Author: Jim Riley Last updated: Sunday 23 September, 2012
Accounting for fixed assets
An important distinction is made in accounting between "current assets"
and " "fixed assets".
Current assets are those that form part of the circulating
capital of a business. They are replaced frequently or converted into cash
during the course of trading. The most common current assets are stocks, trade
debtors, and cash.
Compare current assets with fixed assets. A fixed asset is an asset of a business intended for continuing use, rather
than a short-term, temporary asset such as stocks.
Fixed assets must be classified in a company's balance sheet as intangible,
tangible, or investments. Examples of intangible assets include goodwill,
patents, and trademarks. Examples of tangible fixed assets include land and
buildings, plant and machinery, fixtures and fittings, motor vehicles and
How should the changing value of a fixed asset be reflected in a
The benefits that a business obtains from a fixed asset extend over several
years. For example, a company may use the same piece of production machinery
for many years, whereas a company-owned motor car used by a salesman probably
has a shorter useful life.
By accepting that the life of a fixed asset is limited, the accounts of
a business need to recognise the benefits of the fixed asset as it is "consumed"
over several years.
This consumption of a fixed asset is referred to as depreciation.
Definition of depreciation
Financial Reporting Standard 15 (covering the accounting for tangible fixed
assets) defines depreciation as follows:
"the wearing out, using up, or other reduction
in the useful economic life of a tangible fixed asset whether arising from
use, effluxion of time or obsolescence through either changes in technology
or demand for goods and services produced by the asset.'
A portion of the benefits of the fixed asset will be used up or consumed
in each accounting period of its life in order to generate revenue. To calculate
profit for a period, it is necessary to match expenses with the revenues they
In determining the expenses for a period, it is therefore important to include
an amount to represent the consumption of fixed assets during that period
(that is, depreciation).
In essence, depreciation involves allocating the cost of the fixed asset
(less any residual value) over its useful life. To calculate the depreciation
charge for an accounting period, the following factors are relevant:
- the cost of the fixed asset;
- the (estimated) useful life of the asset;
- the (estimated) residual value of the asset.
What is the relevant cost of a fixed asset?
The cost of a fixed asset includes all amounts incurred to acquire the asset
and any amounts that can be directly attributable to bringing the asset into
Directly attributable costs may include:
- Delivery costs
- Costs associated with acquiring the asset such as stamp duty and import
- Costs of preparing the site for installation of the asset
- Professional fees, such as legal fees and architects' fees
Note that general overhead costs or administration costs would not be included
as part of the total
costs of a fixed asset (e.g. the costs of the factory building in which the
asset is kept, or the cost of the maintenance team who keep the asset in good
The cost of subsequent expenditure on a fixed asset will be added to the
cost of the asset provided that this expenditure enhances the benefits of
the fixed asset or restores any benefits consumed.
This means that major improvements or a major overhaul may be capitalised
and included as part of the cost of the asset in the accounts.
However, the costs of repairs or overhauls that are carried out simply to
maintain existing performance will be treated as expenses of the accounting
period in which the work is done, and charged in full as an expense in that
What is the Useful Life of a fixed asset?
An asset may be seen as having a physical life and an economic life.
Most fixed assets suffer physical deterioration through usage and the passage
of time. Although care and maintenance may succeed in extending the physical
life of an asset, typically it will, eventually, reach a condition where the
benefits have been exhausted.
However, a business may not wish to keep an asset until the end of its physical
life. There may be a point when it becomes uneconomic to continue to use the
asset even though there is still some physical life left.
The economic life of the asset will be determined by such factors as technological
progress and changes in demand. For purposes of calculating depreciation,
it is the estimated economic life rather than the potential physical life
of the fixed asset that is used.
What about the Residual Value of a fixed asset?
At the end of the useful life of a fixed asset the business will dispose
of it and any amounts received from the disposal will represent its residual
value. This, again, may be difficult to estimate in practice. However, an
estimate has to be made. If it is unlikely to be a significant amount, a residual
value of zero will be assumed.
The cost of a fixed asset less its estimated residual value represents the
total amount to be depreciated over its estimated useful life.