Accounting Concepts Related to Fixed Assets¶
This document explains several accounting concepts related to fixed assets, including the cost concept, materiality, repairs and maintenance versus betterment expenses, asset grouping, and fair value accounting.
1. Cost Concept¶
The cost concept dictates that fixed assets are initially recorded at their historical cost (the price paid to acquire them). This cost remains on the books throughout the asset's life, even if the market value changes. Depreciation is accumulated separately and deducted from the historical cost to arrive at the asset's net book value.
Example: If a machine is purchased for $10,000, it will be recorded at $10,000, even if its market value later increases or decreases.
2. Materiality Concept¶
The materiality concept allows companies to expense low-value fixed assets immediately rather than capitalizing them (recording them as assets on the balance sheet). This simplifies accounting for inexpensive items. Companies set a threshold (e.g., $5,000 or $10,000), and any asset costing below this threshold is expensed.
Example: If a company sets a materiality threshold of $5,000 and purchases a printer for $400, it can be expensed immediately instead of being depreciated over its useful life.
3. Repairs and Maintenance vs. Betterment Expenses¶
-
Repairs and Maintenance: These are expenditures made to keep an asset in its normal operating condition. They are expensed in the period they are incurred.
Example: Routine maintenance on a vehicle, replacing a tire, or fixing a broken part. * Betterment Expenses (Improvements): These expenditures enhance the asset's functionality, extend its useful life, or increase its capacity. They are capitalized, meaning they increase the asset's book value and are depreciated over time.
Example: Replacing a car engine with a more efficient one, adding an extension to a building, or upgrading a machine to increase its output.
The distinction between repairs and maintenance and betterment expenses can be subjective. The key is whether the expenditure simply maintains the asset's existing condition or improves it.
4. Asset Grouping¶
How an asset is classified can affect the accounting treatment of replacements.
- Broad Asset Grouping: If an item is part of a larger asset (e.g., electrical fittings within a building), replacing that item is considered repairs and maintenance and is expensed.
- Separate Asset Classification: If the item is classified as a separate asset (e.g., electrical fittings as their own asset category), replacing it is considered an addition to the fixed asset and is capitalized.
Example: Replacing light bulbs in a building (broad grouping) is an expense. Replacing an entire electrical panel that was classified as a separate asset is a capital expenditure.
5. Fair Value Accounting vs. Cost Concept¶
- Cost Concept: As discussed earlier, assets are recorded at their historical cost.
- Fair Value Accounting: International Financial Reporting Standards (IFRS) allow for fair value accounting, where assets are periodically revalued to their current market value. This provides a more up-to-date picture of the asset's worth.
While IFRS allows fair value accounting, many companies still use the cost concept and then test for impairment. Impairment occurs when an asset's recoverable amount (the higher of its fair value less costs to sell and its value in use) is less than its carrying amount (net book value). If impairment is found, the asset's value is written down.
Land Revaluation: Land is often an exception where companies may choose to revalue the asset if there's been a significant increase in its market value.
Example of Land Revaluation:
A company purchased land 30 years ago for $3 million. Its current market value is $100 million. If the company revalues the land, the accounting entry would be:
- Debit: Land (Increase) $97 million
- Credit: Revaluation Reserve (Equity) $97 million
The Revaluation Reserve is a component of equity on the balance sheet. This entry increases the land's book value to $100 million and reflects the unrealized gain in equity.
How can I help you today?