If you are unsure of the standards for capitalizing fixed assets, you’re not alone. It’s a complicated topic and there are many different ways businesses can handle it. That’s why we have put together this guide to ensure that you know how to capitalize your fixed assets according to GAAP standards.
The company must have accurate GAAP (Generally Accepted Accounting Principles) accounting to have the correct balance sheet. In that case, fixed assets must be recorded according to GAAP standards and grouped into appropriate categories for the company’s business model.
What is Capitalizing?
“Capitalizing” a cost allows a company to report that cost as an asset rather than as an expense. It not only enhances the company’s value by putting more assets on the balance sheet, but it also improves profit by reducing expenses. Financial accountants of companies follow the US generally accepted accounting principles or GAAP. These are a set of principles that guide a company on what a company can capitalize on and how it chooses to do so.
What is an Asset?
GAAP defines an asset as something a company owns or controls whose benefit extends into the future. Anything that doesn’t fit this criterion cannot be capitalized.
A fixed asset is a tangible, long-term asset that cannot be readily liquidated.
Current Assets are more liquid and not depreciable.
They have a life of more than one year.
They are expected to be sold or used in the course of the business over the next year.
Such assets are usually classified as PPE – plant, property, and equipment –on the balance sheet.
Cash, cash equivalent, marketable securities and other liquid assets are current assets.
They can be capatalised and termed as assets rather than an expense.
They cannot be capitalised as an asset.
Land, building, equipment, items held in inventory, stocks, bonds, accounts receivables from customers have future economic value and are capitalized as assets.
Other costs such as advertising, marketing, and research and development have to be expensed and cannot be capitalized as asset..
Assets look better than expenses on a financial statement and therefore companies are always looking to capitalize as many expenses as possible.
What are the criteria for capitalization of fixed assets as per GAAP?
1. Time Frame to decide on capital classification
According to the Financial Accounting Standards Board, which lays down the rules for GAAP, assets are those purchases/expenses that have a possible future benefit. On the other hand, expenses require consuming assets, such as cash, to produce goods or deliver services. When a company makes a purchase, it can be challenging to determine whether to classify it as an asset or an expense.
Whether a $50 printer you purchase is an expense or an asset is a matter of debate. In order to simplify the decision, GAAP states that purchases must have a useful life of more than one year to be capitalized as assets to simplify the decision.
2. Set up Costs Can be Capitalized Too
GAAP permits companies to capitalize purchases that are needed to bring the fixed asset to a usable state. Most times, a piece of equipment is not the only expense the company is likely to incur to get the operations going. It may also have to pay to ship the equipment to the location, purchase shipping insurance and waste some material in the beginning as part of trial runs. All of these purchases have been incurred on bringing the equipment/machine to a workable state; therefore, the company can capitalize all of them under GAAP.
Let us assume that a publishing company buys a press from Germany for $5 million to fully understand this. Not only can the company capitalize the purchase price of the press, but also the cost of transporting the equipment from Germany, assembly costs, the cost of any modifications that need to be made to the company’s printing plant, and even the taxes and tariffs paid on the presses can all be capitalized.
On a far smaller scale, if a company buys $100 worth of stock for investment purposes and pays $1 as commission, it can capitalize $101 as the total acquisition cost.
3. Expenses on Improvements can be Capitalized
GAAP also allows companies to capitalize on improvements to fixed assets such as land and equipment, if they are not part of routine maintenance. GAAP allows the costs to be capitalized if they add value to the fixed asset or prolong its life.
For instance, a company can capitalize the expense incurred on a new transmission line for a delivery truck which will prolong its life by five years, but it cannot capitalize cost for a routine oil change. The rules for land are also similar. Companies can capitalize on expenses on sidewalks, signboards, and parking lots but cannot capitalize on the expense incurred on their routine maintenance.
4. Interest Expense on Loan to Develop the Asset
If the company plans to take a loan to develop the asset, the associated interest expense can be capitalized under GAAP. However, the companies are allowed to capitalize the interest expense only if they will construct the asset themselves. The interest cannot be capitalized if the company will purchase or pay somebody else to build the asset. Companies can only recognize the interest expense as they incur the actual expense in constructing the asset.
As an example, if a company spends $10,000 in building an asset in one period, they can capitalize the interest expense only for $10,000.
5. Handling Depreciation
When the company capitalizes on an asset, it doesn’t mean it will never have to expense the cost. Fixed assets such as plant, property, and equipment become less valuable as time passes. Buildings deteriorate, vehicles and equipment suffer wear and tear, and technology becomes obsolete.
GAAP recognizes this and requires that a portion of the total value be recorded as an expense for each year of the asset’s useful life. This is called depreciation. There are multiple ways to calculate depreciation. The asset’s useful life, salvage value, and the method selected for depreciation should all be given due consideration.
A $5 million worth press, for example, might have a useful life of 25 years, at the end of which it will be worth only $200,000 of scrap metal. The company will need to depreciate $4.8 million worth of value over 25 years. Even under the most common depreciation method, the company would claim a depreciation expense to the tune of $192,000 each year for 25 years.
Depreciation also serves another purpose under GAAP: the matching principle. According to this principle, companies must also report all expenses incurred on generating those revenues when they report revenue. In the case of the printing press, $192,000 is the depreciation expense incurred in generating that revenue from that printing press for that year.
The decision to capitalize or expense fixed assets is a complex one and must be taken with due care and after consulting an expert. One must take into consideration a variety of factors such as tax rates, the useful life of the asset, and depreciation methods.