Any tangible item not consumed within one accounting cycle (typically a year) and providing long term utility is referred to as a Fixed Asset. Traditional images include manufacturing equipment, tools, transportation vehicles, buildings and utility related systems (sewage systems, power grids, power plants and dams). In accounting, these assets are recorded to the balance sheet as ‘Fixed Assets’. For very large corporations the line item is referred to as ‘Buildings and Equipment’ or some other generic term identifying capital expenditures for high dollar cost items.
To be classified as a fixed asset the item must pass two tests. The first test is tangible in nature. This means it must have physical characteristics. So such items as patents or research and testing do not pass the test due to a lack of physical existence. In accounting terminology, these are referred to as intangibles and are recorded in a different class of assets. Examples of tangible items include tools, site development costs (pavement, curbing, light poles, even trees), structures and trucks.
The second test is the utility period. This is more commonly referred to as the consumption period. If the item will be consumed or used over an extended period of time i.e. longer than the traditional accounting cycle (a calendar year) it may pass the 2nd part of the test. But we need to be clear here. If the item is purchased and is used up as a part of the product you sell or service you render, it is not a fixed asset, but inventory in nature. The following are examples of tangible and consumable items, therefore not meeting both tests to be classed as fixed assets:
· Toner Cartridge – purchased for use in your office printer, it will most likely last more than one year, but because it is used up providing documents as a part of the service you render, it is not a fixed asset. Remember it passes the first test of tangible but technically it is considered consumed for the second test.
· Raw Resources – you are a concrete provider, you purchase 200 railroad cars of sand and pile it up out in the work yard. This sand is physical in nature i.e. tangible and will be used over the next 18 months. So technically it passes test two of more than one accounting cycle. The reality is that it is a part of the product you provide; therefore it is inventory and not a fixed asset.
· Chemicals, Lubricants, Gases – these items are used over an extended period of time in the manufacturing or service you render; although tangible, they are consumable and therefore should be classed as supplies in the inventory area of your balance sheet.
For the small business entrepreneur the definition requires modification to simplify accounting. There is a tenet of accounting that basically states that the cost should not exceed the benefit derived. For any fixed asset, there is cost associated with ‘carrying’ the asset on the books of record. Fixed Assets are recorded in a special ledger or spreadsheet as fixed assets and subdivided into groups as illustrated below:
Office Equipment $Z,ZZZ
Manufacturing (Tooling) ZZZ,ZZZ
Noticed that this looks like it is organized from the overall lowest cost to the most expensive, but in reality the accountant organized this section based on life expectancy from short life value of office equipment to the never ending life of land. Any reasonable organization format is acceptable as long as the reader can understand the report. On the balance sheet the entire group can just be called ‘Fixed Assets’ or you can detail this into subgroups like above.
Now back to the tenet of benefit must exceed the cost. The carrying costs means that an accountant will review the items each year for calculating depreciation and will most likely have to confirm the existence of the assets via an inventory of the items. So a small businessman shouldn’t spend his time dealing with these types of petty issues as it relates to low cost items. Some items meet both tests of tangible and long life, but it is unrealistic to record them as fixed assets because of the costs to maintain them on the books would exceed the benefit associated with that cost to maintain them on the books. Here are two examples:
· The Desk Trash Can – notice it meets both tests! It is not a part of the item sold or service rendered. But you need to be realistic because you don’t want to record a $13 item to your fixed assets ledger. It should be expensed to the profit and loss statement or placed in a large group asset called ‘Office Auxiliary Equipment’ and combined as one line item in the subgroup of Office Equipment (Desks, Computers, Printers, Etc.). This subgroup is generally created when you first start business and purchase everything from staplers to office signage. Group it all together as one line item and it is included in the Office Equipment section of Fixed Assets. So therefore, Office Equipment has the following subgroups:
- Technology (Computers, Servers, Wiring, Etc.)
- Phones and Phone System
- Desks and Furniture
- Cabinets, Storage Systems, Bookcases
- Software (See Below)
- Office Auxiliary (staplers, trash cans, hole punches, tape dispensers, the cart, books)
- Tools – this one is more financially based than anything else. For some reason they have a tendency to disappear, I don’t why, they just do. So everything from hand tools to extension cords etc. should generally be expended. However, sometimes you will buy tooling systems such as die sets, drill bit systems, etc. We are talking about some serious dollars here and these should be recorded as fixed assets in the equipment group. Odds are that you will keep a closer eye on a tap and die set that costs $4,200 used with your CNC machine than the $19 hammer.
The key is to create a dollar value threshold. I personally believe that anything costing less than $500, but still passes the test of tangible and long life should be expended. However, if you buy a group of items at one time and the combined total is more than $500; I would combined the items as one line item in the ledger and record them as a fixed asset. An example is purchasing the refrigerator, microwave, coffee pot, toaster, and stove for the office kitchen.
Yes, all of the above comply with Generally Accepted Accounting Principles and the Internal Revenue Code.
Software – this is one of the exceptions to the rule above. For some strange reason, the accounting profession has decided that this is a fixed asset. However, the definition was modified because the ever changing world of software providers. They have gotten to the point of reproducing this stuff on an annual basis and requiring the consumer to keep upgrading to stay in compliance. So, the accounting world and the IRS agree that if you purchase off the shelf type of software, it should be immediately expensed. If you purchase custom designed or industry specific software then this should be classed as a fixed asset in your Office Equipment section. I know, it is not tangible in nature, but accountants figured that since it is used regularly (daily) and it generally requires maintenance like equipment, it should be considered tangible. I don’t make the rules, and often I don’t think the rules are the best, but consistency is important in our profession. So software is considered a fixed asset.
In summation, fixed assets must meet two tests. First is tangible in nature and the second test is a long life or utility period. By setting dollar value thresholds and using some common sense, a small business entrepreneur will not get bogged down with the accounting requirements and can stay focused on making a profit. Knowledge is Power.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.
If you found this article helpful, please consider a donation to the site. The donation button is just to the right. Even if you don’t make a contribution, I encourage you to read more articles on the website to help you become a better business entrepreneur.
Other articles related to fixed assets the reader will find beneficial include:
The Fixed Assets Section of the Balance Sheet – there are several different presentation formats for the reader to understand the fixed assets section of the balance sheet. In addition, learn about the notes section related to fixed assets.
Depreciation - now that the reader understands what are fixed assets, he needs to gain an understanding of the generally accepted method of expending that asset to the profit and loss statement.