Virtually every company has an investment in fixed assets, and fixed assets are used to produce goods and services to clients. This investment can range from a single computer to a fleet of cars, for example, or from a leased property to an entire structure of industrial machinery. For most companies, fixed assets represent a significant capital investment, so it is essential that accounting be applied correctly.
In this case, some factors are important in understanding the topic, such as the fact that fixed assets are capitalized. This occurs because the benefit of the asset extends beyond the year of purchase, unlike other costs, which are period costs that benefit only the period incurred. Another important fact is that the fixed assets must be registered at the acquisition cost, since the cost includes all expenses directly related to the acquisition or construction and the preparations for the intended use. Companies must also adopt a capitalization policy that establishes a dollar value limit. Fixed assets that cost less than the limit amount must be accounted for as an expense. Finally, additions that increase the asset's service potential must be capitalized and additions that are better categorized as repairs must be accounted for when incurred.
When it comes to depreciation, for financial reporting purposes, it should be noted that the useful life of an asset may differ from its physical life. The estimated useful life of an asset for financial reporting purposes may also be different from the depreciable useful life for tax reporting purposes. In addition, the objectives of financial reporting and tax depreciation are different, since generally tax methods take advantage of rules that encourage investments in productive assets, allowing for a faster reduction, while depreciation for financial reporting purposes is intended to compare costs with revenue.
The service lifespan may be based on a company's industry standards, based on how long the company expects to use the asset in its operations. Certain assets may be used until they have no value and are disposed of without compensation, while others may still have value to the business at the end of their useful life. If an asset has a residual value at the end of its useful life that can be realized through sale or exchange, the depreciation must be calculated based on the cost minus the estimated recovery amount. As estimates, useful lives must be evaluated over the life of an asset and changes must be made when appropriate.
Another important issue in fixed asset accounting is in relation to your lease or business lease. After all, not all fixed assets are bought by a company. Most companies use both buying and leasing to acquire fixed assets. Under current accounting rules, assets under capital lease are capitalized by the lessee. The depreciable life of assets under capital lease is generally the useful life of the asset or the related lease term.
Real estate leases are generally classified as operating leases by the lessee. As a result, the leased facility is not capitalized by the lessee. However, improvements made to the property are called improvements to third-party properties and must be capitalized when acquired by the tenant. The depreciation period for improvements to third-party properties is the shortest of the useful life of the improvement or the term of the lease agreement.
Taking into account the criteria involving fixed assets, some pros and cons are important to remember, such as the recommendation to consider all costs at the time of acquisition, adopt a capitalization policy, estimate the useful life of the depreciation based on the estimated useful life of an asset, consider whether the asset will have value at the end of its useful life, and base the depreciation on the cost, minus the estimated recovery amount. It is also important to reevaluate useful life estimates continuously, keep your depreciation records in sufficient detail so that assets can be accurately tracked, and consider reducing the recoverable value of assets when significant events or changes in circumstances occur.
The recommendations extend to actions that should not be performed, such as using depreciable lives based on accounting rules for financial reporting purposes, ignoring changes in the use or service of an asset, as it may be necessary to consider the loss of assets, automatically depreciate a leased asset during its useful life, or forget to consider insurance record keeping requirements when registering and tracking fixed assets.
What about the capitalization of software costs? Are there specific guidelines in the accounting standards? In this case, capitalized costs consist of fees paid to third parties to purchase or develop software. Capitalized costs also include fees for hardware installation and testing, including any parallel processing phase. The costs to develop or purchase software that allows the conversion of old data are also capitalized. However, the data conversion costs themselves are counted when incurred. Training and maintenance costs, which generally represent a significant portion of total spending, are counted as period costs and upgrade and upgrade costs must be borne, unless they are likely to result in additional functionality.
When a company buys third-party software, the purchase price may include various elements, such as software training costs, routine maintenance fees, data conversion costs, reengineering costs, and the cost of rights to future updates and enhancements. Such costs must be allocated among all individual elements, based on objective evidence of the fair value of the contract elements.
Fixed assets must also be tested for individual impairment, or as part of a group, when events or changes in circumstances indicate that the book value of an asset may exceed its future gross cash flows. Such circumstances include a significant reduction in the market price of the asset, significant adverse change in the degree or manner in which the asset is being used, significant deterioration in the physical condition of the asset, accumulation of costs that significantly exceed the amount originally expected to acquire or build the asset, and an operating loss in the current period and a history of losses, indicating that future continuing losses associated with the use of the asset may occur.
Recoverable value accounting applies to a situation where a significant asset or collection of assets is not as economically viable as originally thought. Isolated incidents in which a particular asset may be deteriorated are generally not material enough to warrant recognition. In these cases, a change in the estimated life of an asset for depreciation may be all that is needed. The reduction to recoverable value is typically a material adjustment to the value of an asset or collection of assets.
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