = (R330,000 - R30,000) / 5 = R60,000 per year.
Accounting Entry for Yearly Depreciation:
Debit Depreciation Expense: R60,000
Credit Accumulated Depreciation: R60,000.
3. Maintenance and Repairs
Scenario: In 2024, the vehicle requires significant engine repairs costing R25,000, which extend its useful life.
Accounting Treatment: The cost is capitalised as it extends the asset’s life.
Accounting Entry:
Debit Fixed Assets (Vehicle): R25,000
Credit Cash/Bank: R25,000.
4. Disposal
Scenario: In 2028, the company sells the vehicle.
Sale Price: R50,000
Carrying Amount at Disposal:
Original Cost: R330,000 + R25,000 (capitalised repairs) = R355,000
Accumulated Depreciation by 2028: R60,000/year × 5 years = R300,000
Net Book Value in 2028: R355,000 - R300,000 = R55,000
Loss on Sale: R55,000 - R50,000 = R5,000
Accounting Entry:
Debit Cash/Bank: R50,000
Debit Accumulated Depreciation: R300,000
Debit Loss on Disposal: R5,000
Credit Fixed Assets (Vehicle): R355,000.
5. Impairment
Scenario: No impairment is indicated before the vehicle is disposed of as it continues to be in use without a significant decline in performance beyond regular depreciation.
Download CIBA’s handy Accounting Checklist for Fixed Assets with a list of key considerations when accounting for fixed assets.
