Definitions
First things first, there are a few terms we need to make sure everyone knows just from the title!
Fixed Assets are the things that you own which are the touchy, feely things, for example buildings, vehicles, furniture, computers, fixtures. The costs of these are spread out over the useful life of the asset typically 3-30 years this is depreciation. These have a future benefit to the business.
Balance Sheet is one of the top 3 financial statements. It shows how much equity or capital the owner has in the business. This is a snapshot financial statement as of a specific day. It also shows the accounting equation in a statement! Assets=Liabilities + Equities.
Accounting Principle #4
I hate to do this, but you should know about Accounting Principle #4. The Cost Principle states that financial transactions are shown, forever, as the original and historical cost. We do NOT adjust for inflation or the increase or decrease in the value of an item. To relate this to your personal life, when you buy a house, the original purchase price never changes to show what you have earned on the property when you go to sell it and realize the gains/loss based on what you purchased it for, not its current value.
Balance Sheet
OK, back to the original thought! Is your balance sheet showing an accurate picture of the business’ financials? Fixed assets go onto the balance sheet as an asset and in turn shows the equity in the asset on the other side of the equation. Let’s go back to your house. You have the asset of the house which you purchased for $250,000. You have a liability of a mortgage on that for $200,000. The left-over amount is your equity of $50,000. The useful life or length the bank will lend is typically up to 30 years. Therefore, we would depreciate it over the 30 years. However, until we sold the house, it would remain an asset on the books even after those 30 years are up and all the mortgage is paid and all the value is in the equity.
Fixed Asset or Expense?
In order to determine if a purchase should be a fixed asset or an expense, you should have a written capitalization policy to adhere to in your business. What’s your capitalization policy and is it written? Most clients will tell me no at this point. Hey, that’s what I am here for to help and guide you with the financial stuff you need for your business. Great, how do we get started writing one?
First, we need to determine what amount of a purchase will be a fixed asset, anything under that would be treated as an expense for the year. A commonly accepted practice is to have the purchase classified as a fixed asset if it is over $2500. If it is, we would capitalize the purchase and apply a depreciation each year. Anything purchased for less than $2500 would be treated as a current year expense and will be on the Income Statement not the Balance Sheet. Next, we need to document this decision and make a written policy. After we have drafted it, we need to adhere to it for all purchases consistently.
Once we have determined a purchase is a fixed asset, it must be added to balance sheet when acquired. On the flip side, it would be deleted from balance sheet when disposing of fixed asset. When we are adding the fixed asset to the balance sheet, we must determine how long we will depreciate the fixed asset. This can range from 3 to 30 years and is typically based on the useful life of the asset.
Intangible Assets
Intangible assets are another weird thing that we should talk about. This is something like purchasing a franchise and you have the intangible asset of the use of the name of the franchise based on a fee you paid to purchase the franchise. An intangible asset gets amortized over 5-15 years which is similar to depreciation.
Capitalization Policy
If you feel like you need help in writing your capitalization policy, send me a note and we can discuss my assistance in the process. Remember, only you can make the determination and while there are common practices, no 2 businesses are alike and your amount could be higher or lower for the threshold.