Fixed Asset Accounting, Steven Bragg (2011)

AccountingTools Series
Fixed
Asset
Accounting
A Comprehensive Guide
Steven M. Bragg, CPA

Fixed Asset Accounting
The Comprehensive Guide
Steven M. Bragg
Copyright © 2011 by Steven M. Bragg. All rights reserved.
Published by Steven M. Bragg, Centennial, Colorado.
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Table of Contents
Chapter 1 - Introduction to Fixed Assets 1
What are Fixed Assets? 1
The “Fixed Asset” Designation 3
Fixed Asset Classifications 4
Applicable Accounting Frameworks 7
Accounting for Fixed Assets 7
Accounting for Intangible Assets 9
Accounting for Not-for-Profit Fixed Assets 9
Fixed Asset Disclosures 10
Fixed Asset Controls 10
Fixed Asset Policies and Procedures 11
Fixed Asset Record Keeping 11
Fixed Asset Auditing 12
Fixed Asset Measurements 12
Chapter 2 - Capital Budgeting Analysis 17

Overview of Capital Budgeting 17
Bottleneck Analysis 19
Net Present Value Analysis 20
The Payback Method 23
Capital Budget Proposal Analysis 24
The Outsourcing Decision 26
The Capital Budgeting Application Form 28
The Post Installation Review 32
The Lease or Buy Decision 33
Chapter 3 - Initial Fixed Asset Recognition 39

The Capitalization Limit 39
The Base Unit 41
GAAP: Initial Measurement of a Fixed Asset 44
GAAP: Measurement of Assets Acquired in a Business
Combination 45
GAAP: Measurement of Assets Acquired in a Capital Lease 45
GAAP: Non-Monetary Exchanges 47
IFRS: Initial Inclusions in a Fixed Asset 53
IFRS: Initial Cost of a Fixed Asset 55
IFRS: Measurement of Assets Acquired in a Business
Combination 58
IFRS: Measurement of Assets Acquired in a Capital Lease 58
IFRS: Non-Monetary Exchanges 60
Chapter 4 - Interest Capitalization 66

Why and When Do We Capitalize Interest? 66
Assets for Which You Must Capitalize Interest 68
Assets for Which You Do Not Capitalize Interest 68
The Interest Capitalization Period 69
The Capitalization Rate 71
Calculating Interest Capitalization 73
Derecognizing Capitalized Interest 75
Interest Capitalization Under IFRS 75
Chapter 5 - Asset Retirement Obligations 81

The Liability for an ARO 81
The Initial Measurement of an ARO 83
Subsequent Measurement of an ARO 85
Settlement of an ARO 86
AROs Under IFRS 88
Chapter 6 - Depreciation and Amortization 92

The Purpose of Depreciation 93
Depreciation Concepts 93
Accelerated Depreciation 95
Straight-Line Method 97
Sum-of-the-Years’ Digits Method 97
Double-Declining Balance Method 98
Depletion Method 100
Units of Production Method 103
MACRS Depreciation 104
The Depreciation of Land 106
The Depreciation of Land Improvements 107
Depreciation Accounting Entries 108
Accumulated Depreciation 109
Depreciation Under IFRS 110
Other Depreciation Topics 111
Chapter 7 - Subsequent Fixed Asset Measurement 116

The Capitalization of Additional Expenditures 116
Asset Revaluation for Tangible Assets 120
Asset Revaluation for Intangible Assets 124
Chapter 8 - Fixed Asset Impairment 129

Asset Impairment Under GAAP 129
Asset Impairment Under IFRS 134
Chapter 9 - Fixed Asset Disposal 156

Asset Derecognition 156
The Held-for-Sale Classification 156
Reclassification from Held for Sale 161
Discontinued Operations 164
Abandoned Assets 166
Idle Assets 166
Asset Disposal Accounting 166
Asset Disposal Under IFRS 168
Chapter 10 - Fixed Asset Disclosures 173

GAAP Disclosures 173
IFRS Disclosures 179
Chapter 11 - Not-for-Profit Fixed Asset Accounting 197

Initial Recognition of Fixed Assets 197
Restrictions on Contributed Assets 199
Valuation of Contributed Assets 200
Valuation of Contributed Services 201
Valuation of Art and Similar Items 202
Depreciation of Fixed Assets 202
Recordation of Fixed Assets 203
Fixed Asset Controls in a Not-for-Profit Entity 203
Chapter 12 - Fixed Asset Record Keeping 208

Fixed Asset Accounts 208
Construction Project Record Keeping 212
Building Record Keeping 213
Equipment Record Keeping 215
Land Record Keeping 218
Lease Record Keeping 219
Document Retention 221
Fixed Asset Reports 222
Chapter 13 - Fixed Asset Controls 236

Controls for Fixed Asset Acquisition 236
Controls for Fixed Asset Construction 239
Controls for Fixed Asset Theft 240
Controls for Fixed Asset Valuation 242
Controls for Fixed Asset Depreciation 244
Controls for Fixed Asset Disposal 245
The Control of Laptop Computers 246
Chapter 14 - Fixed Asset Policies and Procedures 251

Capital Budgeting Policies and Procedures 251
Asset Recognition Procedures 256
Asset Revaluation Policies and Procedures 259
Asset Exchange Policies and Procedures 261
Depreciation Policies and Procedures 262
Impairment Policies and Procedures 266
Asset Retirement Obligation Policies and Procedures 267
Intangible Asset Policies and Procedures 268
Transfer Policies 269
Disposal Policies and Procedures 270
Record Keeping Policies 271
Tracking Policies and Procedures 272
The Fixed Asset Manual 274
Chapter 15 - Fixed Asset Tracking 280

Tag Tracking 280
Bar Code Tracking 282
RFID Tracking – Active Transmission 283
RFID Tracking –Passive Transmission 284
Wireless Monitoring 284
Chapter 16 - Fixed Asset Measurements 290

Sales to Fixed Assets Ratio 290
Repairs and Maintenance Expense to Fixed Assets Ratio 292
Accumulated Depreciation to Fixed Assets Ratio 294
Cash Flow to Fixed Asset Requirements Ratio 295
Return on Assets Employed 296
Return on Operating Assets 298
Bottleneck Utilization 299
Unscheduled Machine Downtime 300
Chapter 17 - Fixed Asset Auditing 306

Fixed Asset Audit Objectives 306
Fixed Asset Audit Procedures 307
Auditor Requests 311
Appendix - Journal Entries 318
Glossary 324
Preface
Fixed Asset Accounting describes every aspect of the accounting
for fixed assets under both GAAP and IFRS, illustrates key con-
cepts with numerous examples, and adds review questions and an-
swers to improve your comprehension. There are also dozens of
tips and definitions throughout the text. The book is designed for
both practicing accountants and students, since both can benefit
from its detailed descriptions of fixed asset budgeting, acquisition,
disposition, and more. Fixed Asset Accounting addresses four ma-
jor fixed asset accounting topics, which are:
• Part I – Accounting for Fixed Assets. Chapters 1 through 9

cover the complete range of accounting activities related to
fixed assets, including capital budgeting, asset recognition,
interest capitalization, asset retirement obligations, depre-
ciation, impairment, and disposal.
• Part II – Special Accounting for Fixed Assets. Chapter 10
notes the various financial statement disclosures associated
with fixed assets, while Chapter 11 delves into special con-
siderations for the not-for-profit entity.
• Part III – Fixed Asset Systems. Given the high cost of fixed
assets, you need to surround them with a strong control sys-
tem, which is addressed in four chapters. Chapter 12 de-
scribes fixed asset record keeping, while Chapter 13 delves
into a variety of controls over all aspects of fixed asset us-
age. Chapter 14 itemizes many policies and procedures for
fixed asset transactions. Finally, Chapter 15 addresses a
number of available fixed asset tracking technologies.
• Part IV – Related Topics. There are several ancillary areas
that may be of interest to the fixed asset practitioner. Chap-
ter 16 describes a number of ratios that can be used to
monitor fixed assets. Chapter 17 gives an overview of the
procedures that auditors typically follow during the fixed
asset portion of an audit, and describes the information they
will request as part of this audit.
There is also an appendix that contains templates for the journal
entries used in most fixed asset transactions, as well as a compre-
hensive glossary of fixed asset terms.
Fixed Asset Accounting gives you a complete grounding in
every aspect of the accounting systems needed for fixed assets. As
such, it may earn a place on your book shelf as a reference tool for
years to come.
Centennial, Colorado
March, 2011
About the Author
Steven Bragg, CPA, has been the chief financial officer or con-
troller of four companies, as well as a consulting manager at Ernst
& Young. He received a master’s degree in finance from Bentley
College, an MBA from Babson College, and a Bachelor’s degree
in Economics from the University of Maine. He has been a two-
time president of the Colorado Mountain Club, and is an avid al-
pine skier, mountain biker, and certified master diver. Mr. Bragg
resides in Centennial, Colorado. He has written the following
books:
Accounting and Finance for Your Small Business

Accounting Best Practices
Accounting Control Best Practices
Accounting Policies and Procedures Manual
Advanced Accounting Systems
Bookkeeping Essentials
Billing and Collections Best Practices
Business Ratios and Formulas
Controller’s Guide to Costing
Controller’s Guide to Planning and Controlling Operations
Controller’s Guide: Roles and Responsibilities for the New
Controller
Controllership
Cost Accounting Fundamentals
Cost Reduction Analysis
Essentials of Payroll
Fast Close
Financial Analysis
Fixed Asset Accounting
GAAP Guide
GAAP Policies and Procedures Manual
GAAS Guide
IFRS Made Easy
Inventory Accounting
Inventory Best Practices
Investor Relations
Just-in-Time Accounting
Management Accounting Best Practices
Managing Explosive Corporate Growth
Mergers and Acquisitions
Outsourcing
Payroll Accounting
Payroll Best Practices
Revenue Recognition
Run the Rockies
Running a Public Company
Sales and Operations for Your Small Business
The Controller’s Function
The New CFO Financial Leadership Manual
The Ultimate Accountants’ Reference
The Vest Pocket Controller’s Guide
The Vest Pocket GAAP Guide
The Vest Pocket IFRS Guide
Throughput Accounting
Treasury Management
Free On-Line Resources

Mr. Bragg maintains the www.accountingtools.com web site,
which contains the accounting best practices podcast, an account-
ing blog, and a comprehensive index of articles on all possible ac-
counting subjects.
Chapter 1
Introduction to Fixed Assets
Introduction
Why is a fixed asset different from other expenditures that are
charged to expense right away? And how do we classify these
fixed assets? This chapter introduces the concept of the fixed asset,
describes when you should classify an expenditure as a fixed asset,
and provides further references to additional information about
various fixed asset concepts that we will deal with later in this
book.
What is an Expenditure?
An expenditure is a payment or the incurrence of a liability by an
entity.
What are Fixed Assets?

The vast majority of the expenditures that a company makes are
for consumables, such as office supplies, wages, or products that it
sells to customers. The effect of these items pass through the com-
pany quickly – they are used or sold and converted to cash, and
they are recorded as expenses immediately, or with a slight delay
(if they involve inventory). Thus, the benefits they generate are
short-lived.
Fixed assets are entirely different. These are items that generate
economic benefits over a long period of time. Because of the long
period of usefulness of a fixed asset, it is not justifiable to charge
its entire cost to expense when incurred. Instead, the matching
principle comes into play. Under the matching principle, you
should recognize both the benefits and expenses associated with a
transaction (or, in this case, an asset) at the same time. To do so,
we convert an expenditure into an asset, and use depreciation to
gradually charge it to expense over the time period when it is pro-
viding benefits.
What is Depreciation?
Depreciation is the gradual charging to expense of an asset's cost
over its expected useful life.
By designating an expenditure as a fixed asset, we are shifting the

expenditure away from the income statement, where expenditures
normally go, and instead place it in the balance sheet. As we
gradually reduce its recorded cost through depreciation, the expen-
diture gradually flows from the balance sheet to the income state-
ment. Thus, the main difference between a normal expenditure and
a fixed asset is that the fixed asset is charged to expense over a
longer period of time.
What is the Income Statement?

The income statement is a financial report that summarizes an en-
tity's revenue and expenses, as well as its net income or loss. The
income statement shows an entity's financial results over a specific
time period, usually a month, quarter, or year.
What is the Balance Sheet?

The balance sheet is a report that summarizes all of an entity’s as-
sets, liabilities, and equity as of a given point in time, which is
usually the end of an accounting period.
The process of identifying fixed assets, recording them as assets,

and depreciating them is time-consuming, so it is customary to
build some limitations into the process that will route most expen-
ditures directly to expense. One such limitation is to charge an ex-
penditure to expense immediately unless it has a useful life of at
least one year. Another limitation is to only recognize an expendi-
ture as a fixed asset if it exceeds a certain dollar amount, known as
the capitalization limit (see the Initial Fixed Asset Recognition
chapter). These limits keep the vast majority of expenditures from
being classified as fixed assets, which reduces the work of the ac-
counting department.
2
EXAMPLE
Henderson Industrial incurs expenditures for three items, and must decide
whether it should classify them as fixed assets. Henderson’s capitalization limit
is $2,500. The expenditures are:
• It buys a used mold for its plastic injection molding operation for
$5,000. Henderson expects that the mold only has two months of useful
life left, after which it should be scrapped. Since the useful life is so
short, Henderson elects to charge the expenditure to expense immedi-
ately.
• It buys a laptop computer for $1,500, which has a useful life of three
years. This expenditure is less than the capitalization limit, so Hender-
son charges it to expense.
• It buys a 10-ton injection molding machine for $50,000, which has a
useful life of 10 years. Since this expenditure has a useful life of longer
than one year and a cost greater than the capitalization limit, Henderson
records it as a fixed asset, and will depreciate it over its 10-year useful
life.
An alternative treatment of the $5,000 mold in the preceding ex-

ample would be to record it under the Other Assets account in the
balance sheet, and charge the cost to expense over two months.
This is a useful alternative for expenditures that have useful lives
of greater than one accounting period, but less than one year. It is a
less time-consuming alternative for the accounting staff, which
does not have to create a fixed asset record or engage in any depre-
ciation calculations.
The “Fixed Asset” Designation

The “fixed asset” name is used in this book to describe the group
of assets that generate economic benefits over a long period of
time. The accounting literature and common usage have derived a
somewhat longer name for the same assets, which is “property,
plant, and equipment” (PP&E). You will find fixed assets listed as
property, plant, and equipment in many balance sheets. The PP&E
term is not used in this book for two reasons:
• The name describes a subset of all fixed assets, since it only
implies the existence of land, buildings, and machinery.
3
• The PP&E name is simply too long.
Thus, we are using the more all-encompassing “fixed assets” term

throughout the book.
Fixed Asset Classifications

If an expenditure qualifies as a fixed asset, then you need to decide
what its proper account classification should be. Account classifi-
cations are used to aggregate fixed assets into groups, so that you
can apply the same depreciation methods and useful lives to them.
What is a Useful Life?

A useful life is the estimated lifespan of a depreciable fixed asset,
during which it can be expected to contribute to company opera-
tions.
You also usually create general ledger accounts by classification,

and store fixed asset transactions within the classifications to
which they belong (as described further in the Fixed Asset Record
Keeping chapter). Here are the most common classifications used:
• Buildings. This account may include the cost of acquiring a
building, or the cost of constructing one (in which case it is
transferred from the Construction in Progress classification,
described below). If the purchase price of a building in-
cludes the cost of land, then apportion some of the cost to
the Land account (which is not depreciated).
• Computer equipment. This classification can include a
broad array of computer equipment, such as routers, serv-
ers, and backup power generators. It is useful to set the
capitalization limit higher than the cost of desktop and lap-
top computers, so that you do not have to track these items
as assets.
• Construction in progress. This account is a temporary one,
and is intended to store the ongoing cost of constructing a
building; once completed, you shift the balance in this ac-
count to the Buildings account, and then start depreciating
4
it. Besides the materials and labor required for construction,

you can also store in this account architecture fees, the cost
of building permits, and so forth.
• Equipment. This category includes production equipment,
materials handling equipment, molds, the more expensive
tools, and similar items.
• Furniture and fixtures. This is one of the broadest catego-
ries of fixed assets, since it can include such diverse assets
as warehouse storage racks, office cubicles, and desks.
• Intangible assets. This is a non-physical asset, examples of
which are trademarks, customer lists, literary works, broad-
cast rights, and patented technology.
• Land. This is the only asset that is not depreciated, because
it is considered to have an indeterminate useful life. Include
in this category all expenditures to prepare the land for its
intended purpose, such as demolishing an existing building,
or grading the land.
• Land improvements. Include any expenditures that add
functionality to a parcel of land, such as irrigation systems,
fencing, and landscaping.
• Leasehold improvements. These are improvements to
leased space that are made by the tenant, and typically in-
clude office space, air conditioning, telephone wiring, and
related permanent fixtures.
• Office equipment. This account contains such equipment as
copiers, printers, and video equipment. Some companies
elect to merge this classification into the furniture and fix-
tures classification, especially if they have few office
equipment items.
• Software. Includes larger types of departmental or com-
pany-wide software, such as enterprise resources planning
software or accounting software. Many desktop software
packages are not sufficiently expensive to exceed the cor-
porate capitalization limit.
• Vehicles. This account contains automobiles, tractors, trucks,
and similar types of rolling stock.
5
A capital lease is not usually identified as a separate asset, since a

lease merely identifies a form of financing; it does not identify the
type of asset. Consequently, you should record the asset side of a
capital lease in one of the above classifications. The liability side
of the capital lease should be identified as a capital lease. See the
Initial Fixed Asset Recognition chapter for more information.
Tip:
Do not create too many sub-classifications of fixed assets, such as
automobiles, vans, light trucks, and heavy trucks within the main
“vehicles” classification. If the classification system is too finely
divided, there will inevitably be some “cross over” assets that
could fall into several classifications. Also, having a large number
of classifications requires extra tracking work by the accounting
staff.
EXAMPLE
Henderson Industrial decides to construct a new production facility. It purchases

land for $2 million, updates the land with irrigation systems and a parking lot for
$300,000, and constructs the building for $5 million. It then purchases produc-
tion equipment for the facility for $8 million, office equipment for $100,000,
and furniture and fixtures for $400,000. It aggregates these purchases into the
following fixed asset classifications:
Expenditure Item Classification Useful Life Depreciation

Method
Building - $5 million Building 30 years Straight line
Furniture and fix- Furniture and 7 years Straight line
tures - $400,000 fixtures
Irrigation, parking lot Land improve- 15 years Straight line
- $300,000 ments
Land - $2 million Land Indeterminate None
Office equipment - Office equipment 5 years Straight line
$100,000
Production equip- Equipment 15 years Straight line
ment - $8 million
6
Tip:
The local government that charges a company a personal property
tax may require that you complete its tax forms using certain asset
classifications. It may make sense to contact the government to see
which classifications under which it wants you to report, and adopt
these classifications as the company’s official classification sys-
tem. By doing so, you do not have to re-aggregate assets for per-
sonal property tax reporting.
Applicable Accounting Frameworks

The accounting for fixed assets is not uniform throughout the
world. There are two primary accounting frameworks in use. One
is Generally Accepted Accounting Principles (GAAP), which was
founded in the United States, and which uses an extremely de-
tailed, rules-oriented approach to mandating the treatment of ac-
counting transactions. The other framework is International Finan-
cial Reporting Standards (IFRS), which has a greater orientation
toward issuing higher-level guidelines than specific rules. IFRS is
rapidly gaining acceptance outside of the United States, and it will
likely become the dominant accounting framework at some point
in the future.
Working committees from the organizations that create and
update GAAP and IFRS are continually meeting to resolve the dif-
ferences in their approaches to fixed assets, but there are still dif-
ferences in the two frameworks. Because of these differences, we
are presenting both the GAAP and IFRS requirements for fixed
asset accounting in the following chapters.
Accounting for Fixed Assets

There are several key points in the life of a fixed asset that require
recognition in the accounting records; these are the initial recorda-
tion of the asset, the recognition of any asset retirement obliga-
tions, depreciation, subsequent changes in the recorded cost of the
asset, impairment, and the eventual derecognition of the asset. We
describe these general concepts below, and include a reference to
the more comprehensive treatment in later chapters:
7
• Initial recognition. There are a number of factors to con-

sider when initially recording a fixed asset, such as the base
unit, which costs to include, and when to stop capitalizing
costs. These issues are dealt with in the Initial Fixed Asset
Recognition chapter, along with special situations involv-
ing capital leases, non-monetary exchanges, and business
combinations.
• Interest capitalization. If you are constructing an asset, or it
is requiring some time to bring a fixed asset to the condi-
tion and location intended for its use, then you may be able
to capitalize the cost of the interest associated with the pur-
chase. There are very specific rules for the use of interest
capitalization, which are covered in the Interest Capitaliza-
tion chapter.
• Asset retirement obligations. There are situations where
you can reasonably calculate the costs associated with retir-
ing an asset, such as environmental remediation for a strip
mine. These costs are known as asset retirement obliga-
tions, and you are required to recognize their costs as part
of the initial recordation of an asset. The Asset Retirement
Obligations chapter addresses this topic.
• Depreciation. You should gradually charge the cost of a
fixed asset to expense over time, using depreciation. There
are a variety of depreciation methods available, which are
described further in the Depreciation and Amortization
chapter.
• Subsequent changes. Under limited circumstances under
IFRS, you are allowed to revalue your fixed assets, which
has special accounting and disclosure requirements. This
option, as well as the capitalization of subsequent expendi-
tures, is discussed in the Subsequent Fixed Asset Meas-
urement chapter.
• Impairment. If the fair value of a fixed asset falls below its
recorded cost at any point during its useful life, you are re-
quired to reduce its recorded cost to its fair value, and rec-
ognize a loss for the difference between the two amounts.
8
The Fixed Asset Impairment chapter delves into this ac-

counting, as well as the options for reversing impairment if
the fair value of a fixed asset subsequently rises.
• Derecognition. When an asset comes to the end of its use-
ful life, a company will likely sell or otherwise dispose of
it. At this time, you must remove it from the accounting re-
cords, as well as record a gain or loss (if any) on the final
disposal transaction. This issue is discussed in the Fixed
Asset Disposal chapter.
The accounting transactions noted above can involve a consider-

able range of journal entries. Though the entries are integrated into
the text of each chapter, they are also itemized in a journal entries
appendix. The appendix includes a description of each journal en-
try and a sample layout.
Accounting for Intangible Assets

The bulk of this book deals with tangible fixed assets – that is, as-
sets having a physical presence. However, there are also intangible
fixed assets, such as patents and copyrights, which have no physi-
cal substance. An intangible asset derives its value from the rights
or privileges to which they entitle the entity that owns them. They
are largely accounted for in the same manner as tangible fixed as-
sets. When there is a unique accounting treatment for intangible
assets, we make note of it, usually in a separate section within a
chapter.
Accounting for Not-for-Profit Fixed Assets

An entity that is designated as a not-for-profit business may re-
ceive quite a large number of fixed assets as donations, which
means that it does not incur a cost to obtain its assets. Since the
initial recognition of a fixed asset is normally at its acquisition
cost, how do you record a donated asset? Or do you not record it at
all? This accounting is addressed in the Not-for-Profit Fixed Asset
Accounting chapter.
9
Fixed Asset Disclosures

Fixed assets can comprise a large part of the assets listed on a
company’s balance sheet, so it is no surprise that both GAAP and
IFRS require extensive disclosures of a variety of issues involving
fixed assets, including:
• Asset impairment
• Asset retirement obligations
• Assets held for sale
• Capitalized interest
• Changes in accounting estimate
• Depreciation
• Estimates of recoverable amounts
• Intangible assets
GAAP and IFRS have different disclosure requirements, so we

separately list their requirements in the Fixed Asset Disclosures
chapter.
Fixed Asset Controls

Fixed assets can be quite expensive, and are also more mobile than
the designation “fixed” assets would imply. Thus, there is a risk
that they will be lost, damaged, or stolen. There are a number of
controls over fixed assets that result in a close watch being main-
tained over them, such as asset tags, radio frequency identification
tags that trigger an alarm if they pass a building exit, and assigning
responsibility for each asset to a designated manager. Further,
there is a risk that a fixed asset will be sold off without permission,
or that the proceeds from the sale will be diverted. The controls for
all of these issues and more are addressed in the Fixed Asset Con-
trols chapter.
Fixed assets must be properly maintained to ensure that they
remain usable through their useful lives. This calls for the use of
ongoing preventive maintenance, but you can also install controls
in the form of sensors to warn of any impending equipment fail-
10
ures. These sensors, as well as location tracking sensors, are de-

scribed in the Fixed Asset Tracking chapter.
As just noted, fixed assets can be quite expensive, so you need
controls over how they are approved for initial purchase or con-
struction. This is an elaborate analysis and permission system
called capital budgeting, and we cover it in the Capital Budgeting
Analysis chapter.
Fixed Asset Policies and Procedures

There are many transactions involved in the life of a fixed asset,
including such activities as capital budgeting, determining the cor-
rect costs to capitalize upon initial asset recognition, impairment
testing, asset revaluation, and asset disposal. If you do not handle
these transactions in a consistent manner, the accuracy and reliabil-
ity of the accounting records will likely suffer, and auditors will
have an extremely difficult time verifying your fixed asset records.
You can greatly improve the consistency of fixed asset record
keeping by formulating and closely adhering to a set of policies
and procedures that address the most common fixed asset transac-
tions. The Fixed Asset Policies and Procedures chapter contains a
baseline set of policies and procedures that you can modify to meet
the specific requirements of your business.
Fixed Asset Record Keeping

The preceding list of accounting activities should make it clear that
a considerable amount of record keeping is required over the life
span of a fixed asset. At a minimum, this includes the proper clas-
sification of asset classes, and setting up account numbers in the
general ledger for assets, accumulated depreciation, and deprecia-
tion. It may also include more specialized accounting for construc-
tion projects. Furthermore, you should maintain different types of
records for buildings, equipment, land, and leases, and decide how
long to retain these documents. It is also useful to aggregate fixed
asset information into the following reports:
11
• Asset replacement report. Includes information about each

asset that allows you to predict when a fixed asset should
be replaced.
• Audit report. Gives descriptive and location information for
selected assets, so that you can more easily locate them.
• Depreciation report. Summarizes the periodic depreciation
and accumulated depreciation for each fixed asset.
• Maintenance report. Aggregates the scheduled and un-
scheduled maintenance associated with each asset, and
links it to capacity utilization.
• Responsibility report. Notes the name of the person respon-
sible for each asset, as well as the location of the asset.
All of the record keeping issues noted here, as well as the reports
just described, are addressed in considerably more detail in the
Fixed Asset Record Keeping chapter.
Fixed Asset Auditing

If a company has a loan outstanding with a lender, or is publicly
held, it will likely undergo an annual audit. If the company has a
large investment in fixed assets, the audit team will spend a con-
siderable amount of time reviewing a selection of the fixed asset
accounting transactions that arose in the period being audited. The
accounting, procedures, and controls already noted will probably
cover the majority of the issues the auditors would normally find.
Nonetheless, it is useful to know what specific items auditors ask
for as part of an audit, as well as the audit steps normally included
in their audit procedures. The Fixed Asset Auditing chapter pro-
vides this information.
Fixed Asset Measurements

A good management team wants to measure all aspects of a busi-
ness, in order to maximize its efficiency, cash usage, and profits.
The Fixed Asset Measurements chapter shows how to calculate the
following metrics:
12
Measurement Reason for Use

Accumulated depreciation to Determine whether asset replacement levels
fixed assets ratio are changing over time
Bottleneck utilization Determine the level of utilization of a con-
strained resource
Cash flow to fixed asset re- Determine whether a business has sufficient
quirements ratio cash flow to pay for planned fixed asset
purchases
Repairs and maintenance ex- Determine whether a company has unusual
pense to fixed assets ratio proportions of old assets or utilization lev-
els
Return on assets employed Calculate the return on all assets (not just
fixed assets)
Return on operating assets Calculate the return on all assets that are be-
ing actively used to create revenue
Sales to fixed assets ratio Determine fixed asset usage levels compared
to those of competitors
Unscheduled machine down- Determine the extent to which unscheduled
time machine downtime is interfering with pro-
duction
Summary
This chapter has provided an overview of the nature of fixed as-
sets, how you account for them, and a variety of other topics re-
lated to their management. We also provided references to the
chapters later in this book that address these topics in much greater
detail. In addition, a complete listing of the journal entries you may
need for the recording of transactions over the life of a fixed asset
are noted in the Journal Entries appendix. Also, if you are uncer-
tain of the meaning of a term, definitions are provided in the glos-
sary at the end of the book.
13
Review Questions
1. An expenditure is:
a. An expense
b. A fixed asset
c. A payment or the incurrence of a liability
d. An obligation to pay
2. A fixed asset is:

a. Charged to expense when incurred
b. Fixed in place
c. Designed to have a useful life of at least three years
d. An item that generates an economic benefit over a long
time period
3. Fixed assets are also known as:

a. Current assets
b. Property, plant, and equipment
c. Goodwill
d. Investments
4. The land improvements account contains balances that are:

a. Depreciable
b. Not depreciable
c. Periodically rolled into the land account
d. Inclusive of the cost to demolish an existing building
14
Review Answers
1. An expenditure is:
a. Incorrect. An expense is the reduction in value of an as-
set as it is used to generate an economic return.
b. Incorrect. A fixed asset is an item costing in excess of a
business’ capitalization limit, which is expected to gen-
erate economic benefits for at least one year.
c. Correct. An expenditure is a payment or the incurrence
of a liability.
d. Incorrect. An obligation to pay is a liability already in-
curred that creates a legal requirement to pay a third
party in the future.
2. A fixed asset is:

a. Incorrect. A fixed asset is charged to expense over its
useful life through depreciation.
b. Incorrect. A fixed asset can be easily movable, as long
as it meets the criteria for a fixed asset.
c. Incorrect. A fixed asset has a useful life of at least one
year.
d. Correct. A fixed asset is an item that generates an eco-
nomic benefit over a long time period.
3. Fixed assets are also known as:

a. Incorrect. Current assets are supposed to be settled
within one year, whereas fixed assets should generate
economic benefits for more than one year.
b. Correct. A fixed asset is also known as property, plant,
and equipment.
c. Incorrect. Goodwill is a non-specific, intangible asset
arising from a business combination.
d. Incorrect. An investment is funds invested in an instru-
ment or entity from which you expect to generate a re-
turn.
15
4. The land improvements account contains balances that are:

a. Correct. Expenditures classified as land improvements
can be depreciated.
b. Incorrect. You should depreciate expenditures classified
as land improvements.
c. Incorrect. Land improvement expenditures are kept
separate from the land account, since land improve-
ments are depreciable and land is not.
d. Incorrect. The cost to demolish an existing building is
recorded in the land account.
16
Chapter 2
Capital Budgeting Analysis
Introduction
Capital budgeting is a series of analysis steps followed to justify
the decision to purchase an asset, usually including an analysis of
the costs, related benefits, and impact on capacity levels of the pro-
spective purchase. In this chapter, we will address a broad array of
issues that you should consider when deciding whether to recom-
mend the purchase of a fixed asset, including constraint analysis,
the lease versus buy decision, and post acquisition auditing.
Overview of Capital Budgeting

The normal capital budgeting process is for the management team
to request proposals to acquire fixed assets from all parts of the
company. Managers respond by filling out a standard request form,
outlining what they want to buy and how it will benefit the com-
pany. The financial analyst or accountant then assists in reviewing
these proposals to determine which are worthy of an investment.
Any proposals that are accepted are included in the annual budget,
and will be purchased during the next budget year. Fixed assets
purchased in this manner also require a certain number of approv-
als, with more approvals required by increasingly senior levels of
management if the sums involved are substantial.
These proposals come from all over the company, and so are
likely not related to each other in any way. Also, the number of
proposals usually far exceeds the amount of funding available.
Consequently, management needs a method for ranking the prior-
ity of projects, with the possible result that some proposals are not
accepted at all. The traditional method for doing so is net present
value (NPV) analysis, which focuses on picking proposals with the
largest amount of discounted cash flows.
The trouble with NPV analysis is that it does not account for
how an investment might impact the profit generated by the entire
system of production; instead, it tends to favor the optimization of
specific work centers, which may have no particular impact on

overall profitability. Also, the results of NPV are based on the fu-
ture projections of cash flows, which may be wildly inaccurate.
Managers may even tweak their cash flow estimates upward in or-
der to gain project approval, when they know that actual cash
flows are likely to be lower. Given these issues, we favor con-
straint analysis over NPV, though NPV is also discussed later in
this chapter.
A better method for judging capital budget proposals is con-
straint analysis, which focuses on how to maximize use of the bot-
tleneck operation. The bottleneck operation is the most constricted
operation in a company; if you want to improve the overall profit-
ability of the company, then you must concentrate all attention on
management of that bottleneck. This has a profound impact on
capital budgeting, since a proposal should have some favorable
impact on that operation in order to be approved.
There are two scenarios under which certain project proposals
may avoid any kind of bottleneck or cash flow analysis. The first is
a legal requirement to install an item. The prime example is envi-
ronmental equipment, such as smokestack scrubbers, that are man-
dated by the government. In such cases, there may be some analy-
sis to see if costs can be lowered, but the proposal must be ac-
cepted, so it will sidestep the normal analysis process.
The second scenario is when a company wants to mitigate a
high-risk situation that could imperil the company. In this case, the
emphasis is not on profitability at all, but rather on the avoidance
of a situation. If so, the mandate likely comes from top manage-
ment, so there is little additional need for analysis, other than a re-
view to ensure that the lowest-cost alternative is selected.
A final scenario is when there is a sudden need for a fixed as-
set, perhaps due to the catastrophic failure of existing equipment,
or due to a sudden strategic shift. These purchases can happen at
any time, and so usually fall outside of the capital budget’s annual
planning cycle. It is generally best to require more than the normal
number of approvals for these items, so that management is made
fully aware of the situation. Also, if there is time to do so, they are
18
worthy of an unusually intense analysis, to see if they really must

be purchased at once, or if they can be delayed until the next capi-
tal budgeting approval period arrives.
Once all items are properly approved and inserted into the an-
nual budget, this does not end the capital budgeting process. There
is a final review just prior to actually making each purchase, with
appropriate approval, to ensure that the company still needs each
fixed asset.
The last step in the capital budgeting process is to conduct a
post-implementation review, in which you summarize the actual
costs and benefits of each fixed asset, and compare these results to
the initial projections included in the original application. If the
results are worse than expected, this may result in a more in-depth
review, with particular attention being paid to avoiding any faulty
aspects of the original proposal in future proposals.
Bottleneck Analysis
Under constraint analysis, the key concept is that an entire com-
pany acts as a single system, which generates a profit. Under this
concept, capital budgeting revolves around the following logic:
1. Nearly all of the costs of the production system do not vary
with individual sales; that is, nearly every cost is an operat-
ing expense; therefore,
2. You need to maximize the throughput of the entire system
in order to pay for the operating expense; and
3. The only way to increase throughput is to maximize the
throughput passing through the bottleneck operation.
Consequently, you should give primary consideration to those

capital budgeting proposals that favorably impact the throughput
passing through the bottleneck operation.
What is Throughput?
Throughput is revenues minus totally variable costs. Totally vari-
able costs are usually just the cost of materials, since direct labor
does not typically vary directly with sales.
19
This does not mean that all other capital budgeting proposals will
be rejected, since there are a multitude of possible investments that
can reduce costs elsewhere in a company, and which are therefore
worthy of consideration. However, throughput is more important
than cost reduction, since throughput has no theoretical upper
limit, whereas costs can only be reduced to zero. Given the greater
ultimate impact on profits of throughput over cost reduction, any
non-bottleneck proposal is simply not as important.
Net Present Value Analysis

Any capital investment involves an initial cash outflow to pay for
it, followed by a mix of cash inflows in the form of revenue, or a
decline in existing cash flows that are caused by expense reduc-
tions. We can lay out this information in a spreadsheet to show all
expected cash flows over the useful life of an investment, and then
apply a discount rate that reduces the cash flows to what they
would be worth at the present date. This calculation is known as
net present value.
What is a Discount Rate?

A discount rate is the interest rate used to discount a stream of fu-
ture cash flows to their present value. Depending upon the applica-
tion, typical rates used as the discount rate are a firm's cost of capi-
tal or the current market rate.
Net present value is the traditional approach to evaluating capital

proposals, since it is based on a single factor – cash flows – that
can be used to judge any proposal arriving from anywhere in a
company.
EXAMPLE
Milford Sound, a manufacturer of audio equipment, is planning to acquire an

asset that it expects will yield positive cash flows for the next five years. Its cost
of capital is 10%, which it uses as the discount rate to construct the net present
value of the project. The following table shows the calculation:
20
10% Discount
Year Cash Flow Factor Present Value
0 -$500,000 1.0000 -$500,000
1 +130,000 0.9091 +118,183
2 +130,000 0.8265 +107,445
3 +130,000 0.7513 +97,669
4 +130,000 0.6830 +88,790
5 +130,000 0.6209 +80,717
Net Present -$7,196
Value
The net present value of the proposed project is negative at the 10% discount
rate, so Milford should not invest in the project.
In the “10% Discount Factor” column, the factor becomes smaller

for periods further in the future, because the discounted value of
cash flows are reduced as they progress further from the present
day. The discount factor is widely available in textbooks, or can be
derived from the following formula:
Present value Future cash flow

of a future = -----------------------------------------------------------------
cash flow squared by the number discounting periods
(1 + Discount rate)
To use the formula for an example, if we forecast the receipt of

$100,000 in one year, and are using a discount rate of 10 percent,
then the calculation is:
$100,000
Present = ------------
value 1
(1+.10)
Present value = $90,909
A net present value calculation that truly reflects the reality of cash
flows will likely be more complex than the one shown in the pre-
ceding example. It is best to break down the analysis into a number
of sub-categories, so that you can see exactly when cash flows are
21
occurring and with what activities they are associated. Here are the
more common contents of a net present value analysis:
• Asset purchases. All of the expenditures associated with the
purchase, delivery, installation, and testing of the asset be-
ing purchased.
• Asset-linked expenses. Any ongoing expenses, such as war-
ranty agreements, property taxes, and maintenance, that are
associated with the asset.
• Contribution margin. Any incremental cash flows resulting
from sales that can be attributed to the project.
• Depreciation effect. The asset will be depreciated, and this
depreciation shelters a portion of any net income from in-
come taxes, so note the income tax reduction caused by de-
preciation.
• Expense reductions. Any incremental expense reductions
caused by the project, such as automation that eliminates
direct labor hours.
• Tax credits. If an asset purchase triggers a tax credit (such
as for a purchase of energy-reduction equipment), then note
the credit.
• Taxes. Any income tax payments associated with net in-
come expected to be derived from the asset.
• Working capital changes. Any net changes in inventory,
accounts receivable, or accounts payable associated with
the asset. Also, when the asset is eventually sold off, this
may trigger a reversal of the initial working capital
changes.
By itemizing the preceding factors in a net present value analysis,

you can more easily review and revise individual line items.
We have given priority to bottleneck analysis over net present
value as the preferred method for analyzing capital proposals, be-
cause bottleneck analysis focuses on throughput. The key im-
provement factor is throughput, since there is no upper limit on the
amount of throughput that can be generated, whereas there are only
so many operating expenses that can be reduced. This does not
22
mean that net present value should be eliminated as a management

tool. It is still quite useful for operating expense reduction analysis,
where throughput issues are not involved.
The Payback Method

The most discerning method for evaluating a capital budgeting
proposal is its impact on the bottleneck operation, while net pre-
sent value analysis yields a detailed analysis of cash flows. The
simplest and least accurate evaluation technique is the payback
method. This approach is still heavily used, because it provides a
very fast “back of the envelope” calculation of how soon a com-
pany will earn back its investment. This means that it provides a
rough measure of how long a company will have its investment at
risk, before earning back the original amount expended. Thus, it is
a rough measure of risk. There are two ways to calculate the pay-
back period, which are:
1. Simplified. Divide the total amount of an investment by the
average resulting cash flow. This approach can yield an in-
correct assessment, because a proposal with cash flows
skewed far into the future can yield a payback period that
differs substantially from when actual payback occurs.
2. Manual calculation. Manually deduct the forecasted posi-
tive cash flows from the initial investment amount, from
Year 1 forward, until the investment is paid back. This
method is slower, but ensures a higher degree of accuracy.
EXAMPLE
Milford Sound has received a proposal from a manager, asking to spend

$1,500,000 on equipment that will result in cash inflows in accordance with the
following table:
Year Cash Flow

1 +$150,000
2 +150,000
3 +200,000
4 +600,000
5 +900,000
23
The total cash flows over the five-year period are projected to be $2,000,000,
which is an average of $400,000 per year. When divided into the $1,500,000
original investment, this results in a payback period of 3.75 years. However, the
briefest perusal of the projected cash flows reveals that the flows are heavily
weighted toward the far end of the time period, so the results of this calculation
cannot be correct.
Instead, the accountant runs the calculation year by year, deducting the cash
flows in each successive year from the remaining investment. The results of this
calculation are:
Year Cash Flow Net Invested Cash

0 -$1,500,000
1 +$150,000 -1,350,000
2 +150,000 -1,200,000
3 +200,000 -1,000,000
4 +600,000 -400,000
5 +900,000 0
The table indicates that the real payback period is located somewhere between
Year 4 and Year 5. There is $400,000 of investment yet to be paid back at the
end of Year 4, and there is $900,000 of cash flow projected for Year 5. The ac-
countant assumes the same monthly amount of cash flow in Year 5, which
means that he can estimate final payback as being just short of 4.5 years.
The payback method is not overly accurate, does not provide any
estimate of how profitable a project may be, and does not take ac-
count of the time value of money. Nonetheless, its extreme sim-
plicity makes it a perennial favorite in many companies.
Capital Budget Proposal Analysis

Reviewing a capital budget proposal does not necessarily mean
passing judgment on it exactly as presented. You can attach a vari-
ety of suggestions to your analysis of the proposal, which man-
agement may incorporate into a revised proposal. Here are some
examples:
• Asset capacity. Does the asset have more capacity than is
actually needed under the circumstances? Is there a history
of usage spikes that call for extra capacity? Depending on
24
the answers to these questions, consider using smaller as-

sets with less capacity. If the asset is powered, this may
also lead to reductions in utility costs, installation costs,
and floor space requirements.
• Asset commoditization. Wherever possible, avoid custom-
designed machinery in favor of standard models that are
readily available. By doing so, it is easier to obtain repair
parts, and there may even be an aftermarket for disposing
of the asset when the company no longer needs it.
• Asset features. Managers have a habit of wanting to buy
new assets with all of the latest features. Are all of these
features really needed? If an asset is being replaced, then it
is useful to compare the characteristics of the old and new
assets, and examine any differences between the two to see
if they are really needed. If the asset is the only model of-
fered by the supplier, would the supplier be willing to strip
away some features and offer it at a lower price?
• Asset standardization. If a company needs a particular asset
in large quantities, then adopt a policy of always buying
from the same manufacturer, and preferably only buying
the same asset every time. By doing so, the maintenance
staff becomes extremely familiar with maintenance re-
quirements, and only has to stock replacement parts for one
model.
• Bottleneck analysis. As noted earlier in this chapter, assets
that improve the amount of throughput in a production op-
eration are usually well worth the investment, while those
not impacting the bottleneck require substantially more jus-
tification, usually in the direction of reducing operating ex-
penses.
• Extended useful life. A manager may be applying for an as-
set replacement simply because the original asset has
reached the end of its recommended useful life. But is it
really necessary to replace the asset? Consider conducting a
formal review of these assets to see if they can still be used
for some additional period of time. There may be additional
25
maintenance costs involved, but this will almost certainly

be lower than the cost of replacing the asset.
• Facility analysis. If a capital proposal involves the acquisi-
tion of additional facility space, consider reviewing any ex-
isting space to see if it can be compressed, thereby elimi-
nating the need for more space. For example, shift storage
items to less expensive warehouse space, shift from offices
to more space-efficient cubicles, and encourage employees
to work from home or on a later shift. If none of these ideas
work, then at least consider acquiring new facilities through
a sublease, which tends to require shorter lease terms than a
lease arranged with the primary landlord.
• Monument elimination. A company may have a large, fixed
asset around which the rest of the production area is con-
figured; this is called a monument. If there is a monument,
consider adopting a policy of using a larger number of
lower-capacity assets. By doing so, you avoid the risk of
having a single monument asset go out of service and stop-
ping all production, in favor of having multiple units,
among which work can be shifted if one unit fails.
The sponsors of capital proposals frequently do not appreciate this

additional review of their proposals, since it implies that they did
not consider these issues themselves. Nonetheless, the savings can
be substantial, and so are well worth the aggravation of dealing
with annoyed managers.
If the additional review indicates some promising alternatives
that may substantially reduce the cost of a proposal, if not elimi-
nate it entirely, then it may be politically wise to route the pro-
posed changes through the controller or chief financial officer, who
may have the clout to force a serious review of the alternatives by
the project sponsor.
The Outsourcing Decision

It may be possible to avoid a capital purchase entirely by outsourc-
ing the work to which it is related. By doing so, the company may
26
be able to eliminate all assets related to the area (rather than ac-
quiring more assets), while the burden of maintaining a sufficient
asset base now shifts to the supplier. The supplier may even buy
the company’s assets related to the area being outsourced. This
situation is a well-established alternative for high technology
manufacturing, as well as for information technology services, but
is likely not viable outside of these areas.
If you are in a situation where outsourcing is a possibility, then
the likely cash flows resulting from doing so will be highly favor-
able for the first few years, as your capital expenditures vanish.
However, the supplier must also earn a profit and pay for its own
infrastructure, so the cost over the long term will probably not vary
dramatically from what a company would have experienced if it
had kept a functional area in-house. There are three exceptions that
can bring about a long-term cost reduction. They are:
• Excess capacity. A supplier may have such a large amount
of excess capacity already that it does not need to invest
further for some time, thereby potentially depressing the
costs that it would otherwise pass through to its customers.
However, this excess capacity pool will eventually dry up,
so it tends to be a short-term anomaly.
• High volume. There are some outsourcing situations where
the supplier is handling such a massive volume of activity
from multiple customers that its costs on a per-unit basis
decline below the costs that a company could ever achieve
on its own. This situation can yield long-term savings to a
company.
• Low costs. A supplier may locate its facility and work force
in low-cost countries or regions within countries. This can
yield significant cost reductions in the short term, but as
many suppliers use the same technique, it is driving up
costs in all parts of the world. Thus, this cost disparity is
useful for a period of time, but is gradually declining as a
long-term option.
27
There are also risks involved in shifting functions to suppliers.

First, a supplier may go out of business, leaving the company
scrambling to shift work to a new supplier. Second, a supplier may
gradually ramp up prices to the point where the company is sub-
stantially worse off than if it had kept the function in-house. Third,
the company may have so completely purged the outsourced func-
tion from its own operations that it is now completely dependent
on the supplier, and has no ability to take it back in-house. Fourth,
the supplier’s service level may decline to the point where it is im-
pairing the ability of the company to operate. And finally, the
company may have entered into a multi-year deal, and cannot es-
cape from the arrangement if the business arrangement does not
work out. These are significant issues, and must be weighed as part
of the outsourcing decision.
The cautions noted here about outsourcing do not mean that it
should be avoided as an option. On the contrary, a rapidly growing
company that has minimal access to funds may cheerfully hand off
multiple operations to suppliers in order to avoid the up-front costs
associated with those operations. Outsourcing is less attractive to
stable, well-established companies that have better access to capi-
tal.
In summary, outsourcing is an attractive option for rapidly
growing companies that do not have sufficient cash to pay for capi-
tal expenditures, but also carries with it a variety of risks involving
shifting key functions to a supplier over which a company may not
have a great deal of control.
The Capital Budgeting Application Form

Most companies require managers to fill out a standardized form
for all capital budgeting proposals. The type of information that
you include in the form will vary, depending on whether you are
basing the approval decision on bottleneck considerations or the
results of a net present value analysis. However, the header section
of the form will likely be the same in all circumstances. It identi-
fies the project, its sponsor, the date on which it was submitted,
28
and a unique product identification number that is filled in by the

recipient. A sample header is:
Sample Application Header

Project name: 50 Ton plastic injection molder
Project sponsor: E. R. Eddison
Submission date: May 28 Project number: 2011-14
If a proposal is for a legal requirement or a risk mitigation issue,

then it is absolved from most analysis, and will likely move to the
top of the approved project list. Consequently, the form should
contain a separate section for these types of projects, and should
involve a different set of approvers. The corporate attorney may be
involved, as well anyone involved in risk management. A sample
block in the application form for legal and risk mitigation issues is:
Sample Legal and Risk Mitigation Block

Required Approvals
Initial cash flow: -$250,000 All proposals Susan Lafferty
Year 1 cash flow: -10,000 Attorney
Year 2 cash flow: -10,000
Year 3 cash flow: -10,000 < $100,000 George Mason
Risk Officer
Describe legal or risk mitigation issue:
Replanting of pine forest on southern $100,000+ Fred Scurry
property, with annual forestry review, per President
new zoning requirements
If you elect to focus on bottleneck considerations for capital budg-

eting approvals, then include the following block of text in the ap-
plication form. This block focuses on the changes in cash flow that
are associated with a capital expenditure. The block requests an
itemization of the cash flows involved in the purchase (primarily
for finance planning considerations), followed by requests for in-
formation about how the investment will help the company – via
an improvement in throughput, a reduction in operating costs, or an
increase in the return on investment. In the example, note that the
primary improvement used as the basis for the proposal is the im-
29
provement in throughput. This also leads to an enhancement of the

return on investment. There is an increase in the total net operating
cost, which represents a reduction in the positive effect of the
throughput, and which is caused by the annual $8,000 maintenance
cost associated with the investment.
The approvals for a bottleneck-related investment change from
the ones shown previously for a legal or risk mitigation invest-
ment. In this case, a process analyst should verify the information
include in the block, to ensure that the applicant’s claims are cor-
rect. The supervisor in whose area of responsibility the investment
falls should also sign off, thereby accepting responsibility for the
outcome of the investment. A higher-level manager, or even the
board of directors, should approve any really large investment pro-
posals.
Sample Bottleneck Approval Block

Required Approvals
Initial cash flow: -$125,000 All proposals Monica Byers
Year 1 cash flow: -8,000 Process Analyst
Year 2 cash flow: -8,000
Year 3 cash flow: -8,000 < $100,000 Al Rogers
Responsible
Supervisor
Net throughput change:* +$180,000
$100,000+ Fred Scurry
Net operating cost change:* +$8,000 President
Change in ROI:* +0.08%

* On an annual basis
What is a Capital Expenditure?

A capital expenditure is a payment made to acquire or upgrade an
asset. You record a capital expenditure as an asset, rather than
charging it immediately to expense. Instead, you charge it to ex-
pense over the useful life of the asset, using depreciation.
If you do not choose to use a bottleneck-oriented application, then

the following block may be useful in the application. It is based on
30
the more traditional analysis of net present value. You may also
consider using this block as a supplement to the bottleneck block
just noted, in case some managers prefer to work with both sets of
information.
Sample Net Present Value Approval Block

Cash Out Cash In Incremental
Year (payments) (Revenue) Tax Effect Totals
0 -$1,000,000 -$1,000,000
1 -25,000 +$200,000 +$8,750 +183,750
2 -25,000 +400,000 -61,250 +313,750
3 -25,000 +400,000 -61,250 +313,750
4 -25,000 +400,000 -61,250 +313,750
5 -25,000 +400,000 -61,250 +313,750
Totals -$1,125,000 +$1,800,000 -$236,250 +$438,750
Tax Rate: 35%
Hurdle Rate: 12%
Net Present Value: +$13,328
The net present value block requires the presentation of cash flows
over a five-year period, as well as the net tax effect resulting from
this specific transaction. The tax effect is based on $25,000 of
maintenance expenses in every year shown, as well as $200,000 of
annual depreciation, and a 35% incremental tax rate. Thus, in Year
2, there is $400,000 of revenue, less $225,000 of depreciation and
maintenance expenses, multiplied by 35%, resulting in an incre-
mental tax effect of $61,250.
The block then goes on to state the corporate hurdle rate, which
is 12% in the example. We then discount the stream of cash flows
from the project at the hurdle rate of 12%, which results in a posi-
tive net present value of $13,328. Based on just the net present
value analysis, this appears to be an acceptable project.
A variation on the rather involved text just shown is to shift the
detailed cash flow analysis to a backup document, and only show
the resulting net present value in the application form.
The text blocks shown here contain much of the key informa-
tion that management should see before it decides whether to ap-
prove a capital investment. In addition, there should be a consider-
31
able amount of supporting information that precisely describes the

nature of the proposed investment, as well as backup information
that supports each number included in the form.
The Post Installation Review

It is very important to conduct a post installation review of any
capital expenditure project, to see if the initial expectations for it
were realized. If not, then the results of this review can be used to
modify the capital budgeting process to include better information.
Another reason for having a post installation review is that it
provides a control over those managers who fill out the initial capi-
tal budgeting proposals. If they know there is no post installation
review, then they can wildly overstate the projected results of their
projects with impunity, just to have them approved. Of course, this
control is only useful if it is conducted relatively soon after a pro-
ject is completed. Otherwise, the responsible manager may have
moved on in his career, and can no longer be tied back to the re-
sults of his work.
It is even better to begin a post installation review while a pro-
ject is still being implemented, and especially when the implemen-
tation period is expected to be long. This initial review gives senior
management a good idea of whether the cost of a project is staying
close to its initial expectations. If not, management may need to
authorize more vigorous management of the project, scale it back,
or even cancel it outright.
If the post implementation review results in the suspicion that a
project proposal was unduly optimistic, this brings up the question
of how to deal with the responsible manager. At a minimum, the
proposal reviews can flag any future proposals by this reviewer as
suspect, and worthy of especially close attention. Another option is
to tie long-term compensation to the results of these projects. A
third possibility is to include the results of these project reviews in
personnel reviews, which may lead to a reduction in employee
compensation. A really catastrophic result may even be grounds
for the termination of the responsible party.
32
EXAMPLE
Milford Sound has just completed a one-year project to increase the amount of
production capacity at its speaker production work center. The original capital
budgeting proposal was for an initial expenditure of $290,000, resulting in addi-
tional annual throughput of $100,000 per year. The actual result is somewhat
different. The accountant’s report includes the following analysis of the situa-
tion:
Findings: The proposal only contained the purchase price of the

equipment. However, since the machinery was delivered from Ger-
many, Milford also incurred $22,000 of freight charges and $3,000 in
customs fees. Further, the project required the installation of a new
concrete pad, a breaker box, and electrical wiring that cost an additional
$10,000. Finally, the equipment proved to be difficult to configure, and
required $20,000 of consulting fees from the manufacturer, as well as
$5,000 for the materials scrapped during testing. Thus, the actual cost
of the project was $350,000.
Subsequent operation of the equipment reveals that it cannot operate

without an average of 20% downtime for maintenance, as opposed to
the 5% downtime that was advertised by the manufacturer. This re-
duces throughput by 15%, which equates to a drop of $15,000 in
throughput per year, to $85,000.
Recommendations: To incorporate a more comprehensive set of in-

structions into the capital budgeting proposal process to account for
transportation, setup, and testing costs. Also, given the wide difference
between the performance claims of the manufacturer and actual results,
to hire a consultant to see if the problem is caused by our installation of
the equipment; if not, we recommend not buying from this supplier in
the future.
The Lease or Buy Decision

Once the asset acquisition decision has been made, management
still needs to decide if it should buy the asset outright or lease it. In
a leasing situation, a lessor buys the asset and then allows the les-
see to use it in exchange for a monthly fee. Depending on the terms
of the lease, it may be accounted for in one of the following two
ways:
33
• Capital lease. The lessee records the leased asset on its

books as a fixed asset and depreciates it over its useful life,
while recording interest expense separately.
• Operating lease. The lessor records the leased asset on its
books as a fixed asset and depreciates it, while the lessee
simply records a lease payment that it charges to expense as
incurred.
The decision to use a lease may be based on management’s unwill-

ingness to use its line of credit or other available sources of financ-
ing to buy an asset, thereby leaving these other forms of financing
available for other uses. Leases can be easier to obtain that a line of
credit, since the lease agreement always designates the asset as col-
lateral.
What is Collateral?
Collateral is an asset that a borrower has pledged as security for a
loan. The lender has the legal right to seize and sell the asset if the
borrower is unable to pay back the loan by an agreed date.
There are a multitude of factors that a lessor includes in the formu-

lation of the monthly rate that it charges, such as the down pay-
ment, the residual value of the asset at the end of the lease, and the
interest rate, which makes it difficult to break out and examine
each element of the lease. Instead, it is much easier to create sepa-
rate net present value tables for the lease and buy alternatives, and
then compare the results of the two tables to see which is the better
alternative.
EXAMPLE
Milford Sound is contemplating the purchase of an asset for $500,000. It can

buy the asset outright, or do so with a lease. Its cost of capital is 8%, and its in-
cremental income tax rate is 35%. The following two tables show the net present
values of both options.
34
Buy Option
Income Tax Discount Net Present
Year Depreciation Savings (35%) Factor (8%) Value
0 -$500,000
1 $100,000 $35,000 0.9259 32,407
2 100,000 35,000 0.8573 30,006
3 100,000 35,000 0.7938 27,783
4 100,000 35,000 0.7350 25,725
5 100,000 35,000 0.6806 23,821
Totals $500,000 $175,000 $360,258
Lease Option
Pretax Income Tax Discount
Lease Savings After-Tax Factor Net Present
Year Payments (35%) Lease Cost (8%) Value
1 $135,000 47,250 $87,750 0.9259 $81,248
2 135,000 47,250 87,750 0.8573 75,228
3 135,000 47,250 87,750 0.7938 69,656
4 135,000 47,250 87,750 0.7350 64,496
5 135,000 47,250 87,750 0.6806 59,723
Totals $675,000 $236,250 $438,750 $350,351
Thus, the net purchase cost of the buy option is $360,258, while the net purchase
cost of the lease option is $350,351. The lease option involves the lowest cash
outflow for Milford, and so is the better option.
Summary
This chapter addressed a variety of issues you should consider
when deciding whether to recommend the purchase of a fixed as-
set. We put less emphasis on net present value analysis, which has
been the primary capital budgeting tool in industry for years, be-
cause it does not take into consideration the impact on throughput
of a company’s bottleneck operation. The best capital budgeting
analysis process is to give top priority to project proposals that
have a strong favorable impact on throughput, and then use net
present value to evaluate the impact of any remaining projects on
cost reduction.
35
Review Questions
1. Net present value analysis can be a poor choice for capital

budgeting analysis because:
a. It uses a risk-adjusted discount rate
b. It does not include the impact of depreciation on in-
come taxes
c. Cash flow projections may be inaccurate
d. Managers tend to be conservative with their cash flow
projections
2. Scenarios that can legitimately bypass a net present value or

constraint analysis are:
a. Contractual obligations from suppliers
b. Legal requirements and high-risk situations
c. Improvements impacting the inventory buffer
d. Improvements impacting downstream capacity
3. The discount rate is:

a. The prime rate
b. A company’s long-term historical borrowing rate
c. The percentage discount at which a company buys fixed
assets from its suppliers
d. The interest rate used to discount a stream of future
cash flows to their present value
4. You should consider outsourcing to avoid a fixed asset invest-

ment when:
a. The supplier is located in a low-cost region
b. The supplier does not have excess capacity
c. The supplier does not have high production volume
d. The supplier wants escalation clauses
36
Review Answers
1. Net present value analysis can be a poor choice for capital

budgeting analysis because:
a. Incorrect. A risk-adjusted discount rate is a useful tool
for evaluating the present value of cash flows.
b. Incorrect. A properly configured net present value
analysis does include the effect of depreciation on in-
come taxes.
c. Correct. Net present value analysis can be a poor
choice for capital budgeting analysis because cash flow
projections may be inaccurate.
d. Incorrect. Managers tend to be overly optimistic with
their cash flow projections.
2. Scenarios that can legitimately bypass a net present value or

constraint analysis are:
a. Incorrect. If there is a contractual obligation from a
supplier, the company should first evaluate its impact
using net present value or constraint analysis to deter-
mine its impact on the company.
b. Correct. Scenarios that can legitimately bypass a net
present value or constraint analysis are legal require-
ments and high-risk scenarios.
c. Incorrect. The inventory buffer directly impacts the bot-
tleneck operation, so any changes to it should be subject
to a constraint analysis.
d. Incorrect. Improvements impacting downstream capac-
ity will likely have little impact on throughput, and so
should be subject to constraint analysis.
3. The discount rate is:

a. Incorrect. The prime rate is the best interest rate offered
by a lending institution, which is not necessarily the
same interest rate offered to a specific company.
37
b. Incorrect. The long-term historical borrowing rate may

vary greatly from the short-term incremental borrowing
rate that is more applicable to a net present value analy-
sis.
c. Incorrect. The percentage discount for buying fixed as-
sets is usually designated as a volume discount or pur-
chase discount.
d. Correct. The discount rate is the interest rate used to
discount a stream of future cash flows to their present
value.
4. You should consider outsourcing to avoid a fixed asset invest-

ment when:
a. Correct. The supplier is located in a low-cost region,
which translates into long-term savings for the com-
pany.
b. Incorrect. If a supplier does not have excess capacity, it
must make expenditures to create more capacity to han-
dle your business, which reduces its ability to offer low
prices over the long term.
c. Incorrect. If a supplier does not have high production
volume, it cannot spread its fixed costs over very much
production, and so cannot offer low prices over the long
term.
d. Incorrect. An escalation clause allows the supplier to
periodically raise prices.
38
Chapter 3
Initial Fixed Asset Recognition
Introduction
The basic process of recognizing a newly-acquired fixed asset in a
company’s accounting records may at first appear quite simple –
just record the acquisition cost. This simple rule will apply to the
majority of a company’s fixed assets. However, there are also
some special situations that complicate the accounting, such as the
appropriate designation of a base unit, acquired assets, capital
leases, and asset exchanges. Further, International Financial Re-
porting Standards (IFRS) are somewhat different from Generally
Accepted Accounting Principles (GAAP). In this chapter, we deal
with not only the basic initial recordation of a fixed asset under
GAAP and IFRS, but also the variety of special scenarios just
noted.
The Capitalization Limit

One of the most important decisions to be made in the initial rec-
ognition of a fixed asset is what minimum cost level to use, below
which you record an expenditure as an expense in the period in-
curred, rather than recording it as a fixed asset and depreciating it
over time. This capitalization limit, which is frequently abbreviated
as the cap limit, is usually driven by the following factors:
• Asset tracking. If you record an expenditure as a fixed as-
set, the fixed asset tracking system may impose a signifi-
cant amount of control over the newly-recorded fixed asset.
This can be good, if you want to know where an asset is at
any time. Conversely, there is not usually a tracking system
in place for an expenditure that is charged to expense, since
the assumption is that such items are consumed at once,
and so require no subsequent tracking.
• Fixed asset volume. The number of expenditures that will
be recorded as fixed assets will increase dramatically as
you lower the cap limit. For example, there may only be
one fixed asset if the cap limit is $100,000, 50 assets if the

cap limit is $10,000, and 500 assets if the cap limit is
$1,000. You should analyze historical expenditures, as well
as projected purchases, to estimate a cap limit that will pre-
vent the accounting staff from being deluged with addi-
tional fixed asset records. The analysis of projected pur-
chases is particularly important if spending patterns are ex-
pected to change.
• Profit pressure. Senior management may have a strong in-
terest in reporting the highest possible profit levels right
now, which means that they want a very low cap limit that
shifts as many expenditures as possible into capitalized as-
sets. Since this pressure can result in a vast number of very
low-cost fixed assets, this issue can create a considerable
work load for the accounting staff.
• Record keeping cost. What is the lowest asset cost at which
it becomes burdensome to track an individual fixed asset?
There is a labor cost associated with each fixed asset,
which includes depreciation, derecognition, impairment,
and auditing transactions.
• Tax requirements. Some government entities require that
you report fixed assets, so that they can charge a personal
property tax that is calculated from your reported fixed as-
set levels. Clearly, a high cap limit will reduce the number
of reported fixed assets, and therefore the tax paid. How-
ever, government entities may require a minimum cap limit
in order to protect their tax revenues.
From an efficiency or tax liability perspective, a high cap limit is

always best, since it greatly reduces the work of the accountant and
results in lower personal property taxes. From a profitability or as-
set tracking perspective, you would want the reverse, with a very
low cap limit. These conflicting objectives call for some discussion
within the management team about the most appropriate cap limit
– it should not simply be imposed on the company by the account-
ing department.
40
EXAMPLE
Nascent Corporation is reviewing its capitalization limit, which is currently set

at $1,000. A review of this limit reveals that the company has capitalized several
hundred laptop computers, none of which it actively tracks, and which it re-
places as company policy every three years. There are also a number of servers
that were acquired for its data storage facility, each of which cost about $5,000
each. These servers are occasionally subject to failure, and so are monitored
closely. Finally, there are several large astronomical installations around the
world, with each installation costing several million dollars.
Upon review of this information, the company concludes that it should re-set the
capitalization limit to $4,000, so that it excludes all laptop computers, but con-
tinues to include the servers that it has more interest in tracking. This change in
policy will also eliminate roughly 40 percent of all assets tracked, which will
reduce the cost of record keeping. Though there will be an additional expense
associated with immediately charging new laptop purchases to expense, the in-
crease is considered immaterial to the company’s overall profitability.
The Base Unit

There is no specific guidance in either GAAP or IFRS about the
unit of measure that you should use to measure a fixed asset. This
unit of measure, or base unit, is essentially your definition of what
constitutes a fixed asset. Since there is no prescribed definition,
you can create one. You should formalize this definition into a pol-
icy, so that you apply it consistently over time. Here are several
issues to consider when creating your definition of a base unit:
• Aggregation. Should you aggregate individually insignifi-
cant items into a fixed asset, such as a group of desks? This
increases your administrative burden, but does delay recog-
nition of the expense associated with the items.
Tip:
If you are billed by a supplier for several assets on a single invoice,
do not record everything on the invoice as a single fixed asset. In-
stead, determine the base unit for each asset, and allocate the
freight and tax for the entire invoice to the individual fixed assets
that you choose to recognize.
41
• Asset control. If you cannot exercise control over an asset,

do not designate it as a base unit. For example, hand tools
are constantly being used throughout the production shop,
and may not be adequately controlled. Similarly, laptop
computers are moved around constantly, and so might also
not be a good choice for a base unit. In both of these exam-
ples, the cost of the items involved may be so low that they
would fall under the company capitalization limit, and so
would not be a valid base unit in any case.
• Component replacement. Is it likely that large components
of an asset will be replaced during its useful life? If so, you
may want to designate the smaller units as the most appro-
priate base unit to track in the accounting records. This de-
cision may be influenced by the probability of these smaller
components actually being replaced over time.
• Costs are assignable. You should be able to link each base
unit with an invoiced supplier cost (if acquired elsewhere).
Otherwise, you will spend too much time apportioning in-
voiced costs between multiple base units.
• Identification. Can you identify an asset that has been des-
ignated as a base unit, or at least attach an asset tag to it? If
not, then you will not be able to subsequently track it, and
so should not designate it as a base unit. This is a particular
problem with highly complex machinery that contains a va-
riety of equipment that may require replacement at different
intervals; even if you might want to track these components
separately, it may not be possible to disentangle the assets
sufficiently to do so.
• Legal description. If there is a legal description of an asset,
such as is stated on a tax billing for a specific parcel of
land, this can form the basis for a base unit, since you can
then associate future expenses billed by a government en-
tity to the base unit.
• Safety equipment. Some items may be so important to the
safety of employees or facilities that you need to track them
as base units. In this case, the monitoring capabilities of a
42
fixed asset system may be of great importance in ensuring

that these assets are in the proper locations at all times. See
the Fixed Asset Tracking chapter for more information.
• Tax treatment. Is there a tax advantage in separately ac-
counting for the components of a major asset? This may be
the case where the useful life of a component is shorter
than that of a major asset of which it is a part, so that you
can depreciate it quicker.
• Useful life. The useful lives of the components of a base
unit should be similar, so that the entire unit can be elimi-
nated or replaced at approximately the same time.
• Value of information. At what level of asset aggregation is
the information collected the most valuable? If you need to
track the useful lives of major asset components, then you
should consider setting the base unit at the level of those
components. Conversely, if you are merely complying with
the accounting standards and have no further use for any
fixed asset information collected, then it may make sense to
create base units for assets at a high expenditure level.
Tip:
Do not confuse the collection of information needed for accounting
records with information collected for maintenance records. The
accounting database does not normally include any maintenance
information, so you should not set base units based on the need for
maintenance information.
EXAMPLE
Nascent Corporation owns and operates a number of wide-field telescopes

around the world, which are used for tracking near-earth objects that might enter
the atmosphere. Each telescope contains optics that must be removed and re-
coated every 20 years, as well as a drive mechanism that should be replaced
every five years, and a massive concrete mount that realistically requires no
maintenance or replacement of any kind for the foreseeable future. The observa-
tory dome has a thirty-year useful life.
43
Given these differing useful lives and replacement requirements, Nascent elects
to designate the optics, drive mechanism, mount, and dome as separate base
units.
EXAMPLE
Fireball Flight Services operates a high-altitude solar telescope from a small

business jet. Fireball elects to designate the air frame, telescope, jet engines,
radio equipment, and GPS triangulation system as separate base units, since
each one has a different useful life to which costs can be clearly assigned.
GAAP: The Initial Measurement of a Fixed Asset

You should initially record a fixed asset at the historical cost of
acquiring it, which includes the costs to bring it to the condition
and location necessary for its intended use. If these preparatory
activities will occupy a period of time, you can also include in the
cost of the asset the interest costs related to the cost of the asset
during the preparation period (see the Interest Capitalization chap-
ter for more information).
The activities involved in bringing a fixed asset to the condi-
tion and location necessary for its intended purpose include the fol-
lowing:
• Physical construction of the asset
• Demolition of any preexisting structures
• Renovating a preexisting structure to alter it for use by the
buyer
• Administrative and technical activities during preconstruc-
tion for such activities as designing the asset and obtaining
permits
• Administrative and technical work after construction com-
mences for such activities as litigation, labor disputes, and
technical problems
EXAMPLE
Nascent Corporation constructs a solar observatory. The project costs $10 mil-
lion to construct. Also, Nascent takes out a loan for the entire $10 million
44
amount of the project, and pays $250,000 in interest costs during the six-month
construction period. Further, the company incurs $500,000 in architectural fees
and permit costs before work begins.
All of these costs can be capitalized into the cost of the building asset, so Nas-
cent records $1.75 million as the cost of the building asset.
GAAP: The Measurement of Assets Acquired in a Busi-

ness Combination
If a company acquires fixed assets as part of a business combina-
tion, it should recognize all identifiable assets, including such iden-
tifiable intangible assets as a patent, customer relationship, or a
brand. You should record these fixed assets at their fair values as
of the acquisition date.
EXAMPLE
Nascent Corporation acquires Stellar Designs for $40 million. It allocates $10
million of the purchase price among current assets and liabilities at their book
values, which approximate their fair values. Nascent also assigns $22 million to
identifiable fixed assets and $4 million to a customer relationships intangible
asset. This leaves $4 million that cannot be allocated, and which is therefore
assigned to a goodwill asset.
GAAP: The Measurement of Assets Acquired in a Capi-

tal Lease
If you are the lessee and a lease qualifies as a capital lease, then
you should record the asset being leased as a fixed asset. A lease
qualifies as a capital lease if it meets any one of the following four
criteria:
• Transfers ownership of the asset to the lessee by the end of
the lease term.
• The lease contains a bargain purchase option.
• The lease term is equal to 75 percent or more of the esti-
mated economic life of the lease asset.
45
• The present value of the minimum lease payments is equal

to or greater than 90 percent of the fair value of the asset.
You cannot include executory costs or lessor profit in this
calculation.
You cannot use the final two criteria if the lease term begins within
the final 25 percent of the estimated economic life of the asset.
What is a Lessee?
A lessee is the party in a leasing transaction that contracts to make
rental payments to a lessor in exchange for the use of an asset.
You should record this asset at the amount equal to the present
value as of the beginning date of the lease of the minimum lease
payments over the term of the lease, not including any executory
costs included in the lease. If you cannot determine the amount as-
sociated with executory costs, then estimate the amount.
What are Executory Costs?

Executory costs are the transactional and operational fees associ-
ated with a lease, and include such items as insurance, mainte-
nance, and taxes.
If the present value of the minimum lease payments exceeds the

fair value of the leased asset as of the beginning date of the lease,
then record the fair value of the asset instead.
EXAMPLE
Nascent Corporation leases a used spectrographic analyzer. The machine is

well-used already, and is estimated to be within the final 25 percent of its esti-
mated economic life. The lease does not automatically transfer ownership to
Nascent at the end of the lease term, but the lease does include a $10 bargain
purchase option. Thus, the lease qualifies as a capital lease due to the presence
of the bargain purchase option.
46
Under the terms of the lease, Nascent pays $1,000 per month for 30 months.
Nascent’s incremental borrowing rate is eight percent per year. The present
value of 30 monthly payments of $1,000 at a discount rate of eight percent is
$27,109.
Nascent hires an independent appraiser, who determines that the fair value of the
analyzer as of the beginning date of the lease is $28,000. Since the present value
of the minimum lease payments is lower than the estimated fair value, Nascent
records $27,109 as the cost of the spectrographic analyzer.
Nascent records the lease with the following entry:
Debit Credit
Equipment (capital lease) 27,109
Capital lease obligations 27,109
For each of the 30 subsequent monthly lease payments, Nascent credits cash for
$1,000, debits the capital lease obligations liability for the principal portion of
the lease payment, and debits the interest expense account for the interest por-
tion of the lease payment.
GAAP: Non-Monetary Exchanges

What if you acquire a fixed asset through an exchange of assets?
You should follow this sequence of decisions to decided upon the
correct cost at which to record the asset received:
1. Measure the asset acquired at the fair value of the asset sur-
rendered to the other party.
2. If the fair value of the asset received is more clearly evident
than the fair value of the asset surrendered, then measure
the acquired asset at its own fair value.
In either case, you should recognize a gain or loss on the difference

between the recorded cost of the asset transferred to the other party
and the recorded cost of the asset that you have acquired.
If you are unable to determine the fair value of either asset,
then you should record the asset received at the cost of the asset
you have relinquished in order to obtain it. Use this later approach
under any of the following circumstances:
47
• You cannot determine the fair value of either asset within

reasonable limits;
• The transaction is intended to facilitate a sale to a customer
other than the parties to the asset exchange; or
• The transaction does not have commercial substance.
EXAMPLE
Nascent Corporation exchanges a color copier with a carrying amount of

$18,000 with Declining Company for a print-on-demand publishing station. The
color copier had an original cost of $30,000, and had incurred $12,000 of accu-
mulated depreciation as of the transaction date. No cash is transferred as part of
the exchange, and Nascent cannot determine the fair value of the color copier.
The fair value of the publishing station is $20,000.
Nascent can record a gain of $2,000 on the exchange, which is derived from the
fair value of the publishing station that it acquired, less the carrying amount of
the color copier that it gave up. Nascent uses the following journal entry to re-
cord the transaction:
Debit Credit
Publishing equipment 20,000
Accumulated depreciation 12,000
Copier equipment 30,000
Gain on asset exchange 2,000
What is Commercial Substance?

A transaction is considered to have commercial substance under
GAAP if a company expects that its future cash flows will change
significantly as a result of the transaction. A cash flow change is
considered significant if the risk, timing, or amount of future cash
flows of the asset received differ significantly from those of the
asset given up; alternatively, a cash flow change is considered sig-
nificant if there is a significant difference in the entity-specific val-
ues of the assets exchanged. Entity-specific value can vary from
fair value, if the company plans to use assets for a less-than-
optimal activity. Thus, entity-specific value can be less than fair
value.
48
EXAMPLE
Nascent Corporation and Starlight Inc. swap spectroscopes, since the two de-
vices have different features that the two companies need. The spectroscope
given up by Nascent has a carrying amount of $25,000, which is comprised of
an original cost of $40,000 and accumulated depreciation of $15,000. Both spec-
troscopes have identical fair values of $27,000.
Nascent’s controller tests for commercial substance in the transaction. She finds
that there is no difference in the fair values of the assets exchanged, and that
Nascent’s cash flows will not change significantly as a result of the swap. Thus,
she concludes that the transaction has no commercial value, and so should ac-
count for it at book value, which means that Nascent cannot recognize a gain of
$2,000 on the transaction, which is the difference between the $27,000 fair value
of the spectroscope and the $25,000 carrying amount of the asset given up. In-
stead, she uses the following journal entry to record the transaction, which does
not contain a gain or loss:
Debit Credit
Spectroscope (asset received) 25,000
Spectroscope (asset given up) 40,000
What if there is an exchange of cash between the two parties, in

addition to a non-monetary exchange? The accounting varies if the
amount of cash, or boot, paid as part of the asset exchange is rela-
tively small (which is defined under GAAP as less than 25 percent
of the fair value of the exchange), or if it is larger.
What is Boot?
Boot is the cash paid as part of an exchange of assets between two
parties.
In the case of a small amount of boot, the recipient of the cash re-
cords a gain to the extent that the amount of cash received exceeds
a proportionate share of the cost of the surrendered asset. This pro-
portionate share is calculated as the ratio of the cash paid to the
total consideration received (which is the cash received plus the
49
fair value of the asset received); if the amount of the consideration

received is not clearly evident, then you can instead use the fair
value of the asset surrendered to the other party. The calculation is:
Boot
------------------------------------------ x Total gain = Gain recognized
Boot + Fair value of asset received
What is the accounting from the perspective of the party paying

cash as part of the transaction? This entity records the asset re-
ceived as the sum of the cash paid to the other party plus the re-
corded amount of the asset surrendered. If the transaction results in
a loss, then you should record the entire amount of the loss at once.
Under no circumstances are you allowed to record a gain on such a
transaction.
EXAMPLE
Nascent Corporation is contemplating the exchange of one of its heliographs for

a catadioptric telescope owned by Aphelion Corporation. The two companies
have recorded these assets in their accounting records as follows:
Nascent Aphelion
(Heliograph) (Catadioptric)
Cost $82,000 $97,000
Accumulated depreciation 22,000 27,000
Net book value $60,000 $70,000
Fair value $55,000 $72,000
Under the terms of the proposed asset exchange, Nascent must pay cash (boot)
to Aphelion of $17,000. The boot amount is 24 percent of the fair value of the
exchange, which is calculated as:
$17,000 Boot / ($55,000 Fair value of heliograph + $17,000 Boot) = 24%
The parties elect to go forward with the exchange. The amount of boot is less
than 25 percent of the total fair value of the exchange, so Aphelion should rec-
ognize a pro rata portion of the $2,000 gain (calculated as the $72,000 total fair
value of the asset received - $70,000 net book value of the asset received) on the
exchange using the following calculation:
50
24% portion of boot to total fair value received x $2,000 Gain

= $480 Recognized gain
Nascent uses the following journal entry to record the exchange transaction:
Debit Credit
Telescope (asset received) 72,000
Loss on asset exchange 5,000
Cash 17,000
Heliograph (asset given up) 82,000
Nascent’s journal entry includes a $5,000 loss; the loss is essentially the differ-
ence between the book value and fair value of the heliograph on the transaction
date.
Aphelion uses the following journal entry to record the exchange transaction:
Debit Credit
Heliograph (asset received) 53,480
Cash 17,000
Gain on asset exchange 480
Telescope (asset given up) 97,000
Aphelion is not allowed to recognize the full value of the heliograph at the ac-
quisition date because of the boot rule for small amounts of cash consideration;
this leaves the heliograph undervalued by $1,520 (since its fair value is actually
$55,000).
The accounting is different if the amount of boot is 25 percent or

more of the fair value of the exchange. In this situation, both par-
ties should record the transaction at its fair value.
EXAMPLE
Nascent Corporation exchanges a wide field CCD camera for a Schmidt-

Cassegrain telescope owned by Aphelion Corporation. The two companies have
recorded these assets in their accounting records as follows:
51
Nascent Aphelion
(Camera) (Schmidt-Cassegrain)
Cost $50,000 $93,000
Accumulated depreciation (30,000) (40,000)
Net book value $20,000 $53,000
Fair value $24,000 $58,000
Under the terms of the agreement, Nascent pays $34,000 cash (boot) to Aphe-
lion. This boot amount is well in excess of the 25 percent boot level, so both
parties can now account for the deal as a monetary transaction.
Nascent uses the following journal entry to record the exchange transaction,
which measures the telescope acquired at the fair value of the camera and cash
surrendered:
Debit Credit
Telescope (asset received) 58,000
Cash 34,000
CCD camera (asset given up) 50,000
The gain recorded by Nascent is the difference between the $24,000 fair value of
the camera surrendered and its $20,000 book value.
Aphelion uses the following journal entry to record the exchange transaction,
which measures the camera acquired at the fair value of the telescope surren-
dered less cash received:
Debit Credit
Camera (asset received) 24,000
Cash 34,000
Telescope (asset given up) 93,000
The gain recorded by Aphelion is the difference between the $58,000 fair value
of the telescope surrendered and its $53,000 book value.
52
IFRS: Initial Inclusions in a Fixed Asset

Under IFRS, there are some differences from the GAAP require-
ments for the initial recognition of a fixed asset, so we are present-
ing a detailed review of the IFRS requirements.
Under IFRS, you should only recognize an item as a fixed asset
if there will probably be future economic benefits associated with
the item that will flow to the owning entity, and you can reliably
measure the cost of the item. Thus, you can legitimately record
major spare parts and stand-by equipment as fixed assets if you
expect to use them during more than one accounting period. Fur-
ther, if you can only use spare parts and servicing equipment in
connection with a specific fixed asset, you can legitimately record
them as fixed assets.
Tip:
Do not take the preceding advice literally, and record items as
fixed assets for just a few months! The work required to track such
assets will far exceed any resulting improvement in the accuracy of
reported financial results.
The costs that you can include in a fixed asset are the cost initially
incurred to acquire or construct the asset, as well as any costs in-
curred at a later date to add to, replace part of, or service it. When
applying this concept, be aware of the following three situations:
• Repair and maintenance activities. You should charge to
expense in the period incurred the costs of routine servicing
of a fixed asset (typically the costs of labor and consum-
ables).
• Replacement parts. If you replace parts of a fixed asset,
then you should derecognize the parts being replaced, and
recognize as fixed assets those parts being added to the
fixed asset. An example of this situation is replacing a mo-
tor in a machine, or the interior seating in an aircraft. This
rule only applies if there will probably be future economic
benefits associated with the replacement, and you can
measure the cost of the replacement.
53
EXAMPLE
Nova Corporation needs to replace the motor drive on its deep field scanning
telescope. The new drive costs $25,000. The original motor drive cost $20,000
and was depreciated over a five-year period, of which four years have expired.
Nova records the following entry to derecognize the old motor drive:
Debit Credit
Loss on asset derecognition 4,000
Motor drive 20,000
Nova then records the new motor drive as a fixed asset with the following entry:
Debit Credit
Motor drive 25,000
Cash 25,000
• Major inspections. If you must perform a major inspection

to continue operating a fixed asset, then you should record
the cost of the inspection as a fixed asset and derecognize
any remaining cost associated with the preceding inspec-
tion. If the cost of the preceding inspection had not been
capitalized, then you must still derecognize an amount
based on an estimate of what the preceding inspection
would have cost, based on the future cost of a similar in-
spection. This rule only applies if there will probably be fu-
ture economic benefits associated with a major inspection,
and you can measure the cost of the inspection.
EXAMPLE
Fireball Flight Services operates a high-altitude solar telescope from a small

business jet. The airframe is rated for 6,000 hours of flight time, after which the
Federal Aviation Administration will lock down the jet unless it undergoes a
major inspection. The plane reaches its 6,000-hour limitation, and Fireball pays
$75,000 for a major inspection. There is a future economic benefit associated
with this inspection, since the plane would otherwise be restricted from flying.
54
Fireball acquired the jet in used condition, and this is the first time it has per-
formed a major inspection since its acquisition of the plane. Fireball’s mainte-
nance manager estimates that the cost of a previous major inspection would have
been similar to the cost of the most recent one, so Fireball records the following
journal entry to remove the estimated cost of the previous major inspection from
the cost of the jet:
Debit Credit
Jet aircraft 75,000
Fireball then records the following journal entry to capitalize the cost of the
most recent major inspection as a component of the jet:
Debit Credit
Jet aircraft (inspection cost) 75,000
Cash 75,000
Fireball plans to depreciate the cost of the major inspection fixed asset over the
next 6,000 flight hours logged by the jet.
What is Derecognition?
Derecognition is the process of removing a transaction from the
accounting records of an entity. Thus, in the case of a fixed asset,
this is the removal of the asset and any accumulated depreciation
from the accounting records, as well as the recognition of any as-
sociated gain or loss.
IFRS: Initial Cost of a Fixed Asset

The amount that you initially capitalize for a fixed asset is its cost.
The capitalized cost of a fixed asset can include the following
items:
• Purchase price
• Import duties
• Non-refundable taxes on the purchase transaction
• Costs incurred that are directly attributable to bringing the
asset to the location and condition necessary for it to be op-
55
erated as intended. Examples of these directly attributable

costs are:
¾ Assembly and installation
¾ Delivery and handling
¾ Employee benefits arising directly from the construc-
tion or acquisition of the asset
¾ Site preparation
¾ Testing to ascertain functionality
• Professional fees
• Interest costs incurred that relate to asset construction dur-
ing the construction period
• The initial estimate of the cost to be incurred to dismantle
and remove the asset, as well as to restore the site on which
it was placed
• Less: trade discounts and rebates
• Less: proceeds from samples produced during testing
You should not capitalize any of the following costs:

• Opening a new facility
• Introducing a new product or service (and any related mar-
keting costs)
• Conducting business in a new location
• Conducting business with a new customer or class of cus-
tomer
• Administration and general overhead
You should stop capitalizing costs into a designated fixed asset

when the asset is in the location and condition for it to operate as
intended. Due to this restriction, do not capitalize any subsequent
costs to use or redeploy a fixed asset. Examples of costs not to
capitalize are:
• Costs incurred after an asset is in the location and condition
for it to operate as intended, but it is still not operational or
operating at full capacity
56
• Costs to relocate or reorganize some portion or all of a

company’s operations
• Initial operating losses
There are several special cost situations under IFRS that pertain to
fixed assets, though they will not apply in most situations. They
are:
• If a company is self-constructing an asset, charge any ab-
normal costs of wasted material, labor, or other such items
to expense as incurred.
• If a company’s payment for a fixed asset is deferred beyond
common credit terms, then charge a portion of the payment
to interest expense to account for the long-term credit being
granted by the supplier. The amount of interest charged to
expense is the difference between the price paid and the
price the company would have paid under normal credit
terms. Depending on the situation, this interest cost may be
capitalized as part of the fixed asset (see the Interest Capi-
talization chapter for more information).
EXAMPLE
Hubble Corporation builds a new observatory to measure the declining orbits of

satellites and plot the trajectories of incoming debris. The following table shows
whether it can capitalize costs incurred or charge them to expense:
Charge
Item Cost Capitalize to Expense
Administrative overhead $80,000 $80,000
Architectural fees 45,000 $45,000
Balancing certification 10,000 10,000
Construction contractor fees 430,000 430,000
Construction loan interest 40,000 40,000
Import fees on telescope mount 4,000 4,000
Landscaping 35,000 35,000
Move staff to new location 60,000 60,000
Observatory dome 390,000 390,000
Opening day marketing 15,000 15,000
Sales taxes on equipment 70,000 70,000
57
Charge
Item Cost Capitalize to Expense
Scrapped concrete foundation 25,000 25,000
Telescope mount 190,000 190,000
Testing labor 5,000 5,000
Utilities 8,000 8,000
Wide field telescope 580,000 580,000
Zoning application 12,000 12,000
Totals $1,999,000 $1,811,000 $188,000
IFRS: Measurement of Assets Acquired in a Business

Combination
In a business combination, the acquiring entity measures the tangi-
ble and intangible assets acquired at their fair values as of the ac-
quisition date. If the acquirer designates any acquired assets as
held for sale as of the acquisition date, then you should record
them at their fair values, less any costs to sell.
IFRS: Measurement of Assets Acquired in a Capital

Lease
Under IFRS, a lease in which the lessee is considered to own the
leased asset is called a finance lease; this would be called a capital
lease under GAAP. You should classify a lease as a finance lease if
the lease transfers substantially all of the risks and rewards of
ownership to the lessee; if substantially all of the risks and rewards
of ownership are not borne by the lessee, then you must record the
lease as an operating lease (i.e., not as a fixed asset, but rather as a
period expense). Risk and reward include such factors as the pos-
sibilities of loss from technological obsolescence and the gain from
the possible appreciation in value of an asset. The lease terms that
would indicate the presence of a finance lease include any of the
following:
• The lessee owns the asset by the end of the lease term.
• There is a bargain purchase option where the purchase op-
tion is sufficiently below the expected fair value that the
lessee will be reasonably certain to exercise it.
58
• The lease term spans the majority of the economic life of

the asset.
• The present value of the minimum lease payments is sub-
stantially equal to or greater than the fair value of the asset.
• The asset is so specialized that only the lessee can use it
without major alterations.
Tip:
When you lease land, it is more likely that you would record it as
an operating lease, since it has an indefinite economic life, which
eliminates the third of the preceding criteria for a finance lease.
Other possible scenarios indicating that a lease should be classified

as a finance lease include:
• If there is a cancellation clause that the lessee can exercise
to terminate the lease, the lessee must pay the lessor for any
losses incurred by the lessor as a result of the cancellation.
• If there are variations in the residual fair value of the asset
at the end of the lease, these gains or losses accrue to the
lessee.
• The lessee can continue to lease the asset beyond the term
of the original lease at a rate substantially beneath the mar-
ket rate.
If a lease includes both land and buildings, you should allocate the
minimum lease payments between the two assets based on their
relative fair values for the purposes of determining whether either
asset should be considered a finance lease. If you cannot make a
reliable allocation, then you should classify the entire lease as a
finance lease, if it meets the preceding criteria for a finance lease.
If you determine that a lease should be treated as a finance
lease, then record the asset being leased at the lower of its fair
value or the present value of the minimum lease payments. The
discount rate you should use in calculating the present value of the
minimum lease payments is the interest rate implicit in the lease. If
59
you cannot determine this implicit rate, then use the company’s
incremental borrowing rate instead. Further, you should add any
initial direct costs of the lease to the capitalized amount. An exam-
ple of this direct cost is the legal cost of negotiating a lease agree-
ment.
EXAMPLE
Hubble Corporation enters into a 10-year lease of a Newtonian-style telescope

for its Chilean observatory complex. The present value of the minimum lease
payments is $2.3 million, in comparison to the estimated fair value of the asset
of $2.2 million. This is an extremely specialized device whose optical compo-
nents have been adapted to the dry climate where the observatory is situated.
Since the fair value and present value of future minimum lease payments are
essentially the same, and the device is highly specialized, Hubble should record
the lease as a finance lease.
Hubble capitalizes the lease at its fair value of $2.2 million, since that amount is
lower than the present value of future minimum lease payments of $2.3 million.
Hubble also capitalizes the $15,000 of initial direct costs associated with negoti-
ating the lease agreement.
You should not state the amount of a capitalized lease in the bal-
ance sheet net of any related liabilities. Instead, you should sepa-
rately the report the related liabilities.
IFRS: Non-Monetary Exchanges

A company may acquire a fixed asset in exchange for a non-
monetary asset or a mix of cash and non-monetary assets. You
should measure the cost of such an acquired item at its fair value,
except under the following conditions:
• The transaction lacks commercial substance.
• You cannot reliably measure the fair value of either asset
exchanged. An asset is considered to be reliably measur-
able when there is an insignificant variability in the range
of reasonable fair value estimates, or when you can rea-
60
sonably assess and use the probabilities in a range of fair

value estimates to derive a fair value.
What is Commercial Substance?

A transaction has commercial substance under IFRS when the risk,
timing, and amount of cash flows of the swapped assets are differ-
ent, or if the transaction alters the value of the company’s opera-
tions impacted by the transaction, and the difference between the
two is significant in comparison to the fair value of the exchanged
assets.
If you cannot measure an acquired asset at its fair value, then in-
stead use the fair value of the received asset. If neither fair value is
available, then use the carrying amount of the asset given up to ac-
quire the asset.
What is a Carrying Amount?

Carrying amount is the recorded amount of an asset, net of any ac-
cumulated depreciation or accumulated impairment losses.
EXAMPLE
Binary Brothers acquires a tractor for its rocket launching operation in an ex-
change of assets. The tractor has a fair value of $120,000. Binary gives up two
liquid nitrogen fuel tankers in the exchange, which have an original cost of
$200,000 and accumulated depreciation of $60,000. The other party also pays
Binary $40,000 in cash. Binary records the following entry to eliminate the
trucks from its books, record the tractor at its fair value, and record a gain on the
transaction:
Debit Credit
Tractor 120,000
Cash 40,000
Trailers 200,000
61
Binary records a $20,000 gain because the $160,000 fair value of the tractor and
cash received exceeds the $140,000 carrying amount of the trailers surrendered
in the transaction.
Summary
As noted in the introduction, you will likely have a very easy time
recording the initial acquisition of a fixed asset. Determination of
the base unit is also fairly routine in most cases. There is a moder-
ate increase in transactional complexity when you deal with assets
acquired through a business combination, since fair values are
used. Nonetheless, the accounting is not especially difficult. Capi-
tal leases require some additional analysis, since a discounted cash
flow calculation must also be considered. The real complexity lies
in the exchange of assets, where the rules are based on such factors
as the proportional amount of cash paid and the uses to which as-
sets are to be put. In this last case, it is best if you closely review
the applicable accounting standards before recording a transaction.
62
Review Questions
1. The capitalization limit is:

a. The maximum amount of earnings that a corporation is
allowed to retain, above which the Internal Revenue
Service imposes a tax
b. An amount below which all expenditures are charged to
expense
c. An amount above which all expenditures are charged to
expense
d. The amount of retained earnings
2. The choice of a base unit is founded upon:

a. Your ability to identify a fixed asset
b. The asset classification of which it is a part
c. The capitalization limit
d. The subsidiary of which it is a part
3. You should recognize a loss on a non-monetary exchange:

a. In the amount of any administrative costs incurred
b. When the recorded cost of the asset acquired is lower
than the cost of the asset surrendered
c. In the amount of any cash given up as part of the trans-
action
d. When the recorded cost of the asset acquired is greater
than the cost of the asset surrendered
4. Boot is:
a. A fixed asset for which impairment is indicated
b. The cost of an intangible asset
c. The cash paid as part of an exchange of assets between
two parties
d. The amount of fixed assets used as collateral for a loan
63
Review Answers
1. The capitalization limit is:

a. Incorrect. The IRS does have an accumulated earnings
tax, but it is not called the capitalization limit.
b. Correct. An amount below which all expenditures are
charged to expense.
c. Incorrect. Expenditures above the capitalization limit
are capitalized.
d. Incorrect. The amount of retained earnings is based on
the cumulative amount of company earnings, less any
distributions to shareholders.
2. The choice of a base unit is founded upon:

a. Correct. Your choice of a base unit is founded upon
your ability to identify it.
b. Incorrect. Asset classifications are used to aggregate
fixed assets having common characteristics.
c. Incorrect. The capitalization limit is a minimum thresh-
old for recognizing expenditures as fixed assets, and
has nothing to do with the base unit.
d. Incorrect. The assignment of a base unit should be the
same, no matter which subsidiary it is located in.
3. You should recognize a loss on a non-monetary exchange:

a. Incorrect. Administrative costs should be charged to
expense, but would not be classified as a loss.
b. Incorrect. The amount of cash given up as part of an as-
set exchange forms the basis for a gain or loss calcula-
tion, but does not necessarily represent a loss.
c. Incorrect. When the cost of the item acquired is lower
than the cost of the items surrendered, the difference is
recorded as a loss.
d. Correct. When the cost of the item acquired is greater
than the cost of the item surrendered, the difference is
recorded as a gain.
64
4. Boot is:
a. Incorrect. Impairment analysis does not consider the
boot paid for an exchanged asset.
b. Incorrect. Boot may be part of the amount paid for a
purchased intangible asset, but does not necessarily
comprise its entire cost.
c. Correct. The cash paid as part of an exchange of assets
between two parties.
d. Incorrect. Fixed assets may be used as collateral for a
loan, but boot is not related to the term “collateral.”
65
Chapter 4
Interest Capitalization
Introduction
When you record a fixed asset, part of the cost you are allowed to
include is the costs you incurred to bring it to the condition and
location of its intended use. If these activities require some time to
complete, then you can capitalize the cost of the interest incurred
during that period that relate to the asset. This chapter describes the
assets for which interest capitalization is allowable (or not), how to
determine the capitalization period and the capitalization rate, and
how to calculate the amount of interest cost to be capitalized.
What is Interest?
Interest is the cost of funds loaned to an entity by a lender, usually
expressed as a percentage of the principal on an annual basis.
What is Capitalization?
Capitalization is when you record an expenditure as an asset, rather
than an expense. This usually occurs when the amount of an ex-
penditure exceeds a company’s capitalization limit, and it will have
a useful life of greater than one year.
Why and When Do We Capitalize Interest?

Interest is a cost of doing business, and if a company incurs an in-
terest cost that is directly related to a fixed asset, then it is reason-
able to capitalize this cost, since it provides a truer picture of the
total investment in the asset. Since a business would not otherwise
have incurred the interest if it had not acquired the asset, the inter-
est is essentially a direct cost of owning the asset.
Conversely, if you did not capitalize this interest cost and in-
stead charged it to expense, then you would be unreasonably re-
ducing the amount of reported earnings during the period when the
company incurred the expense, and increasing earnings during
later periods, when you would otherwise have been charging the
capitalized interest to expense through normal, ongoing deprecia-
tion charges.
Tip:
If the amount of interest that may be applied to a fixed asset is mi-
nor, try to avoid capitalizing it. Otherwise, you will spend extra
time documenting the capitalization, and the auditors will spend
time investigating it – which may translate into higher audit fees.
The value of the information provided by capitalizing interest

may not be worth the effort of the incremental accounting cost as-
sociated with it. Here are some issues to consider when deciding
whether to capitalize interest:
• How many assets would be subject to interest capitaliza-
tion?
• How easy is it to separately identify those assets that would
be subject to interest capitalization?
• How significant would be the effect of interest capitaliza-
tion on the company’s reported resources and earnings?
Thus, you should only capitalize interest when the informational

benefit derived from doing so exceeds the cost of accounting for it.
The positive impact of doing is greatest for construction projects,
where:
• Costs are separately compiled
• Construction covers a long period of time
• Expenditures are large
• Interest costs are considerable
GAAP specifically does not allow you to capitalize interest for in-
ventory items that are routinely manufactured in large quantities on
a repetitive basis.
67
Assets for Which You Must Capitalize Interest

You must capitalize interest that is related to the following types of
fixed assets:
• That are constructed for the company’s own use. This in-
cludes assets built for the company by suppliers, where the
company makes progress payments or deposits.
• That are constructed for sale or lease, and which are con-
structed as discrete projects.
EXAMPLE
Milford Sound builds a new corporate headquarters. The company hires a con-
tractor to perform the work, and makes regular progress payments to the con-
tractor. Milford should capitalize the interest expense related to this project.
Milford Sound creates a subsidiary, Milford Public Sound, which builds custom-
designed outdoor sound staging for concerts and theatre activities. These pro-
jects require many months to complete, and are accounted for as discrete pro-
jects. Milford should capitalize the interest cost related to each of these projects.
If a company is undertaking activities to develop land for a specific

use, you can capitalize interest related to the associated expendi-
tures for as long as the development activities are in progress.
Assets for Which You Do Not Capitalize Interest

You should not capital interest that is related to the following types
of fixed assets:
• Assets that are already in use or ready for their intended
use.
• Assets not being used, and which are not being prepared for
use.
• Assets not included in the company’s balance sheet.
• Inventories that are routinely manufactured.
68
The Interest Capitalization Period

You should capitalize interest over the period when there are ongo-
ing activities to prepare a fixed asset for its intended use, but only
if expenditures are actually being made during that time, and inter-
est costs are being incurred.
EXAMPLE
Milford Public Sound is constructing an in-house sound stage in which to test its
products. It spent the first two months designing the stage, and then paid a con-
tractor $30,000 per month for the next four months to build the stage. Milford
incurred interest costs during the entire time period.
Since Milford was not making any expenditures related to the stage during the
first two months, it cannot capitalize any interest cost for those two months.
However, since it was making expenditures during the next four months, it can
capitalize interest cost for those months.
If a company stops essentially all construction on a project, then

you should stop capitalizing interest during that period. However,
you can continue to capitalize interest under any of the following
circumstances:
• Brief construction interruptions
• Interruptions imposed by an outside entity
• Delays that are an inherent part of the asset acquisition
process
EXAMPLE
Milford Public Sound is constructing a concert arena that it plans to lease to a

local municipality upon completion. Midway through the project, the municipal-
ity orders a halt to all construction, when construction reveals that the arena is
being built on an Indian burial ground. Two months later, after the burial site has
been relocated, the municipality allows construction to begin again.
Since this interruption was imposed by an outside entity, Milford can capitalize
interest during the two-month stoppage period.
69
You should terminate interest capitalization as soon as an asset is

substantially complete and ready for its intended use. Here are sev-
eral scenarios showing when you should terminate interest capi-
talization:
• Unit-level completion. Parts of a project may be completed
and usable before the entire project is complete. You
should stop capitalizing interest on each of these parts as
soon as they are substantially complete and ready for use.
• Entire-unit completion. All aspects of an asset may need to
be completed before any part of it can be used. You should
continue capitalizing interest on such assets until the entire
project is substantially complete and ready for use.
• Dependent completion. An asset may not be usable until a
separate project has also been completed. You should con-
tinue capitalizing interest on such assets until not only the
specific asset, but also the separate project is substantially
complete and ready for use.
EXAMPLE
Milford Public Sound is building three arenas, all under different circumstances.
They are:
1. Arena A. This is a entertainment complex, including a stage area,
movie theatre, and restaurants. Milford should stop capitalizing interest
on each component of the project as soon as it is substantially complete
and ready for use, since each part of the complex can operate without
the other parts being complete.
2. Arena B. This is a single outdoor stage with integrated multi-level park-
ing garage. Even though the garage is completed first, Milford should
continue to capitalize interest for it, since the garage is only intended to
service patrons of the arena, and so will not be operational until the
arena is complete.
3. Arena C. This an entertainment complex for which Milford is also con-
structing a highway off-ramp and road that leads to the complex. Since
the complex is unusable until patrons can reach the complex, Milford
should continue to capitalize interest expenses until the off-ramp and
road are complete.
70
You cannot continue to capitalize interest when completion is be-

ing deliberately delayed, since the cost of interest then changes
from an asset acquisition cost to an asset holding cost.
EXAMPLE
The CEO of Milford Sound wants to report increased net income for the upcom-
ing quarter, so he orders the delay of construction on an arena facility that would
otherwise have been completed, so that the interest cost related to the project
will be capitalized. He is in error, since this is now treated as a holding cost –
the related interest expense should be recognized in the period incurred, rather
than capitalized.
The Capitalization Rate

The amount of interest cost that you should capitalize for a fixed
asset is that amount of interest that would have been avoided if you
had not acquired the asset.
To calculate the amount of interest cost to capitalize, multiply
the capitalization rate by the average amount of expenditures that
accumulate during the construction period.
What is the Capitalization Rate?

The capitalization rate is the rate you use to calculate the amount
of interest to be capitalized.
The basis for the capitalization rate is the interest rates that are ap-
plicable to the company’s borrowings that are outstanding during
the construction period. If a specific borrowing is incurred in order
to construct a specific asset, then you can use the interest rate on
that borrowing as the capitalization rate. If the amount of a specific
borrowing that is incurred to construct a specific asset is less than
the expenditures made for the asset, then you should use a
weighted average of the rates applicable to other company borrow-
ings for any excess expenditures over the amount of the project-
specific borrowing.
71
EXAMPLE
Milford Public Sound incurs an average expenditure over the construction pe-
riod of an outdoor arena complex of $15,000,000. It has taken out a short-term
loan of $12,000,000 at 9% interest specifically to cover the cost of this project.
Milford can capitalize the interest cost of the entire amount of the $12,000,000
loan at 9% interest, but it still has $3,000,000 of average expenditures that ex-
ceed the amount of this project-specific loan.
Milford has two bonds outstanding at the time of the project, in the following
amounts:
Bond Description Principal Outstanding Interest

8% Bond $18,000,000 $1,440,000
10% Bond 12,000,000 1,200,000
Totals $30,000,000 $2,640,000
The weighted-average interest rate on these two bond issuances is 8.8%

($2,640,000 interest / $30,000,000 principal), which is the interest rate that Mil-
ford should use when capitalizing the remaining $3,000,000 of average expendi-
tures.
These rules regarding the formulation of the capitalization rate are

subject to some interpretation. The key guideline is to arrive at a
reasonable measure of the cost of financing the acquisition of a
fixed asset, particularly in regard to the interest cost that could
have been avoided if the acquisition had not been made. Thus, you
can use a selection of outstanding borrowings as the basis for a
weighted average calculation. This may result in the inclusion or
exclusion of borrowings at the corporate level, or just at the level
of the subsidiary where the asset is located.
EXAMPLE
Milford Public Sound (MPS) has issued several bonds and notes, totaling
$50,000,000, that are used to fund both general corporate activities and con-
struction projects. It also has access to a low-cost 4% internal line of credit that
is extended to it by its corporate parent, Milford Sound. MPS regularly uses this
line of credit for short-term activities, and typically draws the balance down to
72
zero at least once a year. The average amount of this line that is outstanding is
approximately $10,000,000 at any given time.
Since the corporate line of credit comprises a significant amount of MPS’s on-
going borrowings, and there is no restriction that prevents these funds from be-
ing used for construction projects, it would be reasonable to include the interest
cost of this line of credit in the calculation of the weighted-average cost of bor-
rowings that is used to derive MPS’s capitalization rate.
Calculating Interest Capitalization

Follow these steps to calculate the amount of interest to be capital-
ized for a specific project:
1. Construct a table itemizing the amounts of expenditures
made and the dates on which the expenditures were made.
2. Determine the date on which interest capitalization ends.
3. Calculate the capitalization period for each expenditure,
which is the number of days between the specific expendi-
ture and the end of the interest capitalization period.
4. Divide each capitalization period by the total number of
days elapsed between the date of the first expenditure and
the end of the interest capitalization period to arrive at the
capitalization multiplier for each line item.
5. Multiply each expenditure amount by its capitalization
multiplier to arrive at the average expenditure for each line
item over the capitalization measurement period.
6. Add up the average expenditures at the line item level to ar-
rive at a grand total average expenditure.
7. If there is project-specific debt, multiply the grand total of
the average expenditures by the interest rate on that debt to
arrive at the capitalized interest related to that debt.
8. If the grand total of the average expenditures exceeds the
amount of the project-specific debt, multiply the excess ex-
penditure amount by the weighted average of the com-
pany’s other outstanding debt to arrive at the remaining
amount of interest to be capitalized.
73
9. Add together both capitalized interest calculations. If the

combined total is more than the total interest cost incurred
by the company during the calculation period, then reduce
the amount of interest to be capitalized to the total interest
cost incurred by the company during the calculation period.
10. Record the interest capitalization with a debit to the pro-
ject’s fixed asset account and a credit to the interest ex-
pense account.
EXAMPLE
Milford Public Sound is building a concert arena. Milford makes payments re-
lated to the project of $10,000,000 and $14,000,000 to a contractor on January 1
and July 1, respectively. The arena is completed on December 31.
For the 12-month period of construction, Milford can capitalize all of the inter-
est on the $10,000,000 payment, since it was outstanding during the full period
of construction. Milford can capitalize the interest on the $14,000,000 payment
for half of the construction period, since it was outstanding during only the sec-
ond half of the construction period. The average expenditure for which the inter-
est cost can be capitalized is calculated in the following table:
Date of Expenditure Capitalization Capitalization Average

Payment Amount Period* Multiplier Expenditure
Jan. 1 $10,000,000 12 months 12/12 months $10,000,000
= 100%
July 1 14,000,000 6 months 6/12 months 7,000,000
= 50%
$17,000,000
*In the table, the capitalization period is defined as the number of months that elapse
between the expenditure payment date and the end of the interest capitalization period.
The only debt that Milford has outstanding during this period is a line of credit,
on which the interest rate is 8%. The maximum amount of interest that Milford
can capitalize into the cost of this arena project is $1,360,000, which is calcu-
lated as:
8% Interest rate x $17,000,000 Average expenditure = $1,360,000
Milford records the following journal entry:
74
Debit Credit
Fixed assets – Arena 1,360,000
Interest expense 1,360,000
Tip:
There may be an inordinate number of expenditures related to a
larger project, which could result in a large and unwieldy calcula-
tion of average expenditures. To reduce the workload, consider
aggregating these expenses by month, and then assume that each
expenditure was made in the middle of the month, thereby reduc-
ing all of the expenditures for each month to a single line item.
You cannot capitalize more interest cost in an accounting period

than the total amount of interest cost incurred by the business in
that period. If there is a corporate parent, then this rule means that
the amount capitalized cannot exceed the total amount of interest
cost incurred by the business on a consolidated basis.
Tip:
You cannot include the cost of asset retirement obligations in the
expenditure total on which the interest capitalization calculation is
based, since there is no up-front expenditure associated with such
an obligation (see the Asset Retirement Obligations chapter for
more information).
Derecognizing Capitalized Interest

Capitalized interest is considered to be an integral part of the cost
of an asset, so you should account for it in the same manner as any
other capitalized cost of a fixed asset. See the Asset Disposal chap-
ter for more information.
Interest Capitalization Under IFRS

Interest capitalization under International Financial Reporting
Standards is addressed in IAS 23, Borrowing Costs. The IFRS
rules are essentially the same as those required by GAAP. The key
75
features of the IFRS rules related to interest capitalization, includ-

ing some minor differences from GAAP, are:
• You should capitalize interest costs that are directly attrib-
utable to the acquisition, construction, or production of a
fixed asset into the cost of that asset.
• If a company is located in a hyperinflationary economy,
you should charge that portion of interest costs to expense
that compensates for inflation, rather than capitalizing it.
• Interest costs eligible for capitalization are those that would
have been avoided if you had not acquired the asset.
• If you are using a specific borrowing to obtain an asset, you
may capitalize the interest cost associated with that borrow-
ing, less any investment income earned on the temporary
investment of those borrowings (as may occur when the
borrowed funds are received early in the project, but are not
immediately needed).
EXAMPLE
Milford Public Sound issues a one-year note for $20,000,000 at 6% interest to

pay for the construction of a new arena. At the end of the one-year period, Mil-
ford has incurred $1,200,000 in interest costs, but has also earned $250,000 on
interest income from the temporary investment of funds received from the note.
Thus, the maximum amount of interest expense that Milford can capitalize is
$950,000 ($1,200,000 interest cost - $250,000 interest income).
• The capitalization rate to use for capitalizing the cost of in-

terest is the rate on the borrowings incurred specifically for
the project, after which the weighted average rate of other
borrowings are used for any remaining expenditures. The
amount of interest capitalized cannot exceed the total
amount of borrowing costs incurred during the period.
• The start of interest capitalization is the commencement
date, which is defined as the date when a company begins
to incur expenditures for a project, and incurs borrowing
costs, and begins to prepare the asset for its intended use or
76
sale. Preparing an asset for its intended use or sale can en-
compass a variety of administrative activities prior to actual
construction, such as designing the asset or obtaining con-
struction permits.
• You should suspend the capitalization of interest costs
when there are extended periods when a company suspends
the active development of an asset. However, you may still
capitalize interest when there is a temporary delay, such as
waiting for a construction permit to be granted.
• You should terminate all interest capitalization when sub-
stantially all of the activities required to prepare the project
for its intended use or sale are complete. This means that
minor modifications and adjustments will not keep the in-
terest capitalization from being terminated.
• If a portion of a project can be completed while construc-
tion continues on other parts of the project, you should stop
capitalizing the cost of interest on that portion of the pro-
ject.
Summary
The key issue with interest capitalization is whether to use it at all.
It requires a certain amount of administrative effort to compile, and
so is not recommended for smaller fixed assets. Instead, you
should reserve its use for larger projects where including the cost
of interest in an asset will improve the quality of the financial in-
formation reported by the entity. It should not be used merely to
delay the recognition of interest expense.
If you choose to use interest capitalization, then adopt a proce-
dure for determining the amount to be capitalized and closely ad-
here to it, with appropriate documentation of the results. This will
result in a standardized calculation methodology that auditors can
more easily review.
77
Review Questions
1. We capitalize interest in order to:

a. Decrease short-term profits
b. Reduce the recordation work of the accounting staff
c. Provide a truer picture of the total investment in an as-
set
d. Hide the total interest expense from readers of the fi-
nancial statements
2. You should use interest capitalization when:

a. Expenditure levels are small
b. Construction covers a long period of time
c. Interest costs are small
d. The cost of accounting for it is greater than the value of
the informational benefit derived from doing so
3. The amount of interest you can capitalize is:

a. The amount you would have avoided by not acquiring
the asset
b. Limited to 10% of the cost of the asset
c. Based on the maximum amount of expenditures accu-
mulated during the construction period
d. Based on the company’s historical borrowing rate
4. If a company is capitalizing interest in a hyperinflationary

economy, it should:
a. Never capitalize any interest costs
b. Capitalize all applicable interest costs in a normal man-
ner
c. Make capitalization subject to corporate policy
d. Charge interest costs to expense for that portion that
compensates for inflation
78
Review Answers
1. We capitalize interest in order to:

a. Incorrect. Interest capitalization causes short-term prof-
its to increase.
b. Incorrect. Interest capitalization increases the recorda-
tion work of the accounting staff.
c. Correct. Provide a truer picture of the total investment
in an asset.
d. Incorrect. Interest capitalization can obscure the total
amount of interest expense incurred, but this is not the
intent of capitalization.
2. You should use interest capitalization when:

a. Incorrect. Interest capitalization is usually limited to
projects with large expenditure levels.
b. Correct. Construction covers a long period of time.
c. Incorrect. Interest capitalization is usually limited to
situations where the interest cost incurred is substantial.
d. Incorrect. You should use interest capitalization when
the benefit derived from it is greater than the cost of ac-
counting for it.
3. The amount of interest you can capitalize is:

a. Correct. The amount you would have avoided by not
acquiring the asset.
b. Incorrect. It is not limited to 10% of the cost of the as-
set. Rather, it is limited to the total amount of interest
cost incurred by the entity during the period.
c. Incorrect. It is not based on the maximum amount of
expenditures accumulated during the construction pe-
riod, but rather the average amount accumulated.
d. Incorrect. It is not based on the historical borrowing
rate, but rather the interest rates applicable to the en-
tity’s borrowings during the construction period.
79
4. If a company is capitalizing interest in a hyperinflationary

economy, it should:
a. Incorrect. A company is allowed to capitalize a portion
of its interest costs to expense.
b. Incorrect. Only a portion of interest costs may be capi-
talized.
c. Incorrect. Interest capitalization is subject to accounting
standards, not corporate policy.
d. Correct. Charge interest costs to expense for that por-
tion that compensates for inflation.
80
Chapter 5
Asset Retirement Obligations
Introduction
An asset retirement obligation (ARO) is a liability associated with
the retirement of a fixed asset, such as a legal requirement to return
a site to its previous condition. The concept of an ARO is dealt
with in considerable detail within Generally Accepted Accounting
Principles (GAAP), and is only referenced in passing within Inter-
national Financial Reporting Standards (IFRS). Thus, nearly all of
the discussion in this chapter concerns the GAAP requirements for
asset retirement obligations. An example near the end of the chap-
ter illustrates many of the concepts noted below.
The Liability for an Asset Retirement Obligation

A company usually incurs an ARO due to a legal obligation. It
may also incur an ARO if a company promises a third party (even
the public at large) that it will engage in ARO activities; the cir-
cumstances of this promise will drive the determination of whether
there is an actual liability. This liability may exist even if there has
been no formal action against the company. When making the de-
termination of liability, you should base the evaluation on current
laws, not on projections of what laws there may be in the future,
when the asset retirement occurs.
EXAMPLE
Glow Atomic operates an atomic power generation facility, and is required by

law to bring the property back to its original condition when the plant is eventu-
ally decertified. The company has come under some pressure by various envi-
ronmental organizations to take the remediation one step further and create a
public park on the premises. Because of the significant negative publicity gener-
ated by these groups, the company issues a press release in which it commits to
create the park. There is no legal requirement for the company to incur this addi-
tional expense, so the company’s legal counsel should evaluate the facts to de-
termine if there is a legal obligation.
A business should recognize the fair value of an ARO when it in-

curs the liability, and if it can make a reasonable estimate of the
fair value of the ARO.
EXAMPLE
Glow Atomic has completed the construction of an atomic power generation

facility, but has not yet taken delivery of fuel rods or undergone certification
tests. It will incur an ARO for decontamination, but since it has not yet begun
operations, it has not begun to contaminate, and therefore should not yet record
an ARO liability.
If a fair value is not initially obtainable, then you should recognize

the ARO at a later date, when the fair value becomes available. If a
company acquires a fixed asset to which an ARO is attached, then
you should recognize a liability for the ARO as of the fixed asset
acquisition date.
If there is not sufficient information available to reasonably es-
timate the fair value of an ARO, you may be able to use an ex-
pected present value technique that assigns probabilities to cash
flows, thereby creating an estimate of the fair value of the ARO.
You should use an expected present value technique under either
of the following scenarios:
• Other parties have specified the settlement date and method
of settlement, so that the only uncertainty is whether the
obligation will be enforced.
• There is information available from which you can estimate
the range of possible settlement dates and possible methods
of settlement, as well as the probabilities associated with
them.
Examples of the sources from which you can obtain the informa-
tion needed for the preceding estimation requirements are past
practice within the company, industry practice, the stated inten-
tions of management, or the estimated useful life of the asset
82
(which indicates a likely ARO settlement date at the end of the

useful life).
Tip:
The ARO settlement date may be quite a bit further in the future
than the useful life of an asset may initially indicate, if the com-
pany intends to prolong the useful life with asset upgrades, or has a
history of doing so.
If there is an unambiguous requirement that causes an ARO, but

there is a low likelihood of a performance requirement, you must
still recognize a liability. When you incorporate the low probability
of performance into the expected present value calculation for the
ARO liability, this will likely reduce the amount of the ARO that
you recognize. Even if there has been a history of non-enforcement
of prior AROs for which there was an unambiguous obligation,
you should not defer the recognition of a liability.
The Initial Measurement of an Asset Retirement Obliga-

tion
In most cases, the only way to determine the fair value of an ARO
is to use an expected present value technique. When constructing
an expected present value of future cash flows, you should incor-
porate the following points into the calculation:
• Discount rate. Use a credit-adjusted risk-free rate to dis-
count cash flows to their present value. This means that the
credit standing of a business may impact the discount rate
used.
• Probability distribution. When calculating the expected
present value of an ARO, and there are only two possible
outcomes, you should assign a 50 percent probability to
each of the outcomes until you have additional information
that alters the initial probability distribution. Otherwise,
spread the probability across the full set of possible scenar-
ios.
83
EXAMPLE
Glow Atomic is compiling the cost of a decontamination ARO several years in

the future. It is uncertain of the cost, since supplier fees fluctuate considerably. It
arrives at an expected weighted average cash flow based on the following prob-
ability analysis:
Cash Flow Probability Expected

Estimates Assessment Cash Flows
$12,500,000 10% $1,250,000
15,000,000 15% 2,250,000
16,000,000 50% 8,000,000
22,500,000 25% 5,625,000
Weighted average cash flows $17,125,000
You should follow these steps in calculating the expected present

value of an ARO:
1. Estimate the timing and amount of the cash flows associ-
ated with the retirement activities.
2. Determine the credit-adjusted risk-free rate.
3. Recognize any period-to-period increase in the carrying
amount of the ARO liability as accretion expense. To do
so, multiply the beginning liability by the credit-adjusted
risk-free rate derived when the liability was first measured.
4. Recognize upward liability revisions as a new liability
layer, and discount them at the current credit-adjusted risk-
free rate.
5. Recognize downward liability revisions by reducing the
appropriate liability layer, and discount the reduction at the
rate used for the initial recognition of the related liability
layer.
What is Accretion Expense?

Accretion expense is an expense arising from an increase in the
carrying amount of the liability associated with an asset retirement
obligation. It is not interest expense. It is classified as an operating
expense in the income statement.
84
When you initially recognize an ARO liability, you should also

capitalize the related asset retirement cost by adding it to the carry-
ing amount of the related fixed asset.
Subsequent Measurement of an ARO

It is possible that an ARO liability will not remain static over the
life of the related fixed asset. Instead, the liability may change over
time. If the liability increases, you should consider the incremental
increase in each period to be an additional layer of liability, in ad-
dition to any previous liability layers. The following points will
assist in your recognition of these additional layers:
• Initially recognize each layer at its fair value.
EXAMPLE
Glow Atomic has been operating an atomic power plant for three years. It ini-
tially recognized an ARO of $250 million for the eventual dismantling of the
plant after its useful life has ended. In the fifth year, Glow detects groundwater
contamination, and recognizes an additional layer of ARO liability for $20 mil-
lion to deal with it. In the seventh year, a leak in the sodium cooling lines causes
overheating and a significant release of radioactive steam that impacts 50 square
miles of land downwind from the facility. Glow recognizes an additional layer
of ARO liability of $150 million to address this issue.
• Systematically allocate the ARO liability to expense over

the useful life of the underlying asset.
• Measure changes in the liability due to the passage of time,
using the credit-adjusted risk-free rate when each layer of
liability was first recognized. You should recognize this
cost as an increase in the liability. When charged to ex-
pense, this is classified as accretion expense.
• As the time period shortens before an ARO is realized,
your assessment of the timing, amount, and probabilities
associated with cash flows will improve. You will likely
need to alter the ARO liability based on these changes in
estimate. If you make an upward revision in the ARO li-
85
ability, then discount it using the current credit-adjusted

risk-free rate. If you make a downward revision in the ARO
liability, then discount it using the original credit-adjusted
risk-free rate when the liability layer was first recognized.
If you cannot identify the liability layer to which the
downward adjustment relates, then use a weighted-average
credit-adjusted risk-free rate to discount it.
Settlement of an Asset Retirement Obligation

You normally settle an ARO only when the underlying fixed asset
is retired, though it is possible that some portion of an ARO will be
settled prior to asset retirement.
If it becomes apparent that no expenses will be required as part
of the retirement of an asset, then you can reverse any remaining
unamortized ARO to zero.
Tip:
If a company cannot fulfill its ARO responsibilities and a third
party does so instead, this does not relieve the company from re-
cording an ARO liability, on the grounds that it may now have a
obligation to pay the third party instead.
EXAMPLE
Glow Atomic operates an atomic power generation facility, and is legally re-
quired to decontaminate the facility when it is decommissioned in five years.
Glow uses the following assumptions about the ARO:
• The decontamination cost is $90 million.
• The risk-free rate is 5%, to which Glow adds 3% to reflect the effect of
its credit standing.
• The assumed rate of inflation over the five-year period is four percent.
With an average inflation rate of 4% per year for the next five years, the current
decontamination cost of $90 million increases to approximately $109.5 million
by the end of the fifth year. The expected present value of the $109.5 million
payout, using the 8% credit-adjusted risk-free rate, is $74,524,000 (calculated as
$109.5 million x 0.68058 discount rate).
86
Glow then calculates the amount of annual accretion using the 8% rate, as
shown in the following table:
Beginning Ending
Year Liability Accretion Liability
1 $74,524,000 $5,962,000 $80,486,000
2 80,486,000 6,439,000 86,925,000
3 86,925,000 6,954,000 93,879,000
4 93,879,000 7,510,000 101,389,000
5 101,389,000 8,111,000 109,500,000
Glow then combines the accretion expense with the straight-line depreciation
expense noted in the following table to show how all components of the ARO
are charged to expense over the next five years. Note that the accretion expense
is carried forward from the preceding table. The depreciation is based on the
$74,524,000 present value of the ARO, spread evenly over five years.
Accretion Depreciation Total

Year Expense Expense Expense
1 $5,962,000 $14,904,800 $20,866,800
2 6,439,000 14,904,800 21,343,800
3 6,954,000 14,904,800 21,858,800
4 7,510,000 14,904,800 22,414,800
5 8,111,000 14,904,800 23,015,800
$109,500,000
After the plant is closed, Glow commences its decontamination activities. The
actual cost is $115 million.
Here is a selection of the journal entries that Glow recorded over the term of the
ARO:
Debit Credit
Facility decontamination asset 90,000,000
Asset retirement obligation liability 90,000,000
To record the initial fair value of the asset retirement obligation
Debit Credit
Depreciation expense 14,904,800
Accumulated depreciation 14,904,800
To record the annual depreciation on the asset retirement obligation
87
Debit Credit
Accretion expense As noted in
schedule
Asset retirement obligation liability As noted in
schedule
To record the annual accretion expense on the ARO liability
Debit Credit
Loss on ARO settlement 5,500,000
Remediation expense 5,500,000
To record settlement of the excess asset retirement obligation
Asset Retirement Obligations Under IFRS

IFRS has not yet given much attention to the concept of asset re-
tirement obligations. IFRS merely states that you should include in
the initial cost of a fixed asset your initial estimate of the costs of
dismantling and removing an item and restoring the site on which
it is located.
Since the cost of an asset is defined in IFRS as the cash price
equivalent on the recognition date, we may infer that the cost of an
ARO is actually the present value of the future cash flows associ-
ated with this action. If so, you should use as a discount rate the
market rate at the time of recognition, adjusted for the risks spe-
cific to the ARO.
Summary
The accounting for an asset retirement obligation can be complex,
especially if there are multiple liability layers and changes to those
layers occur with some frequency. Because of the additional ac-
counting effort required to track AROs, it makes considerable
sense to use every effort to avoid the recognition of an ARO within
the boundaries set by GAAP. In many cases, the amount of an
ARO will likely be so minimal as to not require recognition. How-
ever, in such industries as mining, chemicals, and power genera-
tion, the concept of the ARO is of great concern, and forms a sig-
nificant proportion of a company’s total liabilities.
88
Review Questions
1. You should certainly record an asset retirement obligation

based on:
a. A projection of future laws
b. A company press release
c. A current legal obligation
d. A statement by a company officer
2. You should record an asset retirement obligation when:

a. You can make a reasonable estimate of its fair value
b. There is a clear liability
c. You can obtain insurance for it
d. The third party to whom the obligation is owed can be
identified
3. If there is a subsequent increase in an asset retirement obliga-

tion, you should:
a. Charge any changes in the liability caused by the pas-
sage of time to interest expense
b. Recognize a new liability layer at its fair value
c. Charge the new liability to expense at once
d. Do not subsequently change your estimate of the liabil-
ity
4. You normally settle an asset retirement obligation when:

a. The estimated useful life of the asset has expired
b. A third party takes on the obligation
c. The company does not have the financial resources to
pay for the ARO
d. The underlying fixed asset is retired
89
Review Answers
1. You should certainly record an asset retirement obligation

based on:
a. Incorrect. You should not record an asset retirement ob-
ligation based on a projection of future laws.
b. Incorrect. A company press release may create an ARO
obligation, but it is not certain.
c. Correct. A current legal obligation.
d. Incorrect. A statement by a company officer may create
an ARO obligation, but it is not certain.
2. You should record an asset retirement obligation when:

a. Correct. You can make a reasonable estimate of its fair
value.
b. Incorrect. You cannot record an ARO, even if there is a
clear liability, if you cannot estimate its fair value.
c. Incorrect. The availability of insurance is not related to
when you can record an ARO.
d. Incorrect. There may be no third party to whom the ob-
ligation is owed, since an ARO usually involves the
remediation of property or land that a company already
owns.
3. If there is a subsequent increase in an asset retirement obliga-

tion, you should:
a. Incorrect. You should charge any changes in the liabil-
ity caused by the passage of time to accretion expense.
b. Correct. Recognize a new liability layer at its fair
value.
c. Incorrect. You should allocate the liability to expense
over the useful life of the asset.
d. Incorrect. You should continually refine your assess-
ment of the liability.
90
4. You normally settle an asset retirement obligation when:

a. Incorrect. The expiration of an asset’s estimated useful
life may not correspond to its actual retirement, and so
does not trigger the settlement of an ARO.
b. Incorrect. If a third party takes on the ARO obligation,
your obligation now shifts to the third party.
c. Incorrect. A company still has an ARO liability even
when it does not have the financial resources to settle it.
d. Correct. The underlying fixed asset is retired.
91
Chapter 6
Depreciation and Amortization
Introduction
This chapter describes why we use depreciation and amortization,
key terms, and the various methods for calculating depreciation
and amortization, as well as the accounting entries associated with
these calculations. We end the chapter with a review of the key
depreciation concepts used in International Financial Reporting
Standards.
What is Depreciation?
Depreciation is the systematic reduction of the cost of a fixed asset.
We use depreciation to match a portion of the cost of an asset to
the revenue that it generates. This is mandated under the matching
principal, where you record revenues with their associated ex-
penses in the same reporting period in order to give a complete pic-
ture of the results of a revenue-generating activity.
What is Amortization?
Amortization is the write-off of an intangible asset over its ex-
pected period of use. Examples of intangible assets are patents,
copyrights, and trademarks.
The difference between depreciation and amortization is that amor-

tization is associated with charging intangible assets to expense
over their usage period, and depreciation is associated with charg-
ing tangible assets to expense over their usage period. A similar
concept, depletion, involves charging the cost of natural resources
to expense over their usage period.
The treatment of amortization is quite similar to the treatment
of depreciation, so much of the discussion in this chapter pertain-
ing to depreciation also applies to amortization.
The Purpose of Depreciation

The purpose of depreciation is to charge to expense a portion of an
asset that relates to the revenue generated by that asset. This is
called the matching principle, where revenues and expenses both
appear in the income statement in the same reporting period, which
gives the best view of how well a company has performed in a
given accounting period. The trouble with this matching concept is
that there is usually only a tenuous connection between the genera-
tion of revenue and a specific asset. Under the tenets of constraint
analysis, all of the assets of a company should be treated as a sin-
gle system that generates a profit; thus, there is no way to link a
specific asset to specific revenue.
To get around this linkage problem, we usually assume a
steady rate of depreciation over the useful life of each asset, so that
we approximate a linkage between the recognition of revenues and
expenses. This approximation threatens our credulity even more
when a company uses accelerated depreciation, since the main rea-
son for using it is to defer taxes (and not to better match revenues
and expenses).
If we were not to use depreciation at all, then we would be
forced to charge all assets to expense as soon as we buy them. This
would result in large losses in the months when this purchase
transaction occurs, followed by unusually high profitability in
those periods when the corresponding amount of revenue is recog-
nized, with no offsetting expense. Thus, a company that does not
use depreciation will have front-loaded expenses, and extremely
variable financial results.
Depreciation Concepts
There are three factors to consider in the calculation of deprecia-
tion, which are:
• Useful life. This is the time period over which you expect
that the asset will be productive, or the number of units of
production expected to be generated from it. Past its useful
life, it is no longer cost-effective to continue operating the
93
asset, so you would dispose of it or stop using it. Deprecia-

tion is recognized over the useful life of an asset.
Tip:
Rather than recording a different useful life for every asset, it is
easier to assign each asset to an asset class, where every asset in
that asset class has the same useful life. This approach may not
work for very high-cost assets, where a greater degree of precision
may be needed.
• Salvage value. When a company eventually disposes of an

asset, it may be able to sell it for some reduced amount,
which is the salvage value. Depreciation is calculated based
on the asset cost, less any estimated salvage value. If sal-
vage value is expected to be quite small, then it is generally
ignored for the purpose of calculating depreciation. Sal-
vage value is not discounted to its present value.
Tip:
If you estimate that the amount of salvage value associated with an
asset is minor, it is easier from a calculation perspective to not re-
duce the depreciable amount of the asset by the salvage value. In-
stead, assume that the salvage value is zero.
EXAMPLE
Pensive Corporation buys an asset for $100,000, and estimates that its salvage
value will be $10,000 in five years, when it plans to dispose of the asset. This
means that Pensive will depreciate $90,000 of the asset cost over five years,
leaving $10,000 of the cost remaining at the end of that time. ABC expects to
then sell the asset for $10,000, which will eliminate the asset from ABC's ac-
counting records.
• Depreciation method. You can calculate depreciation expense

using an accelerated depreciation method, or evenly over the
useful life of the asset. The advantage of using an accelerated
94
method is that you can recognize more depreciation early in

the life of a fixed asset, which defers some income tax ex-
pense recognition into a later period. The advantage of using a
steady depreciation rate is the ease of calculation. Examples
of accelerated depreciation methods are the double declining
balance and sum-of-the-years’ digits methods. The primary
method for steady depreciation is the straight-line method.
The mid-month convention states that, no matter when you pur-

chase a fixed asset in a month, you assume that it was purchased in
the middle of the month for depreciation purposes. Thus, if you
bought a fixed asset on January 5th, you should assume that you
bought it on January 15th; or, if you bought it on January 28, you
should still assume that you bought it on January 15th. By doing
so, you can more easily calculate a standard half-month of depre-
ciation for that first month of ownership.
If you choose to use the mid-month convention, this also
means that you should record a half-month of depreciation for the
last month of the asset's useful life. By doing so, the two-half
month depreciation calculations equal one full month of deprecia-
tion.
Many companies prefer to use full-month depreciation in the
first month of ownership, irrespective of the actual date of pur-
chase within the month, so that they can slightly accelerate their
recognition of depreciation, which in turn reduces their taxable in-
come in the near term.
Accelerated Depreciation
Accelerated depreciation is the depreciation of fixed assets at a
very fast rate early in their useful lives. The primary reason for us-
ing accelerated depreciation is to reduce the reported amount of
taxable income over the first few years of an asset's life, so that a
company pays a smaller amount of income taxes during those early
years. Later on, when most of the depreciation will have already
been recognized, the effect reverses, so there will be less deprecia-
tion available to shelter taxable income. The result is that a com-
95
pany pays more income taxes in later years. Thus, the net effect of
accelerated depreciation is the deferral of income taxes to later
time periods.
A secondary reason for using accelerated depreciation is that it
may actually reflect the usage pattern of the underlying assets,
where they experience heavier usage early in their useful lives
(though this is a rare situation).
There are several calculations available for accelerated depre-
ciation, such as the double declining balance method and the sum
of the years digits method. We will describe these methods later in
this chapter.
If a company elects not to use accelerated depreciation, it can
instead use the straight-line method, where it depreciates an asset
at the same standard rate throughout its useful life. It is customary
to use the straight-line method for the amortization of intangible
assets, since it is difficult to argue that an intangible asset experi-
ences heavy usage earlier in its useful life, and therefore requires
an accelerated method of amortization.
All of the depreciation methods end up recognizing the same
amount of depreciation, which is the cost of the fixed asset less any
expected salvage value. The only difference between the various
methods is the speed with which depreciation is recognized.
Accelerated depreciation requires additional depreciation cal-
culations and record keeping, so some companies avoid it for that
reason (though fixed asset software can readily overcome this is-
sue). They may also ignore it if they are not consistently earning
taxable income, which takes away the primary reason for using it.
Companies may also ignore accelerated depreciation if they have a
relatively small amount of fixed assets, so that the tax effect of us-
ing accelerated depreciation is minimal. Finally, if a company is
publicly held, management may be more interested in reporting the
highest possible amount of net income in order to buoy its stock
price for the benefit of investors - these companies will likely not
be interested in accelerated depreciation, which reduces the re-
ported amount of net income.
96
Straight-Line Method
Under the straight-line method of depreciation, you recognize de-
preciation expense evenly over the estimated useful life of an asset.
The straight-line calculation steps are:
1. Subtract the estimated salvage value of the asset from the
amount at which it is recorded on your books.
2. Determine the estimated useful life of the asset. It is easiest
if you use a standard useful life for each class of assets.
3. Divide the estimated useful life (in years) into 1 to arrive at
the straight-line depreciation rate.
4. Multiply the depreciation rate by the asset cost (less sal-
vage value).
EXAMPLE
Pensive Corporation purchases the Procrastinator Deluxe machine for $60,000.

It has an estimated salvage value of $10,000 and a useful life of five years. Pen-
sive calculates the annual straight-line depreciation for the machine as:
1. Purchase cost of $60,000 – estimated salvage value of $10,000 = De-
preciable asset cost of $50,000
2. 1 / 5-year useful life = 20% depreciation rate per year
3. 20% depreciation rate x $50,000 depreciable asset cost = $10,000 an-
nual depreciation
Sum-of-the-Years’ Digits Method

The sum of the years’ digits (SYD) method is more appropriate
than straight-line depreciation if the asset depreciates more quickly
or has greater production capacity in earlier years than it does as it
ages. Use the following formula to calculate it:
Number of estimated years of life

Depreciation percentage = as of beginning of the year
Sum of the years’ digits
The following table contains examples of the sum of the years’

digits noted in the denominator of the preceding formula:
97
Total Initial
Depreciation Sum of the
Period Years’ Digits Calculation
2 years 3 1+2
3 years 6 1+2+3
4 years 10 1+2+3+4
5 years 15 1+2+3+4+5
The concept is most easily illustrated with the following example:
EXAMPLE
Pensive Corporation buys a Procrastinator Elite machine for $100,000. The ma-
chine has no estimated salvage value, and a useful life of five years. Pensive
calculates the annual sum of the years’ digits depreciation for this machine as:
Number of estimated
years of life as of SYD Depreciation Annual
Year beginning of the year Calculation Percentage Depreciation
1 5 5/15 33.33% $33,333
2 4 4/15 26.67% 26,667
3 3 3/15 20.00% 20,000
4 2 2/15 13.33% 13,333
5 1 1/15 6.67% 6,667
Totals 15 100.00% $100,000
The sum of the years’ digits method is clearly more complex than
the straight-line method, which tends to limit its use unless soft-
ware is used to automatically track the calculations for each asset.
Double-Declining Balance Method

The double declining balance (DDB) method is a form of acceler-
ated depreciation. It may be more appropriate than the straight-line
method if an asset experiences an inordinately high level of usage
during the first few years of its useful life.
To calculate the double-declining balance depreciation rate, di-
vide the number of years of useful life of an asset into 100 percent,
and multiply the result by two. The formula is:
98
(100%/Years of useful life) × 2
The DDB calculation proceeds until the asset’s salvage value is

reached, after which depreciation ends.
EXAMPLE
Pensive Corporation purchases a machine for $50,000. It has an estimated sal-

vage value of $5,000 and a useful life of five years. The calculation of the dou-
ble declining balance depreciation rate is:
(100%/Years of useful life) × 2 = 40%
By applying the 40% rate, Pensive arrives at the following table of depreciation
charges per year:
Book Value at
Beginning of Depreciation DDB Book Value
Year Year Percentage Depreciation Net of Depreciation
1 $50,000 40% $20,000 $30,000
2 30,000 40% 12,000 18,000
3 18,000 40% 7,200 10,800
4 10,800 40% 4,320 6,480
5 6,480 40% 1,480 5,000
Total $45,000
Note that the depreciation in the fifth and final year is only for $1,480, rather
than the $3,240 that would be indicated by the 40% depreciation rate. The rea-
son for the smaller depreciation charge is that Pensive stops any further depre-
ciation once the remaining book value declines to the amount of the estimated
salvage value.
What is Book Value?

Book value is an asset's original cost, less any depreciation that has
been subsequently incurred.
An alternative form of double declining balance depreciation is

150% declining balance depreciation. It is a less aggressive form
of depreciation, since it is calculated as 1.5 times the straight-line
99
rate, rather than the 2x multiple that is used for the double declin-
ing balance method. Thus, if you were to use it, the formula would
be:
(100%/Years of useful life) × 1.5
EXAMPLE
[Note: We are repeating the preceding example, but using 150% declining bal-
ance depreciation instead of double declining balance depreciation]
Pensive Corporation purchases a machine for $50,000. It has an estimated sal-

vage value of $5,000 and a useful life of five years. The calculation of the 150%
declining balance depreciation rate is:
(100%/Years of useful life) × 1.5 = 30%
By applying the 30% rate, Pensive arrives at the following table of depreciation
charges per year:
Book Value at
Beginning of Depreciation DDB Book Value
Year Year Percentage Depreciation Net of Depreciation
1 $50,000 30% $15,000 $35,000
2 35,000 30% 10,500 24,500
3 24,500 30% 7,350 17,150
4 17,150 30% 5,145 12,005
5 12,005 30% 7,005 5,000
Total $45,000
In this case, the depreciation expense in the fifth and final year of $3,602
($12,005 x 30%) results in a net book value that is somewhat higher than the
estimated salvage value of $5,000, so Pensive instead records $7,005 of depre-
ciation in order to arrive at a net book value that equals the estimated salvage
value.
Depletion Method
Depletion is a periodic charge to expense for the use of natural re-
sources. Thus, it is used in situations where a company has re-
100
corded an asset for such items as oil reserves, coal deposits, or

gravel pits. The calculation of depletion involves these steps:
1. Compute a depletion base.
2. Compute a unit depletion rate.
3. Charge depletion based on units of usage.
What is a Depletion Base?

The depletion base is the asset that is to be depleted. It is com-
prised of the following four types of costs:
- Acquisition costs. The cost to either buy or lease property.
- Exploration costs. The cost to locate assets that may then be de-
pleted. In most cases, these costs are charged to expense as in-
curred.
- Development costs. The cost to prepare the property for asset ex-
traction, which includes the cost of such items as tunnels and
wells.
- Restoration costs. The cost to restore property to its original con-
dition after depletion activities have been concluded.
To compute a unit depletion rate, subtract the salvage value of the

asset from the depletion base and divide it by the total number of
measurement units that you expect to recover. The formula for the
unit depletion rate is:
Depletion base – Salvage value

Unit depletion rate =
Total units to be recovered
You then create the depletion charge based on actual units of us-
age. Thus, if you extract 500 barrels of oil and the unit depletion
rate is $5.00 per barrel, then you charge $2,500 to depletion ex-
pense.
The estimated amount of a natural resource that can be recovered

will change constantly as you gradually extract assets from a prop-
erty. As you revise your estimates of the remaining amount of ex-
tractable natural resource, you should incorporate these estimates
101
into the unit depletion rate for the remaining amount to be ex-
tracted. This is not a retrospective calculation.
EXAMPLE
Pensive Corporation’s subsidiary Pensive Oil drills a well with the intention of
extracting oil from a known reservoir. It incurs the following costs related to the
acquisition of property and development of the site:
Land purchase $280,000

Road construction 23,000
Drill pad construction 48,000
Drilling fees 192,000
Total $543,000
In addition, Pensive Oil estimates that it will incur a site restoration cost of
$57,000 once extraction is complete, so the total depletion base of the property
is $600,000.
Pensive’s geologists estimate that the proven oil reserves that are accessed by
the well are 400,000 barrels, so the unit depletion charge will be $1.50 per barrel
of oil extracted ($600,000 depletion base / 400,000 barrels).
In the first year, Pensive Oil extracts 100,000 barrels of oil from the well, which
results in a depletion charge of $150,000 (100,000 barrels x $1.50 unit depletion
charge).
At the beginning of the second year of operations, Pensive’s geologists issue a

revised estimate of the remaining amount of proven reserves, with the new esti-
mate of 280,000 barrels being 20,000 barrels lower than the original estimate
(less extractions already completed). This means that the unit depletion charge
will increase to $1.61 ($450,000 remaining depletion base / 280,000 barrels).
During the second year, Pensive Oil extracts 80,000 barrels of oil from the well,
which results in a depletion charge of $128,800 (80,000 barrels x $1.61 unit
depletion charge).
At the end of the second year, there is still a depletion base of $321,200 that
must be charged to expense in proportion to the amount of any remaining ex-
tractions.
102
Units of Production Method

Under the units of production method, the amount of depreciation
that you charge to expense varies in direct proportion to the
amount of asset usage. Thus, you charge more depreciation in pe-
riods when there is more asset usage, and less depreciation in peri-
ods when there is less asset usage. It is the most accurate method
for charging depreciation, since it links closely to the wear and tear
on assets. However, it also requires that you track asset usage,
which means that its use is generally limited to more expensive
assets. Also, you need to be able to estimate total usage over the
life of the asset.
Tip:
Do not use the units of production method if there is not a signifi-
cant difference in asset usage from period to period. Otherwise,
you will spend a great deal of time tracking asset usage, and will
be rewarded with a depreciation expense that varies little from the
results that you would have seen with the straight-line method
(which is far easier to calculate).
Follow these steps to calculate depreciation under the units of pro-

duction method:
1. Estimate the total number of hours of usage of the asset, or
the total number of units to be produced over its useful life.
2. Subtract any estimated salvage value from the capitalized
cost of the asset, and divide the total estimated usage or
production from this net depreciable cost. This yields the
depreciation cost per hour of usage or unit of production.
3. Multiply the number of hours of usage or units of actual
production by the depreciation cost per hour or unit, which
results in the total depreciation expense for the period.
If the estimated number of hours of usage or units of production

changes over time, then incorporate these changes into the calcula-
tion of the depreciation cost per hour or unit of production. This
will alter the depreciation expense on a go-forward basis.
103
EXAMPLE
Pensive Corporation’s gravel pit operation, Pensive Dirt, builds a conveyor sys-
tem to extract gravel from a gravel pit at a cost of $400,000. Pensive expects to
use the conveyor to extract 1,000,000 tons of gravel, which results in a deprecia-
tion rate of $0.40 per ton (1,000,000 tons / $400,000 cost). During the first quar-
ter of activity, Pensive Dirt extracts 10,000 tons of gravel, which results in the
following depreciation expense:
= $0.40 depreciation cost per ton x 10,000 tons of gravel
= $4,000 depreciation expense
MACRS Depreciation
MACRS depreciation is the tax depreciation system used in the
United States. MACRS is an acronym for Modified Accelerated
Cost Recovery System. Under MACRS, fixed assets are assigned
to a specific asset class. The IRS has published a complete set of
depreciation tables for each of these classes. The classes are:
Depreciation
Class Period Description
3-year property 3 years Tractor units for over-the-road use, race
horses over 2 years old when placed in
service, any other horse over 12 years
old when placed in service, qualified
rent-to-own property
5-year property 5 years Automobiles, taxis, buses, trucks, com-
puters and peripheral equipment, office
equipment, any property used in re-
search and experimentation, breeding
cattle and dairy cattle, appliances and
etc. used in residential rental real estate
activity, certain green energy property
7-year property 7 years Office furniture and fixtures, agricultural
machinery and equipment, any property
not designated as being in another class,
natural gas gathering lines
104
Depreciation
Class Period Description
10-year property 10 years Vessels, barges, tugs, single-purpose agri-
cultural or horticultural structures,
trees/vines bearing fruits or nuts, quali-
fied small electric meter and smart elec-
tric grid systems
15-year property 15 years Certain land improvements (such as shrub-
bery, fences, roads, sidewalks and
bridges), retail motor fuel outlets, mu-
nicipal wastewater treatment plants,
clearing and grading land improvements
for gas utility property, electric trans-
mission property, natural gas distribu-
tion lines
20-year property 20 years Farm buildings (other than those noted un-
der 10-year property), municipal sewers
not categorized as 25-year property, the
initial clearing and grading of land for
electric utility transmission and distribu-
tion plants
25-year property 25 years Property that is an integral part of the water
distribution facilities, municipal sewers
Residential 27.5 years Any building or structure where 80% or
rental property more of its gross rental income is from
dwelling units
Nonresidential 39 years An office building, store, or warehouse that
real property is not residential property or has a class
life of less than 27.5 years
The depreciation rates associated with the more common asset

classes are noted in the following table:
Recovery 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year

Year Property Property Property Property Property Property
1 33.33% 20.00% 14.29% 10.00% 5.00% 3.750%
2 44.45% 32.00% 24.49% 18.00% 9.50% 7.219%
3 14.81% 19.20% 17.49% 14.40% 8.55% 6.677%
4 7.41% 11.52% 12.49% 11.52% 7.70% 6.177%
5 11.52% 8.93% 9.22% 6.93% 5.713%
6 5.76% 8.92% 7.37% 6.23% 5.285%
7 8.93% 6.55% 5.90% 4.888%
8 4.46% 6.55% 5.90% 4.522%
105
Recovery 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year

Year Property Property Property Property Property Property
9 6.56% 5.91% 4.462%
10 6.55% 5.90% 4.461%
11 3.28% 5.91% 4.462%
12 5.90% 4.461%
13 5.91% 4.462%
14 5.90% 4.461%
15 5.91% 4.462%
16 2.95% 4.461%
17 4.462%
18 4.461%
19 4.462%
20 4.461%
21 2.231%
You calculate depreciation for tax reporting purposes by aggregat-

ing assets into the various classes noted in the preceding table, and
using the depreciation rates for each class. MACRS ignores sal-
vage value.
You use the MACRS depreciation rates to determine the de-
preciation expense for taxable income, and the other methods de-
scribed earlier to arrive at the depreciation expense for net income.
Since these depreciation methods have differing results, there will
be a temporary difference between the book values of fixed assets
under the two methods, which will gradually be resolved over their
useful lives. You report the difference between depreciation used
for calculating taxable income and for the financial statements as a
reconciling item in a company’s federal income tax return.
What is a Temporary Difference?

A temporary difference is the difference between the carrying
amount of an asset or liability in the balance sheet and its tax base.
The Depreciation of Land

Nearly all fixed assets have a useful life, after which they no
longer contribute to the operations of a company or they stop gen-
erating revenue. During this useful life, they are depreciated, which
reduces their cost to what they are supposed to be worth at the end
106
of their useful lives. Land, however, has no definitive useful life,

so there is no way to depreciate it.
The one exception is when some aspect of the land is actually
used up, such as when a mine is emptied of its ore reserves. In this
case, you classify the land as a natural resource and depreciate the
natural resources using the depletion method, as described earlier
in this chapter.
The Depreciation of Land Improvements

Land improvements are enhancements to a plot of land to make it
more usable. If these improvements have a useful life, then you
should depreciate them. If there is no way to estimate a useful life,
then do not depreciate the cost of the improvements.
If you are preparing land for its intended purpose, then you
should include these costs in the cost of the land asset. They are
not depreciated. Examples of such costs are:
• Demolishing an existing building
• Clearing and leveling the land
If you are adding functionality to the land and the expenditures

have a useful life, then you should record the expenditures in a
separate Land Improvements account. Examples of land improve-
ments are:
• Drainage and irrigation systems
• Fencing
• Landscaping
• Parking lots and walkways
A special item is the ongoing cost of landscaping. This is a period

cost, not a fixed asset, and so should be charged to expense as in-
curred.
EXAMPLE
Pensive Corporation buys a parcel of land for $1,000,000. Since it is a purchase

of land, Pensive cannot depreciate the cost. Pensive then razes a building that
was located on the property at a cost of $25,000, fills in the old foundation for
107
$5,000, and levels the land for $50,000. All of these costs are to prepare the land
for its intended purpose, so they are all added to the cost of the land. It cannot
depreciate these costs.
Pensive intends to use the land as a parking lot, so it spends $400,000 to pave
the land, and add walkways and fences. It estimates that the parking lot has a
useful life of 20 years. It should record this cost in the Land Improvements ac-
count, and depreciate it over 20 years.
Depreciation Accounting Entries

The basic depreciation entry is to debit the depreciation expense
account (which appears in the income statement) and credit the ac-
cumulated depreciation account (which appears in the balance
sheet as a contra account that reduces the amount of fixed assets).
Over time, the accumulated depreciation balance will continue to
increase as more depreciation is added to it, until such time as it
equals the original cost of the asset. At that time, you stop re-
cording any depreciation expense, since the cost of the asset has
now been reduced to zero.
The journal entry for depreciation can be a simple two-line en-
try designed to accommodate all types of fixed assets, or it may be
subdivided into separate entries for each type of fixed asset, as
noted in the following example.
EXAMPLE
Pensive Corporation calculates that it should have $25,000 of depreciation ex-

pense in the current month. The entry is:
Debit Credit
Depreciation expense 25,000
In the following month, Pensive’s controller decides to show a higher level of

precision at the expense account level, and instead elects to apportion the
$25,000 of depreciation among different expense accounts, so that each class of
asset has a separate depreciation charge. The entry is:
108
Debit Credit
Depreciation expense – Automobiles 4,000
Depreciation expense – Computer equipment 8,000
Depreciation expense – Furniture and fixtures 6,000
Depreciation expense – Office equipment 5,000
Depreciation expense – Software 2,000
The journal entry to record the amortization of intangible assets is

fundamentally the same as the entry for depreciation, except that
the accounts used substitute the word “amortization” for deprecia-
tion.
EXAMPLE
Pensive Corporation calculates that it should have $4,000 of amortization ex-

pense in the current month that is related to intangible assets. The entry is:
Debit Credit
Amortization expense 4,000
Accumulated amortization 4,000
Accumulated Depreciation
When you sell or otherwise dispose of an asset, you should remove

all related accumulated depreciation from the accounting records at
the same time. Otherwise, an unusually large amount of accumu-
lated depreciation will build up on the balance sheet.
EXAMPLE
Pensive Corporate has $1,000,000 of fixed assets, for which it has charged
$380,000 of accumulated depreciation. This results in the following presentation
on Pensive’s balance sheet:
Fixed assets $1,000,000

Less: Accumulated depreciation (380,000)
Net fixed assets $620,000
109
Pensive then sells a machine for $80,000 that had an original cost of $140,000,
and for which it had already recorded accumulated depreciation of $50,000. It
records the sale with this journal entry:
Debit Credit
Cash 80,000
Loss on asset sale 10,000
Fixed assets 140,000
As a result of this entry, Pensive’s balance sheet presentation of fixed assets has
changed, so that fixed assets before accumulated depreciation have declined to
$860,000, and accumulated depreciation has declined to $330,000. The new
presentation is:
Fixed assets $860,000

Less: Accumulated depreciation (330,000)
Net fixed assets $530,000
The amount of net fixed assets declined by $90,000 as a result of the asset sale,
which is the sum of the $80,000 cash proceeds and the $10,000 loss resulting
from the asset sale.
Depreciation Under IFRS

Depreciation under International Financial Reporting Standards is
addressed in IAS 16, Property, Plant, and Equipment. The IFRS
features of the IFRS rules related to depreciation are:
• Separately depreciate any part of a fixed asset whose cost is
significant in relation to the cost of the entire asset.
• Charge depreciation to expense in the period incurred,
unless you are rolling it into another asset (as occurs when
you add the depreciation on manufacturing equipment into
an overhead pool, from which it is allocated to inventory).
• Depreciate a fixed asset on a systematic basis over its use-
ful life (i.e., do not vary the depreciation charge for an un-
justifiable reason).
110
• Review the salvage value and useful life of each asset at

least once a year, and make adjustments to the depreciation
calculations accordingly on a go-forward basis.
• Select a depreciation method that matches the timing of the
future economic benefits of the asset (which argues in favor
of usage-based depreciation methods, such as the units of
production method, rather than such time-based deprecia-
tion methods as the straight-line method).
• Review the depreciation method at least once a year, and
change the method if usage of the benefits provided by the
asset has changed significantly.
Other Depreciation Topics

Depreciation has a notable impact on a company’s cash flow pro-
jections, since it is one of the few expenses that does not involve a
cash outflow. Also, the accountant is sometimes asked if deprecia-
tion is designed to match a reduction in an asset’s market value.
Both topics are addressed below.
Impact on Cash Flow Analysis

Depreciation is a major issue in the calculation of a company's
cash flows, because it is included in the calculation of net income,
but does not involve any ongoing cash outflow. This is because a
company only has a net cash outflow in the entire amount of the
asset when the asset was originally purchased. Thus, a cash flow
analysis should call for the inclusion of net income, with an add-
back for any depreciation recognized as expense during the period.
The one exception is a capital lease, where you record it as an
asset when acquired, but you pay for it over time, under the terms
of the associated lease agreement. In this case, you would still add
back the amount of depreciation in the cash flow analysis, but
would include the amount of any ongoing lease payments. It is
possible that the amounts of depreciation and lease payments will
roughly offset each other in the analysis.
111
Depreciation and Market Value

Depreciation is not intended to reduce the cost of a fixed asset to
its market value. Market value may be substantially different from
net book value, and may even increase over time. Instead, depre-
ciation is merely intended to gradually charge the cost of a fixed
asset to expense over its useful life.
Summary
Depreciation is one of the central concerns of the accountant, since
the broad range of available methods can result in significant dif-
ferences in the amount of depreciation expense recorded in each
period. Generally, you should adopt the straight-line depreciation
method to minimize the amount of depreciation calculations,
unless the usage rate of the assets involved more closely match a
different depreciation method. Companies concerned with reduc-
ing their tax liabilities will be more likely to use the MACRS de-
preciation rates when calculating their taxable income.
Tip:
Use the straight-line depreciation method whenever possible, be-
cause it is easier for outside auditors to verify these calculations.
This may lead to a small reduction in your audit fees.
112
Review Questions
1. Depreciation is defined as:

a. The systematic reduction of the cost of an intangible as-
set
b. The systematic reduction of the cost of natural re-
sources
c. The systematic reduction of the cost of a fixed asset
d. The charge to expense of any expenditure falling be-
neath the capitalization limit
2. Asset classes are useful for assigning a standard ___ and ___ to
individual fixed assets.
a. Useful life and depreciation method
b. Useful life and salvage value
c. Depreciation method and salvage value
d. Useful life and discounted salvage value
3. Accumulated depreciation does not include the following cal-

culation method:
a. The double declining balance method
b. The sum-of-the-years digits method
c. The 150% declining balance method
d. The straight-line method
4. The depletion base does not include:

a. Development costs
b. Administrative overhead costs
c. Restoration costs
d. Exploration costs
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Review Answers
1. Depreciation is defined as:

a. Incorrect. The systematic reduction of the cost of an in-
tangible asset is amortization.
b. Incorrect. The systematic reduction of the cost of a
natural resource is depletion.
c. Correct. The systematic reduction of the cost of a fixed
asset is depreciation.
d. Incorrect. An expenditure is charged to expense if it
falls below the capitalization limit.
2. Asset classes are useful for assigning a standard ___ and ___ to
individual fixed assets.
a. Correct. Both the useful life and depreciation method
can be standardized across all fixed assets assigned to
an asset class.
b. Incorrect. You cannot standardize the application of
salvage value to fixed assets.
c. Incorrect. You cannot standardize the application of
salvage value to fixed assets.
d. Incorrect. You cannot standardize the application of
discounted salvage value to fixed assets.
3. Accumulated depreciation does not include the following cal-

culation method:
a. Incorrect. The double declining balance method is a
valid accelerated depreciation method.
b. Incorrect. The sum-of-the-years digits method is a valid
accelerated depreciation method.
c. Incorrect. The 150% declining balance method is a
valid accelerated depreciation method.
d. Correct. The straight-line method is not an accelerated
depreciation method.
114
4. The depletion base does not include:

a. Incorrect. Development costs are a valid part of the de-
pletion base.
b. Correct. Administrative overhead costs are not part of
the depletion base.
c. Incorrect. Restoration costs are a valid part of the deple-
tion base.
d. Incorrect. Exploration costs are a valid part of the de-
pletion base.
115
Chapter 7
Subsequent Fixed Asset Measurement
Introduction
In the Initial Fixed Asset Recognition chapter, we addressed which
costs to capitalize into a fixed asset during its initial construction
or purchase. But what about events later in its life? There are a
number of subsequent events, including additional expenditures,
depreciation, impairment testing, revaluation, and derecognition.
Depreciation is addressed in detail in the Depreciation and Amorti-
zation chapter, while asset impairment is covered in the Asset Im-
pairment chapter and derecognition is addressed in the Asset Dis-
posal chapter. However, this still leaves the topics of subsequent
expenditure capitalization, as well as the revaluation of fixed as-
sets. These two topics are discussed in the following sections.
Generally Accepted Accounting Principles (GAAP) are largely
silent about how to account for the subsequent measurement of
fixed assets, other than their impairment or eventual derecognition.
Fortunately, there is considerably more guidance in the Interna-
tional Financial Reporting Standards (IFRS), which form the basis
for nearly all of the discussion in this chapter.
The Capitalization of Additional Expenditures

Most of the expenditures that a company incurs in relation to a
fixed asset on a day-to-day basis should be charged to expense as
incurred, because they only relate to the servicing of the asset.
Such costs usually involve supplies and labor, and are typically
recorded in a repairs and maintenance expense account.
Portions of a fixed asset may require replacement from time to
time. Examples of such items are motors that burn out or pipes that
corrode. If the cost of these replacements is less than the corporate
capitalization limit, then you should charge them to expense as in-
curred. However, if they exceed the capitalization limit, you should
capitalize and depreciate them over their useful lives (which may
vary from the useful life of the machine of which they are a part),
subject to the following two rules:
• There are probable future economic benefits associated
with the expenditure that will flow to the entity; and
• You can reliably measure the cost of the item.
What is the Capitalization Limit?

The capitalization limit is the amount paid for an asset, above
which an entity records it as a long-term asset. If an entity pays
less than the capitalization limit for an asset, it charges the asset to
expense in the period incurred.
When you capitalize the cost of a major replacement to a fixed as-

set, you must also derecognize the component being replaced. Oth-
erwise, you would continue to depreciate a component that has al-
ready been removed from the asset and is no longer in use. If you
cannot separately identify the cost of the component being re-
placed, then you should estimate its cost and remove both the esti-
mated cost and any related depreciation from the fixed asset of
which it is a part.
EXAMPLE
Nautilus Tours owns several submarines, which it uses for shallow-water tourist
visits to local reefs. The electric motors used in these submarines have a rated
life of five years (versus 15 years for the pressure hulls). One of the motors fails
and must be replaced, at a cost of $300,000. The submarine in which the motor
is housed was originally purchased in used condition for $6 million, and was
recorded as a single asset.
Nautilus must record the cost of the engine replacement as a fixed asset, at a cost
of $300,000. However, it must also derecognize that portion of the original cost
of the submarine that would have related to the engine, as well as any related
depreciation. Nautilus estimates that the original motor had a cost similar to that
of the replacement unit, but that only one-third of its depreciation has been rec-
ognized (calculated as five years of depreciation completed, out of the 15 years
estimated useful life of the submarine). Consequently, Nautilus must derecog-
nize the estimated cost of the original motor with this entry:
117
Debit Credit
Depreciation 100,000
Loss on derecognition of motor 200,000
Submarine (motor compo- 300,000
nent)
Nautilus then records a separate asset for the motor with the following entry:
Debit Credit
Motor 300,000
Cash 300,000
It may be necessary to perform a periodic major inspection of a

fixed asset, as a condition of continuing to operate it. For example,
a train may require periodic inspections to mitigate the risk of a
catastrophic accident. When a company performs such an inspec-
tion, you should capitalize the cost of the inspection into the cost
of the asset, and depreciate it until the next inspection is required.
When you capitalize such a cost, you must also derecognize the
cost of any inspection performed in a prior period; if no such in-
spection was performed, you must still derecognize an amount
equivalent to what such an inspection would have cost.
EXAMPLE
The submarines owned by Nautilus Tours must undergo a major inspection after
every 1,000 hours of operation, or else they will no longer be certified for opera-
tion by the insurer. One submarine has reached its 1,000-hour limit, and under-
goes a major inspection at a cost of $50,000. Nautilus purchased the submarine
in used condition three years before, and has not previously recognized the sepa-
rate cost of an inspection. It has been depreciating the submarine over 15 years.
Nautilus must record the cost of the major inspection as a fixed asset, at a cost of
$50,000. It must also derecognize that portion of the original cost of the subma-
rine that would have related to the immediately preceding inspection (which it
estimates to be in the same amount). Since only 20 percent of the depreciation
period of the submarine has been recognized (calculated as three years of depre-
ciation completed out of the 15 years estimated useful life of the submarine), the
company must now recognize a loss on the remaining amount of depreciation at
118
the time of derecognition. Consequently, Nautilus creates the following derec-

ognition journal entry for the presumed existing inspection asset:
Debit Credit
Depreciation 10,000
Loss on derecognition of inspection 40,000
Major inspection (inspection date) 50,000
Nautilus then records a separate asset for the new inspection with the following
entry:
Debit Credit
Major inspection (inspection date) 50,000
Cash 50,000
Tip:
The preceding examples show that component replacements and
major inspections are usually depreciated over shorter periods than
those used for the asset of which they are a part, resulting in the
accelerated recognition of depreciation (in the form of a loss) when
they are replaced. To prevent these sudden spikes in expense, con-
sider separately recording these items upon the initial acquisition
of an asset; this may include the use of shorter useful lives for
them in your depreciation calculations.
The accounting guidelines noted thus far are taken from IFRS.
There is little information to reference in GAAP on this topic,
though the general leaning of the available information is for the
cost of major fixed asset overhauls and inspections to be charged
to expense in the period incurred, rather than be capitalized.
One cost that can be capitalized under GAAP is the cost in-
curred to reinstall or rearrangement production equipment, if you
expect that these changes will create future benefits from either
enhanced production efficiencies or reduced production costs.
However, if there is no indication that the changes will extend an
asset’s useful life, enhance production efficiencies, or increase its
119
productive capacity, then you should charge these costs to expense

as incurred.
Asset Revaluation for Tangible Assets

A company that is using the IFRS framework can elect to measure
its fixed assets under either the cost model or the revaluation
model. Under the cost model, you carry the cost of a fixed asset at
its cost, less any accumulated depreciation (see the Depreciation
and Amortization chapter) and accumulated impairment losses (see
the Fixed Asset Impairment chapter). Under the revaluation model,
you carry a fixed asset at its fair value, less any subsequent accu-
mulated depreciation and accumulated impairment losses. You
cannot selectively apply these models to individual fixed assets.
Instead, you must apply them to entire asset classes (though you
can use a different model for a different asset class).
What is an Asset Class?

An asset class is assets of a similar nature and use that are grouped
together. Examples of asset classes are land, buildings, machinery,
furniture and fixtures, and office equipment.
The revaluation method is unique to IFRS. You can only use it if it

is possible to reliably measure the fair value of an asset. You must
also make revaluations with sufficient regularity to ensure that the
amount at which you carry an asset in the company’s records does
not vary materially from its fair value. Further, if you revalue any
fixed asset item, you must also revalue all other assets in the same
fixed asset class; this rule keeps a company from selectively re-
valuing its fixed assets.
Tip:
Though you are required to revalue all of the assets in an asset
class at the same time, you can stretch the rule and revalue them on
a rolling basis, as long as you complete the revaluation within a
short period of time and then keep the analysis up to date.
120
You should use a market-based appraisal by a qualified valuation

specialist to determine the fair value of a fixed asset. If a fixed as-
set is of such a specialized nature that you cannot obtain a market-
based fair value, then you may need to use an alternative method to
arrive an estimated fair value. Examples of such methods are using
discounted future cash flows or an estimate of the replacement cost
of an asset.
Tip:
Hiring an appraiser to conduct ongoing revaluations can be expen-
sive, so unless fair values are volatile, limit your appraisals to
somewhere in the range of every three to five years. For volatile
fair values, consider using an appraisal once a year, and only if you
estimate that the resulting change in fair value will be significant.
If you revalue fixed assets, you also need to adjust any accumu-
lated depreciation as of the revaluation date. Your options are:
• Force the carrying amount of the asset to equal its newly-
revalued amount by proportionally restating the amount of
the accumulated depreciation; or
• Eliminate the accumulated depreciation against the gross
carrying amount of the newly-revalued asset. This method
is the simpler of the two alternatives, and is included in the
example at the end of this section.
What is Accumulated Depreciation?

Accumulated depreciation is the sum total of all depreciation ex-
pense recognized to date on a depreciable fixed asset.
If you elect to use the revaluation model and a revaluation results

in an increase in the carrying amount of a fixed asset, then you
should recognize the increase in other comprehensive income, as
well as accumulate it in equity in an account entitled “revaluation
surplus.” However, if the increase reverses a revaluation decrease
for the same asset that had been previous recognized in profit or
121
loss, then you should recognize the revaluation gain in profit or

loss to the extent of the previous loss (thereby erasing the loss).
What is Other Comprehensive Income?

In the IFRS framework, other comprehensive income is a separate
section of the income statement that follows the profit or loss sec-
tion (see next definition). It contains various items of revenue, ex-
pense, gains, and losses that do not appear within profit or loss.
What is Profit or Loss?

In the IFRS framework, profit or loss is that portion of the income
statement prior to other comprehensive income. It contains the re-
sults of operations, plus finance and tax expenses, and the effect of
discontinued operations.
If a revaluation causes a decrease in the carrying amount of a fixed

asset, you should recognize the decrease in profit or loss. However,
if there is a credit balance in the revaluation surplus for that asset,
you should recognize the decrease in other comprehensive income
to offset the credit balance. The decrease that you recognize in
other comprehensive income decreases the amount of any revalua-
tion surplus that you may have already recorded in equity.
The following table summarizes the proper recognition of re-
valuation changes just described:
Asset Revaluation Change Recognition

Value increases Recognize in other comprehensive in-
come and in the “revaluation sur-
plus” equity account
Value increases, and reverses a prior Recognize gain in profit or loss to the
revaluation decrease extent of the previous loss, with the
remainder in other comprehensive
income
Value decreases Recognize in profit or loss
Value decreases, but there is a credit Recognize in other comprehensive in-
in the revaluation surplus come to the extent of the credit, with
the remainder in profit or loss
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In essence, IFRS is forcing you to prominently display any re-

valuation losses, and gives less reporting stature to any revaluation
gains.
If you derecognize a fixed asset, you should transfer any asso-
ciated revaluation surplus to retained earnings. The amount of this
transferred surplus is the difference between the depreciation based
on the original cost of the asset and the depreciation based on the
revalued carrying amount of the asset.
EXAMPLE
Nautilus Tours elects to revalue one of its tourism submarines, which originally
cost $12 million and has since accumulated $3 million of depreciation. It is
unlikely that the fair value of the submarine will vary substantially over time, so
Nautilus adopts a policy to conduct revaluations for all of its submarines once
every three years. An appraiser assigns a value of $9.2 million to the submarine.
Nautilus creates the following entry to eliminate all accumulated depreciation
associated with the submarine:
Debit Credit
Accumulated depreciation 3,000,000
Submarines 3,000,000
At this point, the net cost of the submarine in Nautilus’ accounting records is $9
million. Nautilus also creates the following entry to increase the carrying
amount of the submarine to its fair value of $9.2 million:
Debit Credit
Submarines 200,000
Other comprehensive income – gain 200,000
on revaluation
Three years later, on the next scheduled revaluation date, the appraiser reviews
the fair value of the submarine, and determines that its fair value has declined by
$350,000. Nautilus uses the following journal entry to record the change:
Debit Credit
Other comprehensive income – gain on 200,000
revaluation
Loss on revaluation 150,000
Submarines 350,000
123
This final entry eliminates all of the revaluation gain that had been recorded in
other comprehensive income, and also recognizes a loss on the residual portion
of the revaluation loss.
You cannot use the revaluation model under GAAP. Instead, you
can only use the cost model.
Asset Revaluation for Intangible Assets

Under IFRS, you are allowed to adopt either the cost model or the
revaluation model for intangible assets, as was just described for
tangible assets. Here are several variations from the accounting for
tangible assets that you must apply to intangible assets:
• You can apply the revaluation model to an intangible asset
that was received through a government grant. Since the
grant may mean that it was initially recognized at a minor
amount, the revaluation could result in the recognition of a
substantial gain.
• You can only determine the fair value of an intangible asset
by reference to an active market. Since active markets are
relatively rare for intangible assets (other than for transfer-
able licenses), this limits the extent to which you can re-
value intangible assets.
• If there is no active market for a specific intangible asset
within a class of intangible assets that have all been reval-
ued, you should carry that asset at its cost, less any accu-
mulated depreciation and accumulated impairment.
• If there is no longer an active market for an intangible as-
set, then you should retain the carrying amount of the asset
at its last revalued amount, less any subsequent accumu-
lated depreciation and accumulated impairment losses. If an
active market reappears at a later date, you can then reacti-
vate the revaluation model.
The key issue with revaluing intangible assets is that you can only
do so if there is an active market. This is quite rare for intangible
124
assets, so the cost model is effectively the only choice in most

situations.
As was the case for tangible assets, you cannot use the revalua-
tion model under GAAP for intangible assets. Instead, you can
only use the cost model.
Summary
This chapter has highlighted two of the most important differences
between the GAAP and IFRS frameworks in regard to fixed asset
accounting. IFRS not only allows the capitalization of subsequent
expenditures, but is moderately insistent in forcing you to do so.
Conversely, GAAP is generally content to require these expendi-
tures to be charged to expense. Further, IFRS allows for the subse-
quent revaluation of fixed assets, which is not allowed at all under
GAAP. As the world gradually transitions toward IFRS, these two
areas will represent key changes that the users of the GAAP
framework must keep in mind.
125
Review Questions
1. You should capitalize an additional expenditure when:

a. You can measure its cost
b. There are future economic benefits
c. There are future economic benefits and you can meas-
ure its cost
d. It exceeds the capitalization limit and you can measure
its cost
2. If you incur the cost of a major periodic inspection as a condi-

tion of continuing to operate an asset, you should:
a. Capitalize the cost and depreciate it over the period un-
til the next inspection
b. Capitalize the cost and depreciate it over the remaining
life of the asset
c. Charge the entire amount to depreciation expense at
once
d. Charge the entire amount to maintenance expense as in-
curred
3. Under the IFRS revaluation model, if there is a valuation in-

crease that reverses a prior decrease, you should:
a. Recognize the gain in other comprehensive income
b. Recognize the gain in profit or loss
c. Not recognize the gain
d. Recognize a gain in profit or loss to the extent of the
previous loss, with the remainder in other comprehen-
sive income
4. Under the IFRS revaluation model, you can only determine the
fair value of an intangible asset by reference to:
a. Similar transactions that occurred recently
b. An appraised value
c. Its cost
d. An active market
126
Review Answers
1. You should capitalize an additional capital expenditure when:

a. Incorrect. The measurement of cost is not sufficient.
There must also be future economic benefits.
b. Incorrect. A future economic benefit is not sufficient.
There must also be a measurable cost.
c. Correct. There are future economic benefits and you
can measure its cost.
d. Incorrect. The measurement of a cost over the capitali-
zation limit is not sufficient. There must also be future
economic benefits.
2. If you incur the cost of a major periodic inspection as a condi-

tion of continuing to operate an asset, you should:
a. Correct. You should capitalize the cost and depreciate
it over the period until the next inspection.
b. Incorrect. Depreciating the inspection cost over the re-
maining life of the asset would only be applicable if
there are no additional inspections expected over the
remaining life of the asset.
c. Incorrect. Do not charge the entire cost of the inspec-
tion to depreciation expense; depreciation is intended
for costs that are spread over multiple periods, not one
period.
d. Incorrect. If the inspection were charged to expense as
incurred, this would be a correct treatment, but not for a
capitalized item.
3. Under the IFRS revaluation model, if there is a valuation in-

crease that reverses a prior decrease, you should:
a. Incorrect. You would only recognize the gain in other
comprehensive income after reversing any previous re-
valuation loss in profit or loss.
b. Incorrect. Revaluation gains are recognized in other
comprehensive income.
127
c. Incorrect. You should recognize a revaluation gain.

d. Correct. You should recognize a gain in profit or loss
to the extent of the previous loss, with the remainder in
other comprehensive income.
4. Under the IFRS revaluation model, you can only determine the
fair value of an intangible asset by reference to:
a. Incorrect. Similar transactions that occurred recently
are not a valid basis for determining the fair value of an
intangible asset.
b. Incorrect. Appraised value is not a valid basis for de-
termining the fair value of an intangible asset.
c. Incorrect. The cost of an intangible asset is used in the
IFRS cost model, not the revaluation model.
d. Correct. An active market.
128
Chapter 8
Fixed Asset Impairment
Introduction
There are rules under both GAAP and IFRS for periodically testing
your fixed assets to see if they are still as valuable as the costs at
which you have recorded them in your accounting records. If not,
you must reduce the recorded cost of these assets by recognizing a
loss. Also, under some circumstances, you are allowed to recover
the amount of these losses, depending upon whether you are using
GAAP or IFRS rules. Unfortunately, there are differences between
the rules imposed by GAAP and IFRS, which can yield different
reporting results. There are two large sections in this chapter that
are devoted to the impairment rules under GAAP and IFRS, with
numerous subheadings within each section.
Asset Impairment Under GAAP

Asset impairment under GAAP is addressed in ASC 360, Property,
Plant, and Equipment. The GAAP rules are somewhat different
from those required under IFRS. This section describes the key
features of the GAAP rules related to asset impairment. There are a
number of sub-headings listed, since this is a significant topic that
covers several areas related to impairment. The most important dif-
ferences between the GAAP and IFRS treatments of asset impair-
ment are noted in the summary at the end of the chapter.
GAAP: Measurement of Asset Impairment

You should recognize an impairment loss on a fixed asset if its car-
rying amount is not recoverable and exceeds its fair value. You
should recognize this loss within income from continuing opera-
tions on the income statement.
The carrying amount of an asset is not recoverable if it exceeds
the sum of the undiscounted cash flows you expect to result from
the use of the asset over its remaining useful life and the final dis-
position of the asset. These cash flow estimates should incorporate
assumptions that are reasonable in relation to the assumptions the

entity uses for its budgets, forecasts, and so forth. If there are a
range of possible cash flow outcomes, then consider using a prob-
ability-weighted cash flow analysis.
Tip:
You are supposed to base the impairment analysis on the cash
flows to be expected over the remaining useful life of the asset. If
you are measuring impairment for a group of assets (as discussed
below), then the remaining useful life is based on the useful life of
the primary asset in the group. You cannot skew the results by in-
cluding in the group an asset with a theoretically unlimited life,
such as land or an intangible asset that is not being amortized.
The amount of an impairment loss is the difference between an

asset’s carrying amount and its fair value. Once you recognize an
impairment loss, this reduces the carrying amount of the asset, so
you may need to alter the amount of periodic depreciation being
charged against the asset to adjust for this lower carrying amount
(otherwise, you will incur an excessively large depreciation ex-
pense over the remaining useful life of the asset).
GAAP: The Impact of Asset Retirement Obligations

When making the asset impairment determination, you should in-
clude in the carrying amount of the fixed asset any capitalized as-
set retirement obligations (AROs). However, you should exclude
the future cash flows associated with an ARO from the undis-
counted cash flows used to test an asset for recoverability, as well
as from the discounted cash flows used to measure its fair value.
For more information about asset retirement obligations, see
the Asset Retirement Obligations chapter.
GAAP: Measurement of Disposal Losses on Assets Held for Sale

If you have designated an asset as held for sale, then you should
periodically test it for a possible loss on the expected disposal of
the asset. You should recognize a loss in the amount by which the
130
fair value less costs to sell of the asset is lower than its carrying
amount.
What is Held for Sale?

Held for sale is a designation given to assets that an entity intends
to sell to a third party within one year. You do not depreciate a
fixed asset that is designated as held for sale. See the Asset Dis-
posal chapter for more information.
You should recognize a disposal loss within income from continu-

ing operations on the income statement.
GAAP: The Asset to be Tested

You should test assets for impairment at the lowest level at which
there are identifiable cash flows that are largely independent of the
cash flows of other assets. In cases where there are no identifiable
cash flows at all (as is common with corporate-level assets), place
these assets in an asset group that encompasses the entire entity,
and test for impairment at the entity level.
You should only add goodwill to an asset group for impairment
testing when the asset group is a reporting unit, or includes a re-
porting unit. Thus, you should not include goodwill in any asset
groups below the reporting unit level.
What is a Reporting Unit?

A reporting unit is an operating segment or one level below an op-
erating segment. An operating segment is a component of a public
entity that engages in business activities and whose results are re-
viewed by the chief operating decision maker, and for which dis-
crete financial information is available.
GAAP: Timing of the Impairment Test

You should test for the recoverability of an asset whenever the cir-
cumstances indicate that its carrying amount may not be recover-
able. Examples of such situations are:
131
• Cash flow. There are historical and projected operating or

cash flow losses associated with the asset.
• Costs. There are excessive costs incurred to acquire or con-
struct the asset.
• Disposal. The asset is more than 50% likely to be sold or
otherwise disposed of significantly before the end of its
previously estimated useful life.
• Legal. There is a significant adverse change in legal factors
or the business climate that could affect the asset’s value.
• Market price. There is a significant decrease in the asset’s
market price.
• Usage. There is a significant adverse change in the asset’s
manner of use, or in its physical condition.
GAAP: Accounting for the Impairment of an Asset Group

If there is an impairment at the level of an asset group, then you
should allocate the impairment among the assets in the group on a
pro rata basis, based on the carrying amounts of the assets in the
group. However, the impairment loss cannot reduce the carrying
amount of an asset below its fair value.
Tip:
The accounting standard goes on to state that you only have to de-
termine the fair value of an asset for this test if it is “determinable
without undue cost and effort.” Thus, if an outside appraisal would
be required to determine fair value, you can likely dispense with
this requirement and simply allocate the impairment loss to all of
the assets in the group.
EXAMPLE
Luminescence Corporation operates a small floodlight manufacturing facility.

Luminescence considers the entire facility to be a reporting unit, so it conducts
an impairment test on the entire operation. The test reveals that a continuing
decline in the market for floodlights (caused by the surge in LED lights in the
market) has caused a $2 million impairment charge. Luminescence allocates the
charge to the four assets in the facility as follows:
132
Proportion Revised
Carrying of Carrying Impairment Carrying
Asset Amount Amounts Allocation Amount
Ribbon machine $8,000,000 67% $1,340,000 $6,660,000
Conveyors 1,500,000 13% 260,000 1,240,000
Gas injector 2,000,000 16% 320,000 1,680,000
Filament inserter 500,000 4% 80,000 420,000
Totals $12,000,000 100% $2,000,000 $10,000,000
GAAP: Reversing an Impairment Loss

Under no circumstances are you allowed to reverse an impairment
loss under GAAP.
Tip:
Unlike IFRS, GAAP does not allow the reversal of a fixed asset
impairment loss. Consequently, it may be useful to obtain a second
opinion (e.g., your outside auditors) before recognizing such an
impairment in the first place.
GAAP: Reversing a Disposal Loss

It is allowable under GAAP to recognize a gain on any increase in
the fair value less costs to sell of a fixed asset that is designated as
held for sale. The amount of this gain is capped at the amount of
any cumulative disposal loss that you have already recognized for
the asset. This gain will increase the carrying amount of the asset.
EXAMPLE
Luminescence Corporation has designated one of its fluorescent bulb factories

as held for sale. The asset group comprising the factory has a carrying amount of
$18 million. After six months, Luminescence determines that the fair value less
costs to sell for the factory is $16 million, due to falling prices for similar facto-
ries, so it recognizes a disposal loss of $2 million. A few months later, the mar-
ket for such factories rebounds, and the company finds that the factory now has
a fair value less costs to sell of $19 million, which is an increase of $3 million.
Luminescence can only recognize a $2 million gain, which reverses the prior
disposal loss.
133
Asset Impairment Under IFRS

Asset impairment under IFRS is addressed in IAS 36, Asset Im-
pairment. The IFRS rules are somewhat different from those re-
quired by GAAP, and are much more lengthy. This section de-
scribes the key features of the IFRS rules related to asset impair-
ment. There are a number of sub-headings listed, since the IAS is a
comprehensive document that covers a large number of areas re-
lated to impairment. The most important differences between the
IFRS and GAAP treatment of asset impairment are noted in the
summary at the end of the chapter.
IFRS: The Impairment Test

An asset is impaired when its carrying amount is greater than its
recoverable amount.
What is a Recoverable Amount?

The recoverable amount of an asset or cash-generating unit is the
higher of its fair value less any costs to sell, and its value in use.
Value in use is the present value of any future cash flows you ex-
pect to derive from an asset or cash-generating unit.
In some cases, there is no way to determine the fair value of an as-

set less costs to sell, since there is no active market for the asset. If
so, just use the value in use as the recoverable amount of an asset.
Tip:
If either an asset’s fair value less costs to sell or its value in use is
higher than its carrying amount, then there is no impairment. Thus,
you do not need to calculate both figures as part of an impairment
test.
When a fixed asset approaches the end of its useful life, it may be
sufficient to use the fair value less costs to sell as the foundation
for an impairment test, and ignore its value in use. The reason is
that the value of an asset at this point in its life is mostly comprised
134
of any proceeds from its disposal, rather than from future cash
flows (which are likely to be minor).
Tip:
The instructions in IAS 36 imply that a considerable amount of
investigation of fair values and discount rate calculations for cash
flows are needed to conduct an impairment test. However, the
standard also states that “estimates, averages, and computational
short cuts may provide reasonable approximations” of these re-
quirements. Consequently, use short cuts whenever you have a rea-
sonable basis for doing so.
IFRS: The Asset to be Tested

You should conduct an impairment test for an individual asset,
unless the asset does not generate cash inflows that are mostly in-
dependent of those from other assets. If an asset does not generate
such cash inflows, then you must instead conduct the test at the
level of the cash-generating unit of which the asset is a part. All
subsequent testing of and accounting for an impairment at the level
of a cash-generating unit is identical to its treatment as if it had
been an individual asset.
What is a Cash-Generating Unit?

A cash-generating unit is the smallest identifiable group of assets
that generates cash inflows independently from the cash inflows of
other assets. Examples of cash-generating units are product lines,
businesses, individual store locations, and operating regions. It is
allowable for a cash-generating unit to have all of its cash inflows
derive from internal transfer pricing, as long as the unit could sell
its output on an active market. Once a group of assets are clustered
into a cash-generating unit, you should continue to define the same
assets as being part of the unit for future impairment testing (unless
there is a justifiable reason for a change).
135
An impairment test should remain at the level of the individual as-

set, rather than for a cash-generating unit, in either of the following
cases:
• The fair value less costs to sell of the asset is higher than its
carrying amount.
• The value in use (i.e., discounted cash flows) of the asset is
estimated to be close to its fair value less costs to sell.
EXAMPLE
Rio Shipping owns a rail line that extends from its private shipping terminal on
Baffin Island to a warehousing area two miles inland, where it stores ore shipped
to it from several mines further inland. The rail line exists only to support deliv-
eries of ore, and it has no way of creating cash flows independent of Rio’s other
operations on Baffin Island. Since it is impossible to determine the recoverable
amount of the rail line, Rio aggregates it into a cash-generating unit, which is its
entire shipping operation on Baffin Island.
EXAMPLE
Rio Shipping enters into a contract with the Port of New York to provide point-
to-point ferry service on several routes across the Hudson River. The Port re-
quires service for 18 hours a day on four routes. One of the four routes has
minimal passenger traffic, and so is operating at a significant loss. Rio can iden-
tify the ferry asset associated with this specific ferry route.
Rio cannot test for impairment at the individual asset level for the ferry operat-
ing the loss-generating route, because it does not have the ability to eliminate
that route under its contract with the Port. Instead, it must test for impairment at
the cash-generating unit level, which is all of the ferry routes together.
IFRS: Goodwill and Impairment Testing

If a company has acquired assets as part of a business combination,
then you should allocate the goodwill associated with that combi-
nation to any cash-generating units, but only if those units are ex-
pected to benefit from the synergies of the combination.
136
Tip:
You can safely ignore this rule in many cases, because the standard
also states that the goodwill allocation only extends down to the
point at which management monitors goodwill for its own internal
purposes. In most cases, goodwill monitoring only extends down
to the business unit level; thus, as long as a cash-generating unit is
smaller than a business unit, the requirements of this standard do
not apply.
If you do allocate goodwill to a cash-generating unit and the com-

pany then sells that unit, you should include the allocated goodwill
in the carrying amount of the unit; this will impact the amount of
any gain or loss that you recognize on disposal of the unit.
If a company sells assets from a cash-generating unit to which
goodwill has been allocated, then you should assign a portion of
the goodwill to the assets being sold, based on the relative values
of the assets being sold and that portion of the unit being retained.
EXAMPLE
Rio Shipping had previously acquired a container ship unloading dock in the
Port of Los Angeles for $50 million, of which $10 million was accounted for as
goodwill. Rio accounts for the overhead cranes in the dock as a cash-generating
unit, to which it allocates $6 million of the goodwill associated with the acquisi-
tion.
Two years later, Rio sells one of the cranes for $5 million. Management esti-
mates that the value of the remainder of the cash-generating unit is $15 million.
Based on this information, Rio’s accounting staff allocates $1.5 million of the
goodwill to the crane, based on the following calculation:
$6 million goodwill x ($5 million crane value / ($5 million crane value
+ $15 million cash-generating unit value))
= $6 million goodwill x 25% of the combined value of the crane asset and cash-
generating unit
= $1.5 million goodwill allocation
137
IFRS: Corporate Assets and Impairment Testing

Assets that are recognized at the corporate level are ones that do
not generate cash inflows independently of other assets, and you
cannot fully attribute their carrying amounts to other cash-
generating units. An example of a corporate asset is a research fa-
cility. It is not usually possible to allocate the cost of these assets to
any cash-generating units, unless there is a direct relationship be-
tween them.
IFRS: Timing of the Impairment Test

IFRS states that you should assess whether there is any indication
of impairment at the end of each reporting period, so this is an ex-
tremely frequent test.
Even if there is no indication of impairment, you should test an
intangible asset for impairment if the asset has an indefinite useful
life or if it is not yet available for use (e.g., intangible assets that
are not yet being amortized). You must perform this test at least
once a year, and should do so at the same time each year. If you
have multiple intangible assets, then you can test each one at a dif-
ferent time of the year. If you initially recognized an intangible as-
set during the current fiscal year, then you should test it for im-
pairment by the end of the current fiscal year.
The reason why the standard requires this annual analysis of in-
tangible assets that are not yet available for sale is that there is
more uncertainty surrounding the ability of these assets to generate
sufficient future economic benefits. Given the higher level of un-
certainty, there is more ongoing risk that they will be impaired.
IFRS: Indications of Impairment

The following are indicators of impairment that you should con-
sider:
• Adverse effects. There have been, or are about to be, sig-
nificant changes that adversely affect the operating envi-
ronment of the business.
• Damage or obsolescence. There is evidence of damage to
the asset, or of obsolescence.
138
• Discount rate change. Interest rates have increased, and

this will materially impact the value in use of an asset,
based on a reduction in the discounted present value of its
cash flows. This is only the case if changes in market inter-
est rates will actually alter the discount rate used to calcu-
late the value in use.
What is Value in Use?

Value in use is the present value of any future cash flows you ex-
pect to derive from an asset or cash-generating unit
EXAMPLE
Rio Shipping acquired a freighter three years ago for $20 million, and routinely
conducts an impairment analysis that is based on the discounted cash flows to be
expected from the ship over the next ten years. The discount rate that Rio uses
for the analysis is 6%, which is based on the current long-term interest rates that
a similar company could obtain in the market place.
Short-term interest rates have recently spiked to 9%. If Rio were to use this rate
as the discount rate, it would greatly reduce the present value of future cash
flows, and likely create an impairment issue. However, since short-term rates
fluctuate considerably, and the freighter still has a long useful life, management
judges that this is the wrong interest rate to use as a basis for the discount rate,
and elects to ignore it. Their decision is bolstered by the fact that long-term in-
terest rates are holding steady at 6%.
• Economic performance. The economic performance of an

asset has declined, or is expected to decline. This can in-
clude higher than expected maintenance costs, actual net
cash flows that are worse than the budgeted amount, or a
significant decline in net cash flows or operating profits.
• Market capitalization change. The carrying amount (i.e.,
book value) of all the assets in the company is more than
the entity’s market capitalization.
139
• Market value decline. An asset’s market value declines sig-

nificantly more than would be indicated by the passage of
time or normal use.
• Usage change. There have been or are about to be signifi-
cant changes in the usage of an asset, such as being ren-
dered idle, plans for discontinuance or restructuring, plans
for an early asset sale, or assessing an intangible asset from
having an indefinite life to having a finite one.
Any of the preceding indicators or other factors may reveal that

there is a possibility of asset impairment; if subsequent investiga-
tion reveals that there will be no impairment charge, the mere exis-
tence of one or more of these indicators may be grounds for adjust-
ing the useful life, depreciation method, or salvage value associ-
ated with an asset.
EXAMPLE
Rio Shipping finds that a worldwide glut in the market for supertankers has re-
duced the usage level of its Rio Sunrise supertanker by 10 percent. This does not
translate into a sufficient drop in the cash flows or market value of the ship to
warrant an impairment charge. Nonetheless, Rio’s management is concerned
that the glut could continue for many years to come, and so it alters the deprecia-
tion method for the supertanker from the straight-line method to the 150% de-
clining balance method, in order to accelerate depreciation and reduce the carry-
ing amount of the asset more quickly.
IFRS: Intangible Asset Measurement

You are supposed to test any intangible asset that has an indefinite
useful life for impairment on an annual basis. To save time in per-
forming this annual test, you are allowed to use the most recent
detailed calculation of such an asset’s recoverable amount that was
made in a preceding period, but only if the situation meets all of
the following criteria:
• Related assets and liabilities are unchanged. The assets
and liabilities of the cash-generating unit of which the in-
140
tangible asset is a part have not changed significantly (if the

intangible asset is part of a cash-generating unit at all);
• Remote likelihood of change. The events and circumstances
since the last calculation indicate only a remote likelihood
that the current recoverable amount would be less than the
asset’s carrying amount; and
• Substantial difference. The most recent calculation of the
recoverable amount yielded an amount substantially greater
than the asset’s carrying amount.
IFRS: Determining Value in Use

Value in use is one of the two components of the calculation of an
asset’s recoverable value (which must be higher than an asset’s
carrying amount in order to avoid an asset impairment). Value in
use is essentially the discounted cash flows associated with an as-
set or cash-generating unit. You should consider the following is-
sues when deriving an asset’s value in use:
• Possible variations in the amount or timing of cash flows
related to an asset
• The current market risk-free rate of interest
• Such other factors as illiquidity and risk related to holding
the asset
If you feel that these considerations warrant a change in the value

in use of an asset, you can build adjustments into either the cash
flows or discount rate used to derive the value in use. Adjustments
to the cash flows can include a weighted average of all possible
cash flow outcomes.
The cash flow estimates that you use to derive the value in use
should be based on the following:
• Management’s best estimate of the economic conditions
likely to exist over the remaining useful life of the asset.
These estimates should be based on reasonable and sup-
portable assumptions, with a greater weighting given to ex-
ternal evidence.
141
• The most recent budget or forecast that has been approved

by management, covering a maximum of five years (unless
you can justify a longer period by having already shown the
ability to forecast accurately over a longer period). Do not
include any changes in cash flows expected to arise from
future restructurings or from the presumed future enhance-
ment of an asset’s performance.
Tip:
You can include in a cash flow analysis those changes arising from
a future restructuring, once management has committed to the
plan. Thus, if you know that cash flows will improve as a result of
such a plan, gaining management approval of the plan may be cru-
cial to avoiding an impairment charge.
• Projections beyond the period covered by the most recent

budget or forecast that are extrapolations using a steady or
declining growth rate for subsequent years (unless you can
justify an increasing rate). Do not use a growth rate that ex-
ceeds the long-term average growth rate for the product,
market, industry, or country where the company operates
(unless you can justify a higher rate).
Tip:
One of the reasons given in the standard for using a steady or de-
clining growth rate in projections is that more favorable conditions
will attract more competitors, who will keep the cash flow growth
rate from increasing. Thus, if you want to use an increasing cash
flow growth rate in your forecasts, you need to justify what will
keep competitors from driving the rate down, such as the existence
of significant barriers to entry, or such legal protection as a patent.
Also, you should ensure that the assumptions on which the cash
flow projections are based are consistent with the results the com-
pany has experienced in the past, which thereby establishes another
142
evidence trail which supports the veracity of the cash flow projec-
tions.
Tip:
This accounting standard makes it quite clear that inordinately high
cash flow projections are frowned upon, so expect to run afoul of
the auditors if you attempt to insert unjustifiable cash flow in-
creases in the value in use calculations. Do not try to avoid an im-
pending impairment charge with alterations to your cash flows,
since you are merely pushing off the inevitable until somewhat
later in the useful life of the asset, when it is impossible to hide the
issue over the few remaining years of the life of the asset.
When constructing the cash flow projections for the value in use
analysis, be sure to include these three categories of cash flow:
• Cash inflows. This arises from continuing use of the asset.
• Cash outflows. This is from the expenditures needed to op-
erate the asset at a level sufficient to generate the projected
cash inflows, and should include all expenditures that can
be reasonably allocated to the asset. If this figure is derived
for a cash-generating unit where some of the assets have
shorter useful lives, the replacement of these assets over
time should be considered part of the cash outflows.
• Cash from disposal. This is the net cash proceeds expected
from the eventual sale of the asset following the end of its
useful life.
Do not include in the cash flow projections any cash flows related
to financing activities or income taxes.
Tip:
As just noted, you are supposed to include in the cash flow projec-
tions the cash outflows connected to overhead that is applied to an
asset.
143
Since a larger amount of overhead application will reduce the

value in use of the asset and make an impairment charge more
likely, you should establish an overhead application procedure that
justifiably allocates the smallest amount of overhead possible to
any assets that are subject to impairment tests. You should only
include those overhead costs for which there is a direct linkage to
the asset.
Once you have compiled the cash flows related to an asset, you
need to establish a discount rate for use in deriving the net present
value of the cash flows. This discount rate should reflect the cur-
rent assessment of:
• The time value of money by the market for an investment
similar to the asset under analysis. This means that the risk
profile, cash flow timing, and cash flow amounts of the as-
set should be reflected in the investment for which you are
using a market-derived interest rate.
• The risks specific to the asset for which you have not al-
ready incorporated adjustments into the cash flow projec-
tions.
IFRS: Determining the Fair Value Less Costs to Sell

The fair value less costs to sell is one of the two components of the
calculation of an asset’s recoverable amount (which must be higher
than an asset’s carrying amount in order to avoid an asset impair-
ment). There are several ways to determine the fair value less costs
to sell, as outlined here.
The best source of information for the fair value less costs to
sell is a price in a binding sales agreement in an arm’s length
transaction, which is adjusted for any incremental costs to sell. It
can be difficult to find such a situation that dovetails so perfectly
with an in-house asset, so expect to use one of the following ap-
proaches that do not yield such perfect information (listed in de-
clining order of preference):
1. Pricing in an active market. If an asset trades in an active
market, you can assume that its market price is a reasonable
144
representation of its fair value, from which you would then

subtract any costs of disposal to arrive at the fair value less
costs to sell. In such a market, assume that the bid price is
the market price. If there are no bid prices, then use the
price of the most recent transaction instead (as long as there
has been no significant change in the economic circum-
stances since the date of the transaction).
What is an Active Market?

An active market is a market in which the items being traded are
homogeneous, there are willing buyers and sellers, and prices are
available to the public.
2. Best information available. In the absence of an active

market or a binding sale agreement, then use the best in-
formation available to estimate the amount that you could
obtain by disposing of the asset in an arm’s length transac-
tion between knowledgeable and willing parties. You
should consider the result of the recent sales of similar as-
sets elsewhere in the industry as “best information.”
Tip:
The best information used to derive fair value less costs to sell
should not include a forced sale, except if management believes
that it will be compelled to sell an asset in this manner.
When deriving fair value less costs to sell, what is involved in

“costs to sell”? Examples of costs to sell are:
• Asset removal costs
• Costs to bring the asset into condition for sale
• Legal costs
• Taxes on the sale transaction
145
These are only examples of costs to sell; if you have similar types
of costs that relate to a sale transaction, then you should consider
them to be costs to sell.
IFRS: Accounting for the Impairment of an Asset

You should recognize an impairment loss when the recoverable
amount of an asset is less than its carrying amount. The amount of
the loss is the difference between the recoverable amount and the
carrying amount. You should recognize this loss immediately in
the income statement.
If you have revalued the asset already, then you should recog-
nize the impairment loss in other comprehensive income to the ex-
tent of the prior revaluation, with any additional impairment being
recognized as a normal expense.
After you recognize an impairment loss, you must also adjust
the depreciation on the asset in future periods to account for the
reduced carrying amount of the asset.
EXAMPLE
Rio Shipping owns a small coastal freighter with an original cost of $14 million
and estimated salvage value of $4 million, and which it has been depreciating on
the straight-line basis for five years. The freighter now has a carrying amount of
$9 million.
Rio conducts an impairment test of the freighter asset, and concludes that the
fair value less cost to sell of the asset is much lower than original estimates, re-
sulting in a recoverable amount of $7 million. Rio takes a $2 million impairment
charge to reduce the carrying amount of the freighter from $9 million to $7 mil-
lion.
The freighter still has five years remaining on its useful life, so Rio revised the
straight-line depreciation for the asset to be $600,000 per year. This is calculated
as the revised $7 million carrying amount minus the $4 million salvage value,
divided by the five remaining years of the freighter’s useful life.
146
IFRS: Accounting for the Impairment of a Cash-Generating Unit

You should recognize an impairment loss when the recoverable
amount of a cash-generating unit is less than its carrying amount.
You cannot reduce the carrying amount of the cash-generating unit
as a whole, since it is not recorded in the company’s records as
such – it is recorded as a group of individual assets. To record the
loss, you must allocate the loss in the following order:
1. Reduce the amount of any goodwill assigned to the cash-
generated unit. If there is any loss still remaining, then pro-
ceed to the next step.
2. Assign the remaining loss to the assets within the cash-
generating unit on the basis of the carrying amount of each
asset. When doing so, you cannot reduce the carrying
amount of an asset below the highest of its:
• Value in use (i.e., discounted cash flows)
• Fair value less costs to sell
• Zero
If you are unable to assign all of the pro rata portion of a

loss to an asset based on the preceding rule, then allocate it
to the other assets in the cash-generated unit based on the
carrying amounts of the other assets.
EXAMPLE
Rio Shipping owns Rio Bay, which is a container ship that it acquired as part of
an acquisition. Rio Shipping has allocated $2 million of goodwill from the ac-
quisition to the Rio Bay for the purposes of its annual impairment test. The ship
is designated as a cash-generating unit that is comprised of three assets, which
are:
• Hull – Carrying amount of $20 million
• Engines – Carrying amount of $7 million
• Crane hoists – Carrying amount of $3 million
Thus, the total carrying amount of the Rio Bay is $32,000,000, including the
allocated goodwill.
147
Rio determines that the recoverable amount of the Rio Bay is $28,000,000,
which represents an impairment loss of $4 million. To allocate the loss to the
assets comprising the cash-generating unit, the company first allocates the loss
to the outstanding amount of goodwill. This eliminates the goodwill, leaving $2
million to be allocated to the three assets comprising the unit. The allocation is
conducted using the following table:
Proportion Revised
Carrying of Carrying Impairment Carrying
Hull $20,000,000 67% $1,340,000 $18,660,000
Engines 7,000,000 23% 460,000 6,540,000
Crane 3,000,000 10% 200,000 2,800,000
hoists
Totals $30,000,000 100% $2,000,000 $28,000,000
IFRS: Reversing an Impairment Loss

At the end of each reporting period, you should assess whether any
prior impairment loss has declined. The following are all indicators
of such an impairment decline:
• Economic performance. The economic performance of the
asset is better than expected.
• Entity performance. There have been significant favorable
changes in the company to enhance the asset’s performance
or restructure the operations of which it is a part.
• Environment. The business environment in which the com-
pany operates has significantly improved.
• Interest rates. Interest rates have declined, which may re-
duce the discount rate used to calculate discounted cash
flows, thereby increasing the recoverable amount of the as-
set.
• Market value. The asset’s market value has increased.
If this analysis concludes that the amount of impairment has de-

clined or been eliminated, then estimate the new recoverable
amount of the asset and increase the carrying amount of the asset
to match its recoverable amount. This adjustment is treated as a
148
reversal of the original impairment loss. You must also document

what change in estimates caused the impairment recovery.
If you are reversing an impairment charge, you can only in-
crease the carrying amount of an asset back to where that carrying
amount would have been without the prior impairment charge, and
net of any amortization or depreciation that would have been rec-
ognized in the absence of an impairment charge. Also, once the
reversal is recorded, you should revise the periodic depreciation
charge so that it properly reduces the new carrying amount over
the remaining life of the asset.
EXAMPLE
Rio Shipping has almost fully automated the operations of its Rio Giorgio con-
tainer ship, so that it can cruise the oceans with a crew of just three people (one
per shift). Rio Shipping has also installed an advanced impeller propulsion sys-
tem that cuts the ship’s fuel requirements in half. These changes vastly reduce
the cash outflows normally needed to operate the ship.
Rio had previously recognized a $4 million impairment loss on Rio Giorgio. The
new cash flow situation results in a recoverable amount that matches the carry-
ing amount of the ship prior to its original impairment charge. However, there
would have been an additional $200,000 of depreciation during the period be-
tween the original impairment loss and the reversal of the impairment charge, so
Rio Shipping can only reverse $3.8 million of the original impairment amount.
If you reverse an impairment charge for a cash-generating unit,

then you should allocate the reversal to all of the assets comprising
that unit on a pro rata basis, using the carrying amounts of those
assets as the basis for the allocation. This is the same concept al-
ready described for the allocation of an impairment loss – only
now it is in reverse. When you calculate this allocation back to in-
dividual assets, the resulting asset carrying amount cannot go
above the lower of:
• The recoverable amount of the asset, or
149
• The carrying amount of the asset, net of depreciation or

amortization, as if the initial impairment had never been
recognized.
If there is an allocation limitation caused by either of these items,

then allocate the remaining impairment reversal among the other
assets in the unit.
EXAMPLE
Rio Shipping conducts a re-examination of the recoverable amount of its Rio

Bay container ship, which was described in an earlier example for the initial
recognition of impairment losses. Various changes to the propulsion system of
the ship have reduced its operating costs to the point where Rio Shipping can
justifiably increase its estimate of the ship’s recoverable amount by $1 million.
The revised carrying amounts of the assets comprising the cash-generating unit
are carried forward from the prior example, and are noted below:
Revised
Asset Carrying Amount
Hull $18,660,000
Engines 6,540,000
Crane Hoist 2,800,000
Total $28,000,000
The following table shows the adjusted carrying amounts of the three assets fol-
lowing the allocation of the impairment reversal back to them.
Proportion Initial Adjusted

Carrying of Carrying Reversal Carrying
Hull $18,660,000 67% $670,000 $19,330,000
Engines 6,540,000 23% 230,000 6,770,000
Crane Hoist 2,800,000 10% 100,000 2,900,000
Totals $28,000,000 100% $1,000,000 $29,000,000
*Calculation not shown here
However, to properly allocate the impairment reversal back to these assets, Rio
Shipping must determine the carrying amount of each asset, net of depreciation,
as if the initial impairment had never occurred. This causes a problem, because
the hull and crane hoist both have a longer estimated useful life than the engines,
150
which are expected to be replaced midway through the life of the other assets.
Consequently, the engines have been depreciated at a quicker rate than the other
assets, and so cannot accept the full amount of the impairment allocation.
This results in the following additional allocation of the impairment reversal,

where only a portion of the allocation can go to the engines, while the remaining
impairment reversal is then allocated among the other two assets.
Carrying
Amount as if Impairment Proportion Second
Adjusted Impairment Reversal of Adjusted Stage
Carrying Never Still to Carrying Reversal
Asset Amount Occurred* Allocate** Amounts Allocation
Hull $19,330,000 $20,500,000 87% $148,000
Engines 6,770,000 6,600,000 $170,000
Crane Hoist 2,900,000 3,400,000 13% $22,000
Totals $29,000,000 --- $170,000 100% $170,000
* Calculation not shown here
** Calculated as the adjusted carrying amount of $6,770,000 minus the carrying amount as if the
initial impairment had never occurred, of $6,600,000.
You should recognize any impairment reversal in the income

statement as soon as it occurs. There is a variation on this rule that
involves revalued assets. See the Asset Revaluation chapter for
more information.
Even if the analysis to reverse an impairment does not actually
result in an impairment reversal, it may provide sufficient cause to
adjust the remaining useful life of the asset, as well as the depre-
ciation method used or its estimated salvage value.
The preceding discussion of how to reverse an impairment loss
applies equally to individual assets and cash-generating units.
Tip:
This discussion of impairment reversals does not include goodwill,
which cannot be reversed. This is because IAS 38, Intangible As-
sets, prohibits the recognition of internally generated goodwill,
which such an increase is construed to be.
151
Summary
The IFRS treatment of fixed asset impairment is much more de-
tailed than the treatment given it under GAAP (which is unusual,
given the usual prolixity of GAAP in comparison to IFRS). De-
spite this difference in verbiage, there are only a small number of
significant differences between GAAP and IFRS, which are noted
in the following table:
Item GAAP Treatment IFRS Treatment

Cash flow fore- Shall cover the remaining Numerous restrictions on the
casts useful life of the asset forecast period; generally
limited to five years
Comparison to GAAP compares the car- IFRS compares the carrying
carrying amount rying amount to an as- amount to an asset’s re-
set’s fair value coverable amount, which
is the higher of the asset’s
fair value less costs to sell
or its value in use
Impairment loss Prohibited for impairment Allowed up to the amount of
reversal losses, but allowed to the original impairment
reverse prior disposal
losses on held for sale
assets
152
Review Questions
1. You should recognize an impairment loss under GAAP:

a. When an asset’s carrying amount exceeds the sum of its
discounted cash flows
b. In other comprehensive income
c. When an asset’s carrying amount is not recoverable and
exceeds the sum of its undiscounted cash flows
d. As an adjustment to beginning retained earnings
2. When there is an impairment loss on a fixed asset classified as

held for sale, you should:
a. Only recognize the loss upon sale of the asset
b. Recognize the loss at once in other comprehensive in-
come
c. Ignore the loss
d. Recognize the loss as an adjustment to beginning re-
tained earnings
3. The following is not applicable as an indicator of impairment

under IFRS:
a. An increase in the discount rate
b. The obsolescence of an asset
c. Significant adverse changes in the business environ-
ment
d. A decline in the production rate of an asset
4. The following is not an indicator of an active market:

a. An offer price is made public
b. The items being traded are homogeneous
c. There are willing buyers and sellers
d. Prices are available to the public
153
Review Answers
1. You should recognize an impairment loss under GAAP:

a. Incorrect. Discounting of cash flows is not used for the
determination of impairment.
b. Incorrect. Impairment losses are recognized within in-
come from continuing operations.
c. Correct. When an asset’s carrying amount is not re-
coverable and exceeds the sum of its undiscounted cash
flows.
d. Incorrect. Impairment losses are recognized within in-
come from continuing operations.
2. When there is an impairment loss on a fixed asset classified as

held for sale, you should:
a. Incorrect. You should always recognize an impairment
loss at once.
b. Correct. Recognize the loss at once in other compre-
hensive income.
c. Incorrect. You should always recognize an impairment
loss at once.
d. Incorrect. The loss should be recognized in other com-
prehensive income.
3. The following is not applicable as an indicator of impairment

under IFRS:
a. Incorrect. An increase in the discount rate is an indica-
tor of impairment.
b. Incorrect. The obsolescence of an asset is an indicator
of impairment.
c. Incorrect. Significant adverse changes in the business
environment can be an indicator of impairment.
d. Correct. A decline in the production rate of an asset
may reflect short-term production scheduling require-
ments, and so is not necessarily an indicator of impair-
ment.
154
4. The following is not an indicator of an active market:

a. Correct. The presence of an offer price is not necessar-
ily an indicator of an active market.
b. Incorrect. Homogenous items being traded is an indica-
tor of an active market.
c. Incorrect. Willing buyers and sellers is an indicator of
an active market.
d. Incorrect. Prices that are available to the public is an
indicator of an active market.
155
Chapter 9
Fixed Asset Disposal
Introduction
There are a number of issues related to the disposal of an asset.
You may need to designate an asset as held-for-sale before even
selling it, which requires some knowledge of the circumstances
under which this designation is required. There are also different
designations for discontinued operations. Further, you need to
know how to remove an asset from the accounting records. Finally,
there are slight differences between the GAAP and IFRS account-
ing for disposals. We will address all of these issues in the follow-
ing sections.
Asset Derecognition
An asset is derecognized upon its disposal, or when no future eco-
nomic benefits can be expected from its use or disposal. Derecog-
nition can arise from a variety of events, such as an asset’s sale,
scrapping, or donation.
The net effect of asset derecognition is to remove an asset and
its associated accumulated depreciation from the balance sheet, as
well as to recognize any related gain or loss. You cannot record a
gain on derecognition as revenue. The gain or loss on derecogni-
tion is calculated as the net disposal proceeds, minus the asset’s
carrying amount.
What is the Carrying Amount?

The carrying amount is the recorded amount of an asset, net of any
accumulated depreciation or accumulated impairment losses.
The Held-for-Sale Classification

There is a special asset classification under GAAP that is called
held-for-sale. This classification is important for two reasons:
• All assets classified as held for sale are presented sepa-
rately on the balance sheet.
• You do not depreciate or amortize assets classified as held

for sale.
Under GAAP, you should classify a fixed asset or a disposal

group as held for sale if all of the following criteria are met:
• Management commits to a plan to sell the assets.
• The asset is available for sale immediately in its present
condition.
• There is an active program to sell the asset.
• It is unlikely that the plan to sell the asset will be changed
or withdrawn.
• Sale of the asset is likely to occur, and should be completed
within one year.
• The asset is being marketed at a price that is considered
reasonable in comparison to its current fair value.
EXAMPLE
Ambivalence Corporation plans to sell its existing headquarters facility and

build a new corporate headquarters building. It will remain in its existing quar-
ters until the new facility is complete, and will transfer ownership of the build-
ing to a buyer only after it has moved out. Since the company’s continuing pres-
ence in the existing building means that it cannot be available for sale immedi-
ately, the situation fails the held-for-sale criteria, and Ambivalence should not
reclassify its existing headquarters building as held-for-sale. This would be the
case even if Ambivalence had a firm purchase commitment to buy the building,
since the actual transfer of ownership will still be delayed.
What is a Disposal Group?

A disposal group is a group of assets that you expect to dispose of
in a single transaction, along with any liabilities that might be
transferred to another entity along with the assets (such as debts,
obligations under a warranty agreement, and so forth). If you re-
move an asset from a disposal group, then re-evaluate the assets
remaining in the group to see if they still meet the six held-for-sale
criteria just noted.
157
The one-year limitation noted in the preceding criteria can be cir-

cumvented in any of the following situations:
• Expected conditions imposed. An entity other than the
buyer is likely to impose conditions that will extend the
sale period beyond one year, and the seller cannot respond
to those conditions until after it receives a firm purchase
commitment, and it expects that commitment within one
year.
EXAMPLE
Ambivalence Corporation has a geothermal electricity-generating plant on the

site of its Brew Master production facility. It plans to sell the geothermal plant
to a local electric utility. The sale is subject to the approval of the state regula-
tory commission, which will likely require more than one year to issue its opin-
ion. Ambivalence cannot begin to obtain the commission’s approval until after it
has obtained a firm purchase commitment from the local utility, but expects to
receive the commitment within one year. The situation meets the criteria for
maintaining an asset in the held-for-sale classification for more than one year.
• Unexpected conditions imposed. The seller obtains a firm

purchase commitment, but the buyer or others then impose
conditions on the sale that are not expected, and the seller is
responding to these conditions, and the seller expects a fa-
vorable resolution of the conditions.
EXAMPLE
Ambivalence Corporation enters into a firm purchase commitment to sell its

potions plant, but the buyer’s inspection team finds that some potions have
leaked into the local water table. The buyer demands that Ambivalence mitigate
this environmental damage before the sale is concluded, which will require more
than one year to complete. Ambivalence initiates these activities, and expects to
mitigate the damage. The situation meets the criteria for maintaining an asset in
the held-for-sale classification for more than one year.
158
• Unlikely circumstances. An unlikely situation arises that

delays the sale, and the seller is responding to the change in
circumstances, and is continuing to market the asset at a
price that is reasonable in relation to its current fair value.
EXAMPLE
Ambivalence Corporation is attempting to sell its charm bracelet manufacturing

line, but market conditions deteriorate, and it is unable to sell the line at the
price point that it wants. Management believes that the market will rebound, so
it leaves the same price in place, even though the market price is probably 20%
lower. Given that the price now exceeds the current fair value of the manufactur-
ing line, the company is no longer marketing it at a reasonable price, and so
should no longer list the asset in the held-for-sale classification.
If a company acquires an asset as part of a business combination

and wants to immediately classify it as held for sale, the asset must
meet these requirements:
• Sale of the asset is likely to occur, and should be completed
within one year.
• If any of the other criteria noted above are not met as of the
acquisition date, it is probable that they will be met shortly
after the acquisition has been completed.
Tip:
The Accounting Standards Codification states in ASC 360-10-45-
12 that three months is “usually” the amount of time allowed for
the buyer to meet the held-for-sale criteria. Given the wording of
this pronouncement, there is probably some leeway in the actual
amount of time allowed.
If you classify assets as held-for-sale, then you should measure

them at the lower of their carrying amount or their fair value minus
any cost to sell. If you must write down the carrying amount of an
asset to its fair value minus any cost to sell, then you should recog-
nize a loss in the amount of the write down. You may also recog-
159
nize a gain on an increase in the fair value minus any cost to sell,
but only up to the amount of any cumulative losses that you previ-
ously recognized.
What is a Cost to Sell?

The cost to sell is the costs incurred in a sale transaction that would
not have been incurred if there had been no sale. Examples of costs
to sell are title transfer fees and brokerage commissions. If a sale is
expected to be more than one year in the future, you should dis-
count the cost to sell to its present value.
When you classify an asset as held-for-sale, you do not also accrue

any expected future losses associated with operating it while it is
so classified. Instead, you should recognize these costs only as in-
curred.
EXAMPLE
Ambivalence Corporation sells its Brew Master product line in 20X1, recogniz-
ing a gain of $100,000 prior to applicable taxes of $35,000. During the final year
of operations of the Brew Master line, Ambivalence lost $50,000 on its opera-
tion of the line; it lost $80,000 during the preceding year. The applicable amount
of tax reductions related to these losses were $(17,000) and $(28,000), respec-
tively. It reports these results in the income statement as follows:
20X0 20X1
Discontinued operations:
Loss from operation of the Brew Master
product line (net of applicable taxes of $(52,000) $(33,000)
$28,000 and $17,000)
Gain on disposal of Brew Master product
-- $65,000
line (net of applicable taxes of $35,000)
Part of the sale agreement requires that Ambivalence reimburse the buyer for
any outstanding warranty claims. In the following year, the amount of these
claims is $31,000, prior to an applicable tax reduction of $(11,000). Ambiva-
lence reports this update to the discontinued operation in the following year with
this disclosure in the income statement:
160
20X0 20X1 20X2

Discontinued operations:
Loss from operation of the Brew
Master product line (net of appli-
$(52,000) $(33,000) --
cable taxes of $28,000 and
$17,000)
Gain on disposal of Brew Master
product line (net of applicable -- $65,000 --
taxes of $35,000)
Adjust to gain on disposal of Brew
Master product line (net of appli- -- -- $(20,000)
cable taxes of $11,000)
When you itemize the assets and liabilities of discontinued opera-

tions in the balance sheet, you should not present them as a com-
bined net figure. Instead, present them separately as assets and li-
abilities.
Reclassification from Held for Sale

What if, despite initial expectations, an asset that has been classi-
fied as held for sale is not sold? If an asset no longer meets any one
of the six criteria for classification noted in the preceding section,
then you should remove it from the held-for-sale classification. At
the time of reclassification, you should measure it at the lower of:
• The carrying amount of the asset prior to its classification
as held-for-sale, minus any depreciation or amortization
that would have been charged to it during the period when
it was classified as held-for-sale, or
• The fair value of the asset when the decision was made not
to sell it.
This measurement requirement effectively keeps a company from

shifting assets into the held for sale classification in order to
fraudulently avoid incurring any related depreciation expense,
since they will still have to incur the expense at a later date.
161
Note:
The FASB Accounting Standards Codification states in ASC 360-
35-44 that an asset being reclassified from the held-for-sale desig-
nation should now be classified as held and used. Since there does
not appear to be any distinction between the held and used classifi-
cation and the normal accounting for fixed assets that are in use,
we will assume that these assets are actually returned to their nor-
mal fixed asset accounting designations.
When you adjust the accounting records for this measurement, re-
cord the transaction as an expense that is included in income from
continuing operations, and record the entry in the period when you
make the decision not to sell the asset. You should charge the ex-
pense to the income statement classification to which you would
normally charge depreciation for the asset in question. Thus, the
adjustment for a production machine would likely be charged to
the cost of goods sold, while the adjustment for office equipment
would likely be charged to general and administrative expense.
EXAMPLE
Ambivalence Corporation intends to sell its potion brewing factory, and so clas-
sifies the related assets into a disposal group and reports the group as held for
sale, in the amount of $1,000,000. The journal entry is:
Debit Credit
Equipment held-for-sale 1,000,000
Production machinery 1,000,000
After six months, the controller determines that the fair value of the disposal
group has declined to $950,000, and so writes down the equipment cost with this
entry:
Debit Credit
Loss on decline of fair value of held-for-sale 50,000
equipment
Equipment held-for-sale 50,000
162
The carrying value of the disposal group is now $950,000. After three more
months, an independent appraiser determines that the fair value of the disposal
group has now increased to $1,010,000. The controller can only record a gain up
to the amount of any previously recorded losses, so he records the gain with this
entry:
Debit Credit
Equipment held-for-sale 50,000
Recovery of fair value of held-for-sale 50,000
equipment
The carrying value of the disposal group is now $1,000,000.
After one full year has passed, management concludes that it cannot sell the
disposal group, and decides to continue operating the potion brewing factory.
The controller reclassifies the disposal group out of the held-for-sale classifica-
tion with this entry:
Debit Credit
Production machinery 1,000,000
Equipment held-for-sale 1,000,000
During the period when Ambivalence classified the disposal group as held for
sale, it would have incurred a depreciation expense on the group of $50,000. The
fair value of the group has now been re-appraised at $975,000. Since the carry-
ing amount less depreciation of $950,000 is lower than the fair value of
$975,000, Ambivalence records a charge of $50,000 to reduce the carrying
amount of the group to $950,000 with the following entry:
Debit Credit
Depreciation – Production machinery 50,000
Accumulated depreciation – Production 50,000
machinery
Tip:
The reclassification of assets into and out of the held-for-sale clas-
sification requires additional accounting effort to track. To mini-
mize this effort, maintain a high capitalization limit, so that most
assets are charged to expense when purchased.
163
Also, if you expect that an asset will be sold within a very short
time period, it is easier to not shift the asset into the held-for-sale
classification and then almost immediately sell it; instead, depreci-
ate the asset up until the point of sale. Clearly, some judgment is
needed to follow the intent of the held-for-sale rules without en-
gaging in an excessive amount of unnecessary accounting work.
Discontinued Operations
If a business reports a component of the entity as held-for-sale and
disposes of it, the business should report the results of that compo-
nent of the entity within the discontinued operations section of its
income statement. The business should only do so if both of the
following conditions are met:
• The disposal has resulted in the operations and cash flows
of the component having been removed from the business,
and
• The business no longer has a significant continuing in-
volvement in the component.
What is a Component of an Entity?

A component of an entity has its own operations and cash flows,
and so can be readily distinguished from the entity of which it is a
part.
There may be indirect cash flows associated with the disposal of a

component that do not interfere with the first of the preceding cri-
teria. These indirect cash flows may include:
• Interest income from seller financing of the sale transaction
• Contingent consideration that may be received from the
buyer at a later date
• Royalties received from the buyer
A business is considered to still have a significant continuing inter-

est in a component when it has the ability to influence the operat-
ing or financial policies of the component that it has disposed of.
164
This can be a difficult determination to make, since it involves the

aggregate impact of a company’s continuing ownership interest in
a component and any contractual arrangements with it. A company
may be considered to have a significant continuing interest in a
component if a contractual arrangement has a major impact on the
component’s overall operations, or gives the company a large in-
volvement in the component’s operations.
The following scenarios do not result in continuing cash flows
or involvement by the selling business in a component:
• Payments related to the sale price. Contingent payments
related to the purchase price of the component may go on
for some time after the transaction closes.
• Payments related to contingencies. The parties may settle
obligations related to such contingencies as product war-
ranty obligations well after the sale date.
• Payments related to employee benefits. The parties may
settle obligations related to employee terminations, pension
plans, and other obligations after the sale date.
If you determine that the classification of a component has

changed, either into or out of the discontinued operations classifi-
cation, then you must reclassify these operations into the new cate-
gory designation for all periods presented in the company’s com-
parative financial statements.
Tip:
The requirement to reclassify prior periods either into or out of the
discontinued operations classification is inordinately burdensome,
since a business may not have detailed records for a component for
prior years. Consequently, only change classifications if there is
strong evidence in favor of doing so.
If there are adjustments to the sale price of a discontinued opera-

tion in later accounting periods, you should classify them sepa-
rately within the discontinued operations section of the income
165
statement, and describe them in the notes accompanying the finan-

cial statements.
Abandoned Assets
If a company abandons an asset, you should consider the asset to
be disposed of, and account for it as such (even if it remains on the
premises). However, if the asset is only temporarily idle, then you
should not consider it to be abandoned, and should continue to de-
preciate it in a normal manner.
If you have abandoned an asset, then reduce its carrying
amount down to any remaining salvage value on the date when the
decision is made to abandon the asset.
Idle Assets
Some fixed assets will be idle from time to time. There is no spe-
cific consideration of idle assets in GAAP, so you should continue
to depreciate them in a normal manner. However, here are addi-
tional considerations regarding what an idle asset may indicate:
• Asset impairment. If an asset is idle, it may be an indicator
that the value of the asset has declined, which may call for
an impairment review.
• Disclosure. You should identify idle assets separately on
the balance sheet, and disclose why they are idle.
• Useful life. If an asset is idle, this may indicate that its use-
ful life is shorter than the amount currently used to calcu-
late its depreciation. This may call for a re-evaluation of its
useful life.
Asset Disposal Accounting

There are two scenarios under which you may dispose of a fixed
asset. The first situation arises when you are eliminating a fixed
asset without receiving any payment in return. This is a common
situation when a fixed asset is being scrapped because it is obsolete
or no longer in use, and there is no resale market for it. In this case,
you reverse any accumulated depreciation and reverse the original
166
asset cost. If the asset is fully depreciated, then that is the extent of
your entry.
EXAMPLE
Ambivalence Corporation buys a machine for $100,000 and recognizes $10,000

of depreciation per year over the following ten years. At the end of the ten-year
period, the machine is not only fully depreciated, but also ready for the scrap
heap. Ambivalence gives away the machine for free, and records the following
entry.
Debit Credit
Accumulated Depreciation 100,000
Machine asset 100,000
A variation on this situation is to write off a fixed asset that has not
yet been completely depreciated. In this case, write off the remain-
ing undepreciated amount of the asset to a loss account.
EXAMPLE
To use the same example, Ambivalence Corporation gives away the machine
after eight years, when it has not yet depreciated $20,000 of the asset's original
$100,000 cost, because there are still two years of depreciation left. In this case,
Ambivalence records the following entry:
Debit Credit
Loss on asset disposal 20,000
The second scenario arises when you sell an asset, so that you re-
ceive cash (or some other asset) in exchange for the fixed asset you
are selling. Depending upon the price paid and the remaining
amount of depreciation that has not yet been charged to expense,
this can result in either a gain or a loss on sale of the asset.
167
EXAMPLE
Ambivalence Corporation still disposes of its $100,000 machine, but does so

after seven years, and sells it for $35,000 in cash. In this case, it has already re-
corded $70,000 of depreciation expense. The entry is:
Debit Credit
Cash 35,000
Gain on asset disposal 5,000
What if Ambivalence had sold the machine for $25,000 instead of $35,000?
Then there would be a loss of $5,000 on the sale. The entry would be:
Debit Credit
Cash 25,000
Loss on asset disposal 5,000
If there is a gain or loss on disposal of a fixed asset, you should

include it in income from continuing operations before income
taxes on the income statement.
Asset Disposal Under IFRS

Asset disposal under International Financial Reporting Standards is
addressed in IAS 16, Property, Plant, and Equipment. The IFRS
features of the IFRS rules related to asset disposal are:
• You should derecognize an asset when it is disposed of or
when you expect no future economic benefits from its use.
• Do not classify a gain on the sale of an asset as revenue
(unless it is classified as an inventory item and held-for-
sale).
• Include any gain or loss on asset derecognition in the same
period when you derecognize it. This gain or loss is calcu-
168
lated as the difference between the net disposal proceeds

and the carrying amount of the asset.
One item of note is that, if you replace part of a fixed asset, you
must derecognize the carrying amount of the replaced part, even if
the replaced part has not been depreciated as a separate item. If
you cannot determine the carrying amount of the replaced part, use
the cost of the part that is replacing it as a reasonable indication of
what the replaced part cost when it was originally acquired.
Tip:
It may be useful to adopt a relatively high capitalization limit (the
dollar amount paid for an asset, above which an entity records it as
a long-term asset) in order to charge the cost of many of these re-
placement parts to expense as incurred. This avoids the extra time
needed to investigate and derecognize the parts being replaced.
Summary
The disposal of an asset is a relatively simple matter, as long as
there is adequate documentation of what is being derecognized. If
not, then you will likely have a large number of fully-depreciated
assets and offsetting accumulated depreciation in the accounting
records, relating to assets that have long since departed the prem-
ises.
The held-for-sale classification introduces additional complex-
ity to the reporting of fixed assets, and also impacts the recordation
of depreciation. You should be aware of the held-for-sale criteria
and properly report assets in this classification; otherwise, the com-
pany’s auditors may require that you do so as part of their year-end
audit recommendations, and alter the depreciation calculations for
the impacted assets, resulting in an adjustment to your preliminary
financial results for the year.
169
Review Questions
1. A characteristic of a held-for-sale fixed asset is that it:

a. Continues to be depreciated
b. Is physically segregated from other assets
c. Is classified separately on the balance sheet
d. Continues to be amortized
2. A disposal group is defined as:

a. A group of assets that you expect to dispose of in a sin-
gle transaction
b. A group of assets whose associated liabilities you ex-
pect to retain
c. A specific class of assets that you expect to dispose of
d. A group of assets whose useful lives have been com-
pleted
3. If an asset is temporarily idle, it may be an indicator that:

a. You should use accelerated depreciation on it
b. The value of the asset has declined, which may call for
an impairment review
c. Its useful life should be extended by the amount of the
idle period
d. It no longer has a salvage value
4. Under IFRS, you should not classify a gain on sale of an asset

as revenue unless:
a. It is an immaterial amount
b. It is a material amount
c. It is being depreciated over less than three years
d. It is classified as an inventory item and held for sale
170
Review Answers
1. A characteristic of a held for sale fixed asset is that it:

a. Incorrect. A held for sale asset is not depreciated.
b. Incorrect. There is no requirement to physically segre-
gate an asset classified as held for sale.
c. Correct. Is classified separately on the balance sheet.
d. Incorrect. A held for sale asset is not amortized.
2. A disposal group is defined as:

a. Correct. A group of assets that you expect to dispose
of in a single transaction.
b. Incorrect. Associated liabilities are expected to be dis-
posed of with a disposal group.
c. Incorrect. The assets in a disposal group may come
from multiple asset classes.
d. Incorrect. A disposal group may contain assets having a
broad range of remaining useful lives.
3. If an asset is temporarily idled, it may be an indicator that:

a. Incorrect. A temporarily idled asset does not necessarily
require a change to an accelerated depreciation method.
b. Correct. The value of the asset has declined, which
may call for an impairment review.
c. Incorrect. You should not extend the life of an idle asset
by the amount of the idle period.
d. Incorrect. A temporarily idled asset may still retain its
salvage value.
4. Under IFRS, you should not classify a gain on sale of an asset

as revenue unless:
a. Incorrect. The materiality of a gain does not impact the
recognition of the gain as revenue.
b. Incorrect. The materiality of a gain does not impact the
recognition of the gain as revenue.
171
c. Incorrect. The depreciation period does not impact the

recognition of a gain as revenue.
d. Correct. It is classified as an inventory item and held
for sale.
172
Chapter 10
Introduction
This chapter contains an itemization of the various disclosures re-
quired under both Generally Accepted Accounting Principles
(GAAP) and International Financial Reporting Standards (IFRS).
Within the general categories of GAAP and IFRS, there are nu-
merous subheadings related to the disclosures for specific topics
within the general fixed assets category.
In this chapter, we state that a company’s financial statements
should contain a variety of disclosures. This means that the disclo-
sures are to be located either within the body of the financial
statements themselves, or within the accompanying notes. In most
cases, the appropriate place will be the accompanying notes.
GAAP Disclosures
This section contains the disclosures for various aspects of fixed
assets that are required under GAAP. At the end of each set of re-
quirements is a sample disclosure containing the more common
elements of the requirements.
GAAP: General Fixed Asset Disclosures

The financial statements should disclose the following information
about a company’s fixed assets:
• Accumulated depreciation. The balances in each of the ma-
jor classes of fixed assets as of the end of the reporting pe-
riod.
What is a Class?
A class is a group of fixed assets having common characteristics
and usage. Fixed assets are commonly grouped into such classes as
furniture and fixtures or leasehold improvements, where they are
subject to a common useful life and depreciation method.
• Asset aggregation. The balances in each of the major

classes of fixed assets as of the end of the reporting period.
• Depreciation expense. The amount of depreciation charged
to expense in the reporting period.
• Depreciation methods. A description of the methods used
to depreciate assets in the major asset classifications.
EXAMPLE
Suture Corporation gives a general description of its fixed asset recordation and
depreciation as follows:
The company states its fixed assets at cost. For all fixed assets, the
company calculates depreciation utilizing the straight-line method over
the estimated useful lives for owned assets or, where appropriate, over
the related lease terms for leasehold improvements. Useful lives range
from 1 to 7 years.
Our fixed assets include the following approximate amounts:
December 31,
20X2 20X1
Computer equipment $9,770,000 $8,410,000
Computer software 2,800,000 1,950,000
Furniture and fixtures 860,000 780,000
Intangible assets 1,750,000 4,500,000
Leasehold improvements 400,000 360,000
Less: Accumulated depreciation (5,400,000) (4,800,000)
and amortization
Totals $10,180,000 $11,200,000
GAAP: Asset Retirement Obligations

If a company’s assets are subject to asset retirement obligations,
then you should disclose the following information:
• Description. Describe any asset retirement obligations, as
well as fixed assets with which they are associated.
• Fair values. Disclose the fair values of any assets that are
legally restricted for purposes of setting asset retirement
174
obligations. If you cannot reasonably estimate the fair value

of an asset retirement obligation, then state the reasons for
this estimation difficulty.
• Reconciliation. Present a reconciliation of the beginning
and ending carrying amounts of all asset retirement obliga-
tions, in aggregate, showing the changes attributable to the
following items:
¾ Accretion expense
¾ Liabilities incurred in the reporting period
¾ Liabilities settled in the reporting period
¾ Revisions to estimated cash flows
EXAMPLE
Suture Corporation discloses the following information about its asset retirement
obligations:
The company records the fair value of a liability for an asset retirement
obligation (ARO) that is recorded when there is a legal obligation asso-
ciated with the retirement of a tangible long-lived asset and the liability
can be reasonably estimated. The recording of ARO primarily affects
the company’s accounting for its mining of properties in Nevada for
various substances used in its medical research. The company performs
periodic reviews of its assets for any changes in the facts and circum-
stances that might require recognition of a retirement obligation.
The following table indicates the changes to the company’s before-tax

asset retirement obligations in 20X3, 20X2, and 20X1:
(000s) 20X3 20X2 20X1

Balance at January 1 $5,350 $4,450 $2,900
Liabilities assumed in ABC acqui- -- -- 1,200
sition
Liabilities incurred 200 250 100
Liabilities settled (1,000) (400) (200)
Accretion expense 270 250 300
Revisions in estimated cash flows 1,320 800 150
Balance at December 31 $6,140 $5,350 $4,450
In the table above, the amounts for 20X2 and 20X3 associated with
“Revisions in estimated cash flows” reflect increased cost estimates to
175
abandon the Harkness Mine in Nevada, due to increased regulatory re-

quirements.
GAAP: Capitalized Interest Disclosures

If a company has capitalized any of its interest expense, you should
disclose the total amount of interest cost it incurred during the pe-
riod, as well as the portion of it that has been capitalized.
EXAMPLE
Suture corporation discloses the following information about the interest cost it
has capitalized as part of the construction of a laboratory facility:
The company incurred interest cost of $800,000 during the year. Of that
amount, it charged $650,000 to expense and included the remaining
$150,000 in the capitalized cost of its Dumont laboratory facility.
GAAP: Change in Estimate Disclosures

It is relatively common to have changes in estimates related to
fixed assets, since there are a variety of situations in which you
may conclude that it is necessary to alter an asset’s useful life, sal-
vage value, or depreciation method – all of which are considered
changes in estimate. If so, disclose the effect of a change in esti-
mate on income from continuing operations, net income, and any
per-share amounts for the reporting period. This disclosure is re-
quired only if the change is material.
EXAMPLE
Suture Corporation reports the following change in estimate within the notes
accompanying its financial statements:
During 20X4, management assessed its estimates of the residual values

and useful lives of the company’s fixed assets. Management revised its
original estimates and now estimates that the medical production
equipment that it had acquired in 20X1 and initially estimated to have a
useful life of 8 years and salvage value of $100,000 will instead have a
176
useful life of 12 years and salvage value of $80,000. The effects of this
change in accounting estimate on the company’s 20X4 financial state-
ments are:
Increase in:
Income from continuing operations and net income $250,000
Earnings per share $0.03
GAAP: Intangible Asset Impairment Disclosures

If you have recognized an impairment loss for an intangible asset,
then disclose the following information for each such impairment:
• Amount. Note the amount of the impairment loss and the
method used to determine fair value.
• Description. Describe the asset and the circumstances caus-
ing the impairment.
• Location. Note the line item in the income statement in
which the loss is reported.
• Segment. State the segment in which the impaired asset is
reported.
EXAMPLE
Suture Corporation determines that the values of several acquired patents have
declined, which it discloses as follows:
The company has written down the value of its patents related to the
electronic remediation of cancer, on the grounds that subsequent testing
of this equipment has not resulted in the levels of cancer remission that
management had anticipated. The company employed an appraiser to
derive a new value that was based on anticipated cash flows. The re-
sulting loss of $4.5 million was charged to the cancer treatment seg-
ment of the company, and is contained within the “Other Gains and
Losses” line item on the income statement. The remaining value as-
cribed to these intangible assets as of the balance sheet date is $1.75
million. Management does not plan to sell the patents.
177
GAAP: Intangible Asset Disclosures

If you have acquired individual intangible assets or such assets that
are part of a group, you should disclose the following information
about them:
For Assets Subject to Amortization

• Amortization expense. Disclose the amortization charged to
expense in the reporting period, as well as the estimated
aggregate amortization expense for each of the next five
fiscal years.
• Amortization period. Note the weighted-average amortiza-
tion period, both for all intangible assets and by major in-
tangible asset class.
• Carrying amount. Disclose the total amount of intangible
assets, as well as the amount assigned to any major class of
intangible asset. Also disclose accumulated amortization,
both in total and by class of intangible asset.
• Residual value. If there is any significant residual value,
disclose it in total and by major intangible asset class.
For Assets Not Subject to Amortization

• Carrying amount. Disclose the total amount of intangible
assets, as well as the amount assigned to any major class of
intangible asset.
• Policy. Describe the company’s accounting policy for the
treatment of any costs incurred in the renewal of an intan-
gible asset’s term.
• Renewal costs. If you capitalize renewal costs, disclose by
major intangible asset class the total costs incurred during
the reporting period to renew the term of an intangible as-
set.
• Renewal Period. If these assets have renewal terms, state
the weighted-average period before the next renewal for
each major class of intangible asset.
178
EXAMPLE
Suture Corporation discloses the following information about its intangible as-
sets:
As of December 31, 20X1

Gross Carrying Accumulated
Amount Amortization
Amortized intangible assets
Patents $4,000,000 $1,450,000
Trademarks 1,200,000 400,000
Unpatented technology 800,000 650,000
Total $6,000,000 $2,500,000
Unamortized intangible assets

Distribution license $500,000
Trademark 450,000
Total $950,000
Aggregate amortization expense:

For the year ended 12/31/X1 $560,000
Estimated amortization expense:

IFRS Disclosures
This section contains the disclosures for various aspects of fixed
assets that are required under IFRS. At the end of each set of re-
quirements is a sample disclosure containing the more common
elements of the requirements.
IFRS: General Fixed Asset Disclosures

The financial statements should disclose the following information
about a company’s fixed assets for each class of asset:
179
• Base. The measurement base used to determine the gross

carrying amount.
• Commitments. The amount of any contractual obligations to
acquire fixed assets.
• Construction expenditures. The amount of expenditures
recognized to date in the carrying amount of an asset during
its construction.
• Depreciation. The depreciation methods used.
• Disposition compensation. The amount paid to the com-
pany by third parties for fixed assets that were impaired,
lost, or given up, and which are included in profit or loss.
• Reconciliation. Show a reconciliation in the following for-
mat of the carrying amount at the beginning and end of the
reporting period:
¾ Asset additions
¾ Assets or disposal groups classified as held for sale
¾ Assets acquired through business combinations
¾ Changes resulting from revaluations
¾ Impairment losses recognized or reversed in other com-
prehensive income
¾ Impairment losses recognized in profit or loss
¾ Impairment losses reversed in profit or loss
¾ Depreciation
¾ Net exchange differences caused by the translation of
the financial statements from the company’s functional
currency to a different presentation currency
¾ Other changes
• Restrictions. The descriptions and amounts of any restric-
tions on the title to assets, as well as on assets pledged as
security for liabilities.
• Summary totals. The gross carrying amount and accumu-
lated depreciation (which includes any accumulated im-
pairment losses) at the beginning and end of the reporting
period.
• Useful life. The useful lives or depreciation rates used.
180
EXAMPLE
Franklin Drilling discloses the following information about its oil and gas opera-
tions:
The company states its fixed assets at cost, less accumulated deprecia-
tion and accumulated impairment losses. The initial cost of an asset
comprises its purchase price or construction costs, any costs attribut-
able to bringing the asset into operation, the initial estimate of any de-
commissioning obligation, and borrowing costs. Exchanges of assets
are measured at fair value unless the exchange transaction lacks com-
mercial substance or the fair values of either asset is not reliably meas-
urable. The company recognizes the gain or loss on derecognition of an
asset in profit or loss.
The company measures its oil and gas properties, as well as related
pipelines, using the unit-of-production method. Amortization of the
cost of producing wells is over the amount of proved developed re-
serves. The company depreciates the remainder of its fixed assets on a
straight line basis over its expected useful life, which ranges from 3-7
years for furniture and fixtures to 20-30 years for refineries.
The company’s investment in and depreciation of fixed assets is as fol-

lows:
Oil and Gas Furniture and

(000s) Buildings Properties Fixtures Total
At January 1, 20X1 $14,000 $182,000 $9,000 $205,000
Asset additions 3,000 43,000 1,000 47,000
Assets acquired 5,000 70,000 4,000 79,000
Revaluation changes -- 10,000 -- 10,000
Impairment losses -- (18,000) -- (18,000)
Exchange adjust- 1,000 11,000 -- 12,000
ments
Depreciation (8,000) (98,000) (5,000) (111,000)
Totals $15,000 $200,000 $9,000 $224,000
IFRS: Capitalized Interest Disclosures

If you have capitalized the cost of interest into any fixed assets,
then disclose the following information:
• Capitalized amount. The amount of interest cost capitalized
during the reporting period.
181
• Capitalization rate. The capitalization rate that you used to

calculate the amount of borrowing costs eligible for capi-
talization.
EXAMPLE
Franklin Drilling discloses the following information about its capitalization of

interest:
The company incurred $13 million of interest costs during the year
ended 12/31/X1, of which it charged $2 million to expense and capital-
ized $11 million. The capitalized amounts were related to the develop-
ment of various oilfield production facilities. The capitalization rate
that the company used to calculate the amount of borrowing costs eligi-
ble for capitalization was 6.5%, which was based on long-term market
interest rates for loans associated with development projects of similar
duration and risk.
IFRS: Change in Estimate Disclosures

During the life of a fixed asset, it is possible that you may evaluate
it and conclude that that there has been a change in accounting es-
timate, resulting in accounting changes in the current period or fu-
ture periods. If so, you may need to disclose changes for such
items as:
• Depreciation methods
• Estimated costs to dismantle, remove or restore fixed assets
• Residual values
• Useful lives
Tip:
Only make disclosures about changes in estimate if the changes are
material to the results of the entity. The carrying amounts of most
assets are not large enough to result in a material change in the fi-
nancial statements, no matter how large the change in estimate
may be.
182
EXAMPLE
Franklin Drilling reports the following change in estimate within the notes ac-
companying its financial statements:
During 20X1, management assessed the depreciation methods, removal

costs, residual values, and useful lives of its fixed assets. Management
has adjusted its estimates and now concludes that the pipeline from its
Braithwaite Field is corroding faster than anticipated, and so has ad-
justed its remaining useful life from 15 years to 10 years. The effect of
this change in accounting estimate on the company’s 20X1 financial
statements is a reduction of its income from continuing operations of $2
million.
IFRS: Estimates of Recoverable Amounts

A company may have cash-generating units that contain alloca-
tions of goodwill or intangible assets with indefinite useful lives.
What is a Cash-Generating Unit?

A cash-generating unit is the smallest identifiable group of assets
that generates cash inflows independently from the cash inflows of
other assets. Examples of cash-generating units are product lines,
businesses, individual store locations, and operating regions.
If the amount of goodwill or these intangible assets is a significant

proportion of the company’s total carrying amount of goodwill or
intangible assets with indefinite useful lives, then you should dis-
close the following information:
• Basis of measurement. Whether value in use or fair value
less costs to sell has been used to determine the unit’s re-
coverable amount. The following disclosures also apply,
depending on the basis of measurement:
¾ Fair value basis. Describe the methodology used to de-
termine fair value less costs to sell. If the methodology
does not include the use of an observable market price,
then also disclose key assumptions used, and describe
how management determined the values assigned to
183
each key assumption, and whether they are based on

past experience or are consistent with externally-based
information; if not, describe how they differ from past
experience or external information. If the fair value less
costs to sell is based on discounted cash flow estimates,
then disclose the period and growth rate of the projec-
tions, as well as the discount rate applied to them.
¾ Value in use basis. Describe the key assumptions used
as the basis for cash flow projections. Also, note how
management determined the values assigned to each
key assumption, and whether they are based on past ex-
perience or are consistent with externally-based infor-
mation; if not, describe how they differ from past ex-
perience or externally-based information. Also note the
cash flow projection period, and include a justification
if this period exceeds five years. Further, describe the
growth rate used to extrapolate cash flow projections,
and justify the rate if it exceeds the long-term average
growth rate for the product, market, or country. Finally,
note the discount rate applied to the cash flow projec-
tions.
• Goodwill allocation. The carrying amount of the goodwill
allocated to the unit.
• Intangible allocation. The carrying amount of the intangi-
ble assets with indefinite useful lives allocated to the unit.
• Sensitivity test. If a reasonably possible change in a key as-
sumption used to determine the recoverable amount would
result in the carrying amount exceeding the recoverable
amount, then disclose:
¾ Amount at risk. The amount by which the unit’s recov-
erable amount exceeds its carrying amount.
¾ Assumption value. The value assigned to the key as-
sumption causing the disclosure.
¾ Sensitivity. The amount by which the value must
change for the recoverable amount to equal the unit’s
carrying amount.
184
If the amount of goodwill or intangible assets with indefinite useful

lives is allocated among several cash-generating units, and the
amount so allocated is not significant in comparison to a com-
pany’s total carrying amount of goodwill or intangible assets with
indefinite useful lives, then make the following disclosures:
• Quantification. State the aggregate amount of goodwill or
intangible assets with indefinite useful lives that have been
allocated to units.
• Significance. State that the amount of the allocation is not
significant.
EXAMPLE
Franklin Drilling discloses the following information about the recoverable

amounts of its assets:
The recoverable amount of the Brickel Oil Field cash-generating unit

has been determined based on a value in use calculation. That calcula-
tion uses cash flow projections based on financial budgets approved by
management and covering a five-year period, using a discount rate of
7.9 percent. Cash flows beyond that five-year period have been ex-
trapolated using a steady 5.6 percent growth rate. This growth rate does
not exceed the long-term average growth rate for the market in which
Franklin operates. Management believes that any reasonably possible
change in the key assumptions on which the recoverable amount of the
Brickel cash-generating unit is based would not cause its carrying
amount to exceed its recoverable amount.
IFRS: Held for Sale Disclosures

If you have designated any assets as held for sale, then make the
following disclosures:
• Classification. Separately present a fixed asset classified as
held for sale in the balance sheet. If there are liabilities as-
sociated with the asset, then also separately present them in
the balance sheet. You must also separately present in other
comprehensive income the income or expense related to an
asset that is classified as held for sale.
185
Tip:
You cannot combine the assets and liabilities associated with an
asset designated as held for sale and present them on a net basis.
They must be presented separately.
• Description. Describe the asset that has been classified as

held for sale.
• Impairment gains and losses. State the amount of any im-
pairment losses or loss reversals associated with the asset
that is held for sale.
• Plan changes. Describe the circumstances leading to a de-
cision to change the held for sale status of an asset, as well
as the impact of this decision on the results of operations
for all reporting periods presented.
• Prior periods. If you have separately classified the amounts
for a fixed asset as held for sale in the current period, you
do not have to do so for the same asset in any prior periods
that may be presented alongside the results of the current
reporting period.
• Sale terms. Describe the circumstances of the projected as-
set sale, and the manner and timing of the sale.
• Segment. The segment of which the asset is a part.
EXAMPLE
Franklin Drilling makes the following disclosure about its assets classified as
held for sale as of the end of the current period:
Franklin Drilling has an active program to identify and dispose of any

fixed assets that are either non-strategic or underutilized. Under the dic-
tates of this program, the company has identified its Baikal pipeline as
non-strategic, and classified it as held for sale. The Baikal pipeline has
a carrying amount of $80 million. The company recorded an impair-
ment loss on the pipeline of $20 million in 20X1, and of an additional
$25 million in 20X3. The company has identified a buyer for the pipe-
line, and expects to sell the asset for an amount approximating its cur-
rent carrying amount within the next year. The pipeline is recorded as
held for sale within the company’s Transportation segment.
186
IFRS: Impairment Disclosures

If you have reduced the carrying amount of any fixed assets due to
impairment, then you should make the disclosures noted below.
These disclosures are to be aggregated at the asset class level, not
for individual assets.
• Impairment recognized. The amount of any impairment
losses recognized in profit or loss during the reporting pe-
riod, and the line items in which the losses are included.
• Impairment reversals. The amount of impairment reversals
recognized in profit or loss during the reporting period, and
the line items in which the losses are included.
• Revalued asset impairments. The amount of impairment
losses on revalued assets recognized in other comprehen-
sive income during the reporting period.
• Revalued asset impairment reversals. The amount of im-
pairment reversals recognized in other comprehensive in-
come during the reporting period.
If you are reporting on the results of a company’s segments, then

you will also have to report the amount of impairment losses and
impairment reversals in profit or loss and other comprehensive in-
come for the reporting period for each segment.
If there is a material impairment loss or reversal for an individ-
ual asset or cash-generating unit, then disclose the following in-
formation:
• Circumstances. The circumstances that led to either the
recognition or reversal of the impairment.
• Description. A description of the asset or cash-generating
unit. In either case, also note the reportable segment to
which it belongs, if any. If the subject is a cash-generating
unit and the method of aggregating the unit has changed,
describe the change in aggregation method and the com-
pany’s reasons for doing so.
• Quantification. The amount of the impairment loss or loss
reversal.
187
• Recoverable basis. State whether the recoverable amount of

the asset or cash-generating unit is its value in use or its fair
value less costs to sell.
¾ Fair value basis. If the recoverable amount is based on
its fair value less costs to sell, then describe the basis
for the determination (such as by referring to prices in
an active market).
¾ Value in use basis. If the recoverable amount is based
on its value in use, then note the discount rate used in
the current calculation, as well as any previous estimate
of the value in use.
If, on the other hand, the amount of an impairment or impairment

reversal is not material at the level of an individual asset or cash-
generating unit, then instead disclose aggregate impairment losses
and reversals, as well as the following information:
• Circumstances. The circumstances that led to the recogni-
tion of the impairment losses or reversals.
• Classes impacted. The classes of assets affected by im-
pairment losses or reversals.
EXAMPLE
Franklin Drilling discloses the following information about the impairment of its
fixed assets:
During 20X1, the company recognized impairment losses of $9 million.

The main elements of the write-down were $7 million related to our
Medina oil field development, and $2 million for the Pablo Montez
pipeline project. Both impairments were triggered by our decision not
to proceed with project completion, due to excessive political risk and
increased completion costs. These losses are recognized in the Other
Gains and Losses line item in our income statement. The impairment
loss on the Medina oil field development is recognized in our Explora-
tion segment, while the impairment loss on the Pablo Montez pipeline
project is recognized in our Transportation segment.
188
IFRS: Intangible Asset Disclosures

If you have intangible assets, then disclose the following informa-
tion for each class of these assets; further, the disclosure should
distinguish between internally generated intangible assets and
other intangible assets:
What is an Intangible Asset Class?

An intangible asset class is a group of assets having similar charac-
teristics and usage. Examples are brand names, licenses, and copy-
rights.
• Amortization. Disclose the amortization methods used for

those intangible assets having finite useful lives.
• Carrying amounts. Disclose the gross carrying amount, as
well as any accumulated amortization as of the beginning
and end of the reporting period. You should aggregate ac-
cumulated impairment losses with the accumulated amorti-
zation.
• Contract commitments. Disclose the amount of any con-
tractual commitments to acquire intangible assets.
• Government grants. If you acquired intangible assets
through a government grant and recognized it at fair value,
then disclose the amount initially recognized, its current
carrying amount, and whether they are now recognized un-
der the cost model or revaluation model.
• Indefinite life assessment. If you have classified an intangi-
ble asset as having an indefinite useful life, then state its
carrying amount and why you have assigned it an indefinite
useful life designation, including the key factors supporting
that decision.
• Line items. Note the line items in the income statement
where amortization is included.
• Material intangible assets. Describe any individual intan-
gible asset that is material to the company’s financial
189
statements, as well as its carrying amount and the remain-

ing amortization period.
• Reconciliation. Provide a reconciliation of the carrying
amount of intangible assets at the beginning and end of the
period, which includes the following items that occurred
during the reporting period:
¾ Additions from internal development
¾ Additions acquired separately
¾ Additions acquired through business combinations
¾ Assets classified as held for sale
¾ Changes resulting from revaluations, impairment
losses, and impairment loss reversals appearing in other
comprehensive income
¾ Impairment losses recognized in profit or loss
¾ Impairment losses reversed in profit or loss
¾ Amortization
¾ Net exchange differences from the translation of the
company’s financial statements into the presentation
currency
¾ Net exchange differences from the translation of a for-
eign operation into the company’s presentation cur-
rency
¾ Other items causing a change in the carrying amount
• Restrictions. Note any intangible assets to which title is re-
stricted, and for which their carrying amounts are pledged
as security for company liabilities.
• Revaluation. If you are accounting for any intangible assets
at revalued amounts, then disclose:
¾ By asset class, the effective date of revaluation, the car-
rying amount, and what would have been the carrying
amount under the cost model.
¾ Any revaluation surplus for intangible assets at the be-
ginning and end of the reporting period, as well as
changes during the period.
¾ Any restrictions on the distribution of a revaluation sur-
plus to shareholders.
190
¾ The methods and assumptions used in the estimation of

asset fair values.
• Useful lives. State whether the useful lives of these assets
are indefinite or finite. If they are finite, disclose their use-
ful lives or their amortization rates.
The cost model and the revaluation model are described in the
Subsequent Asset Measurement chapter.
EXAMPLE
Franklin Drilling discloses the following information about its intangible assets:
Goodwill is stated at cost less any accumulated impairment losses.

Goodwill is allocated to cash-generating units and is tested annually for
impairment. Patents are stated at cost less amortization and any accu-
mulated impairment losses. Amortization is recognized in the income
statement on a straight-line basis over the estimated useful lives of the
underlying patents, which do not exceed 18 years.
(000s) Goodwill Patents Total

Additions through business combinations $42,000 $4,000 $46,000
Additions during the period -- 500 500
Exchange rate differences -- (100) (100)
Amortization -- 350 350
Balance on December 31, 20X1 $42,000 $4,750 $46,750
IFRS: Revaluation Disclosures

If you have fixed assets that have been revalued, then disclose the
following information:
• Appraiser. Whether an independent valuation entity was
involved.
• Assumptions. The methods and assumptions used to esti-
mate fair value.
• Carrying amount. The carrying amount for each asset class
that would have been recognized under the cost model.
• Date. Effective date of the revaluation.
191
• Surplus. The revaluation surplus, including the change in

its balance during the period and restrictions imposed on
the distribution of this surplus to shareholders.
• Valuation method. Whether valuations were derived from
observable prices in an active market, or from recent mar-
ket transactions on arms’ length terms, or other methods.
EXAMPLE
Franklin Drilling discloses the following information about the revaluation of a

cash-generating unit:
The company has conducted an appraisal of the value of its Brickel Oil
Field cash-generating unit, using the services of an independent valua-
tion firm. This appraiser independently estimated cash flows to be gen-
erated by the cash-generating unit, which formed the basis for its opin-
ion of fair value. The result of this appraisal was a revaluation that in-
creased the unit’s carrying amount by $25 million as of June 1, 20X1.
Following the revaluation, the unit has a cumulative revaluation surplus

of $37 million. It is unlikely that this revaluation can be distributed to
shareholders, due to restrictions on cash flows out of the country where
the unit is located.
If the company had recognized the carrying amount of the unit under
the cost model, it would have had a carrying amount of $172 million as
of 12/31/20X1.
IFRS: Optional Disclosures

The following disclosures are not required, but may provide useful
information to the recipients of a company’s financial statements:
• Fair value. The fair value of fixed assets when it differs
materially from their carrying amount.
• Fully depreciated assets. The gross carrying amount of any
fully depreciated fixed assets that the company is still us-
ing.
• Idle equipment. The carrying amount of any temporarily
idle fixed assets.
192
• Retired assets. The carrying amount of any fixed assets that

have been retired from active use, but which are not classi-
fied as held for sale.
What is the Gross Carrying Amount?

Gross carrying amount is the total cost of a fixed asset prior to any
reductions for depreciation or impairment.
Summary
In nearly all areas of accounting, the sheer volume of GAAP pro-
nouncements greatly exceeds IFRS, but this is not the case for dis-
closures related to fixed assets. IFRS consistently requires more
disclosure that GAAP on a variety of topics, particularly for esti-
mates of recoverable amounts, impairments, intangible assets, and
revaluations. Consequently, if you are reporting under IFRS, you
may need to collect and aggregate additional information in order
to meet disclosure requirements.
193
Review Questions
1. Under GAAP, you do not need to disclose:

a. The geographical location of assets
b. Depreciation methods
c. Depreciation expense
d. The balances in the major asset classifications
2. The disclosure of an asset retirement obligation should include:

a. The legal basis for the obligation
b. The probability distribution of expected cash flows
c. A description of the obligation
d. A reconciliation of the changes in the retained earnings
account
3. Under IFRS, held for sale disclosures do not have to include:

a. The locations where the assets are stored
b. A description of the assets held for sale
c. Impairment gains or losses associated with the assets
d. The circumstances of the projected sales
4. Under IFRS, revaluation disclosures include:

a. The name of the appraiser or appraisal firm
b. The valuation method used
c. The time period since the last revaluation
d. The date when you switched from the cost model
194
Review Answers
1. In GAAP, you do not need to disclose:

a. Correct. The geographical location of assets is not a
disclosure requirement.
b. Incorrect. You should disclose depreciation methods.
c. Incorrect. You should disclose depreciation expense.
d. Incorrect. You should disclose the balances in the major
asset classifications.
2. The disclosure of an asset retirement obligation should include:

a. Incorrect. The legal basis for the obligation is not a dis-
closure requirement.
b. Incorrect. The probability distribution of expected cash
flows is not a disclosure requirement.
c. Correct. A description of the obligation.
d. Incorrect. Any reconciliation of the retained earnings
account is not related to asset retirement obligation dis-
closures.
3. Under IFRS, held for sale disclosures do not have to include:

a. Correct. There is no disclosure requirement for asset
locations.
b. Incorrect. A description of the assets held for sale is a
c. Incorrect. Impairment gains or losses associated with
the assets is a disclosure requirement.
d. Incorrect. The circumstances of the projected sales is a
4. Under IFRS, revaluation disclosures include:

a. Incorrect. The name of the appraiser is not a disclosure
requirement.
b. Correct. The valuation method used is a disclosure re-
quirement.
195
c. Incorrect. The time period since the last revaluation is

not a disclosure requirement.
d. Incorrect. The date when you switched from the cost
model is not a disclosure requirement.
196
Chapter 11
Not-for-Profit Fixed Asset Accounting
Introduction
A not-for-profit entity is defined under Generally Accepted Ac-
counting Principles (GAAP) as one possessing the following char-
acteristics to some degree:
• Contributions. It receives significant contributions from
other parties who do next expect any return compensation.
• Purpose. It does not exist primarily to earn a profit.
• Ownership. It does not have the ownership structure com-
mon in a business enterprise.
Thus, a not-for-profit entity is not one that is owned by investors,

or which provides special benefits to its owners, members, or par-
ticipants. Examples of not-for-profit organizations are associations,
libraries, museums, and universities.
The accounting for fixed assets in a not-for-profit organization
can be different from the accounting normally used by for-profit
entities, if the assets are donated. In this chapter, we will review
when you should capitalize a contributed asset, what value to as-
sign to it, and whether to depreciate it.
Initial Recognition of Fixed Assets

When a not-for-profit entity receives a contribution of any kind
(not just a fixed asset), it records the asset with an offsetting entry
to a revenue or gain account. You should record a contribution as
revenue if it is part of the entity’s ongoing major activities, or re-
cord it as a gain if the contribution is part of peripheral or inciden-
tal activity.
If the contributor places a restriction on the use of a fixed asset,
this does not impact the underlying value of the donation, so you
would record the same amount for such a contributed asset as you
would for one without a restriction, with no change in the timing of
recognition.
If a not-for-profit entity receives a contributed asset for which

there is a major uncertainty about its value, then you do not have to
recognize it in the accounting records. Examples of such assets are
those of historical value, photographs, or items that may be of use
solely for scientific research.
Conversely, you should record an asset that has a future eco-
nomic benefit or service potential (usually by exchanging it for
cash or using it to generate goods or services).
EXAMPLE
Newton Enterprises provides free science classes to high school students. It re-
ceives the following contributions:
• A philosopher’s stone. The stone is of historical significance, but
probably does not transmute lead into gold. Since there is considerable
uncertainty about its value, Newton does not record the asset.
• A used lawn mower. The lawn mower is of no direct use to Newton’s
primary operations, and will be sold. Newton accordingly records the
lawn mower as a gain.
• An electron microscope. The microscope is of direct use in Newton’s
primary operations, so Newton records it as revenue.
As an example of the journal entries to be used for a donated asset,

if the microscope in the preceding example were to be valued at
$50,000, the journal entry might be:
Debit Credit
Scientific devices 50,000
Revenue 50,000
If the lawn mower in the preceding example were to be valued at

$1,000, the journal entry might be:
Debit Credit
Maintenance equipment 1,000
Gain on contributed assets 1,000
198
Restrictions on Contributed Assets

If a donor makes a contribution that is an unconditional promise to
give, then you should recognize the contribution when received.
This calls for sufficient verifiable documentation that the promise
was both made and received. The promise should be legally en-
forceable. If a contributor is able to rescind the promise to give,
then you should not recognize the asset being contributed.
What is an Unconditional Promise to Give?

An unconditional promise to give is a commitment that only re-
quires the passage of time or a demand by the receiving entity for
the commitment to be realized.
If a contributor makes a contribution that is a conditional promise

to give, you should only recognize the asset when the underlying
conditions have been substantially met (e.g., at the point when the
promise becomes unconditional).
What is a Conditional Promise to Give?

A conditional promise to give is a promise to contribute that is de-
pendent upon the future occurrence of a specific future event
whose occurrence is uncertain.
EXAMPLE
Newton Enterprises receives an offer from a contributor to pay $2 million for a

new classroom building, but only if Newton can raise matching funds from other
contributors within one year. Given the conditional nature of this offer, Newton
cannot record the asset until the matching funds have been raised within the
specified time period.
You may consider a conditional promise to give to be essentially

unconditional if there is only a remote possibility that the condition
will not be met.
199
EXAMPLE
Newton Enterprises receives a promise of multi-year funding for new schools,

but only if Newton supplies its financial statements to the contributor at the end
of each fiscal year. There is only a remote possibility that Newton will not com-
ply with this requirement, so Newton can treat the contribution as an uncondi-
tional promise to give.
What if a donor contributes a fixed asset, but attaches a conditional

promise to the contribution? You now have the fixed asset on your
premises, but can you record it as a fixed asset? No. Until the con-
dition has been met or the donor has waived it, you should record
the received asset as a refundable advance from the donor.
Valuation of Contributed Assets

You should recognize a donated asset at its fair value as of the re-
ceipt date. The following techniques are available for deriving fair
value:
• Market approach. Use information from actual market
transactions to arrive at an estimated fair value. Ideally, this
information is based on quoted prices in an active market
for identical items, but may also use information from
transactions for similar items, or just the best available in-
formation.
• Income approach. Use discounted cash flows to derive the
present value of an asset.
• Cost approach. Use an asset’s current replacement cost.
This is essentially the cost of acquiring or building a substi-
tute asset that has comparable utility.
If you elect to use the income approach, and the asset being con-
tributed will not be received for at least a year, then you could use
the projected fair value of the asset as of the date when you expect
to receive it, discounted back to its present value. Where it is im-
possible to determine fair value as of a future date, you can use the
200
fair value of the asset at the initial recognition date, though without
any discounting to present value.
EXAMPLE
Newton Enterprises is given an office building for use as a training center by a

city government that has no use for the building. The city is suffering through a
severe downturn, and the government was unable to find a buyer for the build-
ing. In general, there is very little market information available for the valuation
of similar buildings, given the paucity of sale transactions. Newton also has
trouble using the income approach to derive a value for the building, since it
gives science classes for free. Thus, it elects to use the cost approach to value
the building, under which it determines that the cost to create a substitute build-
ing of comparable utility would be $700,000.
Valuation of Contributed Services

What if volunteers donate their time to construct a fixed asset?
You should record the value of these services in either of the fol-
lowing situations:
• The services create or enhance non-financial assets; or
• The services require specialized skills, are provided by per-
sons with those skills, and would otherwise need to be pur-
chased.
You should value these services at either their fair value or at the
fair value of the fixed asset created or the change in value of the
fixed asset being improved.
EXAMPLE
Newton Enterprises constructs a science school, using the services of a large

group of volunteers, which include architects, carpenters, electricians, and
plumbers. Newton spends $800,000 on materials for the building project. Once
the asset is placed in service, a third-party appraiser estimates that the fair value
of the building is now $1.2 million. Newton can therefore record the building
asset at a cost of $1.2 million, of which $400,000 is the value of contributed
services.
201
Valuation of Art, Historical Treasures, and Similar Items

If a donor contributes works of art, historical treasures, or similar
items, you can recognize them as assets, with offsetting revenue or
gains. This only applies if the items contributed are not part of a
collection. If such contributions are part of a collection, then you
can use any of the following alternatives for reporting them:
• Record them as fixed assets.; or
• Record only as fixed assets only those items received after
a specific date; or
• Do not record them.
You are not allowed to record only selected collections or items as

fixed assets; instead, you must consistently apply any recordation
policy that you select for all collections or items.
You should capitalize the cost of major preservation or restora-
tion projects, and assign them useful lives that extend until the next
expected preservation or restoration project for the same asset.
EXAMPLE
Newton Enterprises maintains a small science museum, to which a donor con-

tributes an original quadruplex telegraph built by Thomas Edison. An independ-
ent appraisal establishes that the device has a fair value of $150,000. Newton
adds the telegraph to its Edison collection and records it as a fixed asset. This
results in revenue of $150,000, as well as a new fixed asset.
Depreciation of Fixed Assets

A not-for-profit entity should depreciate any contributed assets that
it has recorded as fixed assets, if they have a useful life. If an as-
set’s useful life is extremely long (as would be the case for a work
of art), you do not have to recognize depreciation for it. You
should only avoid depreciation in this manner if both of the follow-
ing conditions exist:
• The asset should be preserved perpetually, due to its cul-
tural, aesthetic, or historical value; and
202
• The entity has the ability to preserve the asset (such as by

preserving it in a protected environment), and is currently
doing so.
You should depreciate art collections, on the grounds that they ex-
perience wear and tear during their intended uses that requires pe-
riodic major restoration efforts.
If you have capitalized the cost of a major restoration project,
you should depreciate this cost over the expected period before the
next restoration project is expected. You should do this even if the
asset being restored or preserved is not depreciated.
Recordation of Fixed Assets

You should use the same record keeping standards for donated
fixed assets as stated in the Fixed Asset Record Keeping chapter.
In addition, you should maintain information about the following
two items:
• Donor. Identify the person or entity that contributed the as-
set, along with contact information.
• Restrictions. Note any restrictions placed on your use of the
asset by the donor.
These two additional items may interact. For example, you may no
longer have a need for an asset, and wish to sell it to create space
for another asset. If so, you may need to contact the donor to have
a restriction lifted, or to have the asset returned to the donor.
It is also useful to maintain a report that itemizes the restric-
tions on fixed assets, so that the entity does not deal with an asset
in a manner that will violate a restriction. This report should be
periodically updated and issued to the management team for re-
view.
Fixed Asset Controls in a Not-for-Profit Entity

A key reason to designate an asset as a fixed asset is that an en-
tity’s system of controls for fixed assets will then apply to it. These
controls should be well-documented, monitored by management,
203
and reviewed by auditors. However, a not-for-profit may not re-

cord a contribution as a fixed asset at all, as may be the case with
historical or research objects. To afford these contributions the
same protections offered by the traditional control system to desig-
nated fixed assets, it would be helpful to record them in a manner
similar to “normal” fixed assets. For example, you could record
them as line items in the fixed asset register, but with a zero cost,
or in a separate manual journal that is kept separate from the for-
mal accounting records. The key point here is that a contribution
that is not recorded in the accounting records will likely find its
way out of the entity sooner or later, whether or not that is the in-
tent of management.
Similarly, it is useful to set a low capitalization limit in a not-
for-profit entity, just so that there is a record available of the exis-
tence of fixed assets and their locations. This is of particular im-
portance in an entity that relies in large part on the services of vol-
unteers. There may be considerable turnover among volunteers, so
there is no institutional memory of where fixed assets are located.
Setting a low capitalization limit is an inexpensive way to supple-
ment what little institutional memory of fixed assets there may be.
Summary
A not-for-profit entity must deal with several fixed asset decisions
that a for-profit business never encounters – whether to record a
contributed asset, at what value to record it, and whether to depre-
ciate it at all. These decisions are only for contributed assets. For
fixed assets that are purchased in the normal manner, the account-
ing found in all other chapters of this book will apply.
204
Review Questions
1. A not-for-profit entity should record a contributed asset as

revenue when:
a. It has provided an asset in exchange
b. The item is part of the entity’s ongoing major activities
c. It engages in a sale transaction with a third party
d. The item is part of the entity’s peripheral activities
2. If a donor makes an unconditional promise to give, you should:

a. Recognize the commitment
b. Not recognize the commitment
c. Wait until there is physical receipt of the asset before
recognition
d. Disclose the commitment but do not recognize it until
there is physical receipt of the asset
3. The following technique is not allowed for deriving the fair

value of a contributed asset:
a. The asset’s current replacement cost
b. Discounted cash flows
c. Information from actual market transactions
d. The pay back method
4. When you keep records about a donated fixed asset, donation-

specific information should include:
a. The name of the manager responsible for the asset
b. The location of the asset
c. The donor name, contact information, and asset usage
restrictions
d. The receipt date of the asset
205
Review Answers
1. A not-for-profit entity should record a contributed asset as

revenue when:
a. Incorrect. A contributed asset is given without any asset
being exchanged for it.
b. Correct. The item is part of the entity’s major ongoing
activities.
c. Incorrect. Revenue recognition occurs at the point of
contribution, not at the point of sale to a third party.
d. Incorrect. The contribution would be recorded as a gain
if it had been related to the entity’s peripheral activities.
2. If a donor makes an unconditional promise to give, you should:

a. Correct. Recognize the commitment.
b. Incorrect. Not recognizing an unconditional promise to
give goes against the requirements of GAAP.
c. Incorrect. Waiting until there is physical receipt is an
excessively conservative treatment of an unconditional
promise to give.
d. Incorrect. Disclosing the commitment but not recogniz-
ing it until receipt is an excessively conservative treat-
ment of an unconditional promise to give.
3. The following technique is not allowed for deriving the fair

value of a contributed asset:
a. Incorrect. Current replacement cost is a valid valuation
technique.
b. Incorrect. Discounted cash flows is a valid valuation
technique.
c. Incorrect. Information from actual market transactions
is a valid valuation technique.
d. Correct. The pay back method is used in capital budg-
eting, and is not a valid valuation technique.
206
4. When you keep records about a donated fixed asset, donation-

specific information should include:
a. Incorrect. The name of the manager responsible for the
asset is usable for all fixed assets, and so is not specific
to donated assets.
b. Incorrect. The location of the asset is usable for all
fixed assets, and so is not specific to donated assets.
c. Correct. The donor name, contact information, and as-
set usage restrictions.
d. Incorrect. The receipt date of the asset is usable for all
fixed assets, and so is not specific to donated assets.
207
Chapter 12
Introduction
A fundamental part of fixed asset accounting is to properly record
the information associated with each asset, as well as to aggregate
this information into reports that managers can use. This chapter
addresses the accounts normally used to record fixed assets in the
general ledger, as well as the forms used to record key information
about several types of fixed assets. Finally, it goes into consider-
able detail regarding several types of fixed asset reports.
Tip:
You may need to assemble a large amount of documentation, de-
pending upon the fixed asset to which it relates. To avoid the cost
of doing so, consider as high a capitalization limit as possible. This
means that only the more expensive items are recorded as assets,
while all other expenditures are charged to expense in the period
incurred. This approach will accelerate the recognition of ex-
penses, but reduces the total cost of record keeping.
Fixed Asset Accounts

When you are recording fixed assets in the general ledger, you
need some accounts in which to record them.
What is the General Ledger?

The general ledger is the master set of accounts that summarize all
transactions occurring within an entity.
The standard approach is to create a set of general ledger accounts

that correspond to the asset classes into which you plan to aggre-
gate your fixed assets. Typical asset classes to consider are:
• Buildings
• Computer equipment
• Computer software
• Furniture and fixtures
• Intangible assets
• Land
• Land improvements
• Leasehold improvements
• Machinery
• Office equipment
• Vehicles
There should be a separate asset class for any group of assets that
has similar characteristics, usage patterns, and useful lives.
If a company has specialized assets, then you can certainly cre-
ate a new asset class for them. For example, if a company builds
pipelines, it can aggregate them into a pipelines asset class.
Tip:
Do not create an account if you have no assets to record in it. If
you eventually acquire new types of assets, you can always create
accounts for them at a later date.
You may want to create an offsetting accumulated depreciation

account for each fixed asset account, though it is acceptable to
have a single accumulated depreciation account for all tangible as-
sets and a single amortization amount for all intangible assets.
Tip:
Use a single accumulated depreciation account for all fixed assets,
unless there is a clear reporting need to have separate accumulated
depreciation accounts for each class of fixed asset. When you have
multiple accumulated depreciation accounts, there is an increased
risk that entries will be made to the wrong accounts, so that the to-
tal accumulated depreciation is correct, but you must spend time
investigating why individual account balances are wrong.
209
The exact account codes that you assign to the general ledger fixed
asset accounts will depend upon the number of digits used in your
chart of accounts, and the presence of other asset accounts in the
chart.
What is the Chart of Accounts?

The chart of accounts is a listing of all accounts used in the general
ledger, usually sorted in order by account number. Accounts are
usually listed in order of their appearance in the financial state-
ments, starting with the balance sheet and continuing with the in-
come statement.
Asset accounts typically begin with the numeral “1”, and fixed as-
sets appear on the chart of accounts after cash, investments, ac-
counts receivable, and inventory, so let us assume that the second
digit is a “5”, to place the fixed assets after the items just noted.
We could then assign them the following account numbers:
Account
Number Account Name
1505 Buildings
1510 Computer equipment
1515 Computer software
1520 Furniture and fixtures
1525 Intangible assets
1530 Land
1535 Land improvements
1540 Leasehold improvements
1545 Machinery
1550 Office equipment
1555 Vehicles
1605 Accumulated depreciation – Buildings

1610 Accumulated depreciation – Computer equipment
1615 Accumulated depreciation – Computer software
1620 Accumulated depreciation – Furniture and fixtures
1625 Accumulated amortization – Intangible assets
1630 Accumulated depreciation – Land
1635 Accumulated depreciation – Land improvements
210
Account
Number Account Name
1640 Accumulated depreciation – Leasehold improvements
1645 Accumulated depreciation – Machinery
1650 Accumulated depreciation – Office equipment
1655 Accumulated depreciation – Vehicles
Note that there are gaps in the numbering between each account.
This leaves you room to add additional accounts in the future.
These sample account numbers include a complete set of ac-
cumulated depreciation accounts, just to show how this more com-
prehensive treatment would be categorized.
Tip:
If you elect to set up a separate accumulated depreciation account
to offset each fixed asset account, then mirror the numbering of the
fixed asset account in its offsetting accumulated depreciation ac-
count. Thus, the 1505 building account number noted above has an
accumulated depreciation account of 1605. This makes it easier to
create mistake-free depreciation journal entries.
What about the accounts to which you charge depreciation ex-

pense? You can have a single account each for depreciation ex-
pense and amortization expense, if you only want to charge these
expenses to the company as a whole. However, if you want to
charge these expenses to individual departments, then you should
create a depreciation expense account for each department. Again,
the precise layout and numbering will depend upon your chart of
accounts, but the basic concept is to use the same depreciation ex-
pense account number for all departments, with a department code
either preceding or following the depreciation account code. For
example, the account numbering could be:
Account
Number Account Name
10-850 Accounting department – Depreciation expense
20-850 Engineering department – Depreciation expense
211
Account
Number Account Name
30-850 Production department – Depreciation expense
40-850 Sales department – Depreciation expense
This format shows a department-specific code at the front of the

depreciation account number (which remains 850 in all cases). An
alternative treatment is to reverse the order of the coding, so that
the department-specific code is located at the end of the account
number, as in the following example:
Account
Number Account Name
850-10 Depreciation expense – Accounting department
850-20 Depreciation expense – Engineering department
850-30 Depreciation expense – Production department
850-40 Depreciation expense – Sales department
Construction Project Record Keeping

If there is a large construction project that will result in a fixed as-
set, then you need to carefully compile and organize the expendi-
tures related to the project, so that the correct amount can be capi-
talized. This information used to be manually compiled in a project
cost sheet that summarized expenditures by such categories as la-
bor, materials, and contractor fees. However, it is much easier to
create a general account code for each project, as well as sub-codes
to further refine the expenditure categories, and then use the ac-
counts payable module of the accounting software to aggregate the
required information.
You will still need to assemble copies of the various invoices
and payroll records into a project binder, which provides sufficient
source documentation for auditors to verify the amounts of the
capitalized expenditures. Further, you should document the in ser-
vice date, which is when the project has resulted in an asset that is
ready for its intended use – this is the depreciation start date.
An item requiring special documentation is the capitalization of
interest related to a construction project. You should follow the
212
requirements of GAAP or IFRS in calculating the amount to capi-

talize (as described in the Interest Capitalization chapter), and
document the calculation.
Further documentation of buildings is noted in the following
section, which relates to expenditures after a building has been
placed in service.
Building Record Keeping

One of the most difficult record keeping chores for the accountant
is for the expenditures related to a building that has already been
constructed and placed in service. There may be invoices arriving
from many suppliers, and the accounting staff needs to sort
through them and decide which are related to building enhance-
ments that can be capitalized, and which should be charged to ex-
pense.
The simplest way to handle these expenditures is to adopt a de-
fault position that they should be charged to expense in the period
incurred. Not only does this massively reduce the amount of long-
term record keeping, but it also reflects reality – very few ongoing
expenditures should be capitalized. In addition, you should require
the controller to code any invoices that are higher than a certain
expenditure level, and provide the controller with a detailed expla-
nation of which expenditures should be capitalized. This two-step
approach shunts aside most supplier invoices into the expense
category, and places final authority for capitalization in the hands
of an expert who has specific guidelines for doing so.
You should set up a record keeping system for a building at
two levels – one set of information for the entire building as it was
originally constructed or purchased, and a second set of informa-
tion for any additions to it that were subsequently capitalized.
Thus, the key record keeping items are:
• Description. Provide brief description of the building that is
sufficient to identify it.
• Address. Note the street address of the building.
213
• Cost. This is the initial capitalized cost of the building,

which is used for subsequent depreciation, as well as for
impairment testing.
• In service date. This is the date on which the building is
ready for its intended use, and is the traditional trigger date
for the start of depreciation.
• Useful life. This is the estimated useful life of the building.
There may be an asset class for buildings, where you use a
standardized useful life for all buildings owned by the
company. However, most companies own very few build-
ings, so it may be acceptable to adopt a different useful life
for each building, especially if there are significant differ-
ences in the useful lives of the various buildings.
• Assessed value. The government will create an assessed
value for the property, on which it then charges a tax rate.
You may want to track the assessed value over time, as
well as compile a record of any requests for review of the
assessed value, and the results of the requests.
• Impairment circumstances. If there has been a write down
in the value of a building due to impairment, then note the
circumstances of the impairment, and when it occurred.
This may require extensive documentation if there have
been several impairments or impairment reversals.
• Land reference. If the company owns the land on which the
building is located, then include a cross-reference to your
land records (see the Land Record Keeping section below).
If you also capitalize additional expenditures after the building has

been put into service, then consider adding the following informa-
tion to the building record:
• Expenditure documentation. This may be quite large, if the
capitalized item involves multiple expenditures and suppli-
ers. If so, create a summary sheet that lists all of the expen-
ditures included in the capitalized item, with references to
the supplier name, invoice number, invoice date, and ex-
214
penditure amount. The auditors will need this information

to verify your capitalization transaction.
• Justification for capitalization. Provide an explanation of
why the expenditures have been capitalized, referencing the
specific provisions of GAAP or IFRS under which you
elected to do so. See the Subsequent Fixed Asset Measure-
ment chapter for more information.
• Depreciation information. Describe the useful life of the
capitalized expenditures and the depreciation method used
to derive the ongoing depreciation expense.
EXAMPLE
Gargantuan Corporation’s accounting staff creates the following asset record for
one of its buildings:
Asset number: 006498

Description: Corporate headquarters building
Address: 543 Big Circle, Munificent, California 90022
Cost: $25,410,000
In service date: March 1, 20X3
Useful life: 30 years
Assessed value: $24,500,000 as of notification on November 30, 20X4
Impairment circumstances: None
Land reference: See asset number 006497
Subsequent capitalizations: Added multi-level parking garage with in-
service date of January 15, 20X5, with capitalized cost of $2,800,000.
See attached summary sheet for details.
Justifications for subsequent capitalizations: Adds to use of the building
and generates separate cash flow from parking fees. See GAAP stan-
dards in ASC 360-10.
Depreciation for subsequent capitalizations: Useful life and depreciation
method match the remaining life of the building.
Equipment Record Keeping

There are typically far more fixed assets in the equipment category
(which can include office equipment and furniture and fixtures)
than in any other category. Given the volume and generally lower
215
cost of these items in comparison to building or land assets, the

record keeping tends to be more minimal, with perhaps just a pur-
chase order stapled to a copy of the supplier invoice. However, the
record keeping for equipment should be more extensive, including
the following items:
• Description. This is a description of the equipment that is
sufficient to identify it.
• Tag number. This is the identification number of the asset
tag that the company affixes to its assets.
• Serial number. If no tag numbers are used, then instead list
the serial number of the asset, as assigned by the manufac-
turer.
• Location. Note the location where the asset resides.
• Responsible party. This is the name or position of the per-
son who is responsible for the equipment.
• In service date. This is the date on which the equipment is
ready for its intended use, and is the traditional trigger date
for the start of depreciation.
• Cost. The cost may simply be the original purchase price,
or it may be a more extensive record of additions to the
equipment over time as high-cost items are replaced.
• Useful life. This can be the manufacturer’s recommended
equipment life, or you can supplement it over time if man-
agement concludes that the useful life should be changed,
with notations regarding the impact on the depreciation
rate.
• Asset class. Note the class of assets in which the equipment
is categorized. Since a standard depreciation method is
typically assigned to an asset class, you do not also have to
specify the depreciation method. If you use a standard use-
ful life for an asset class, then you do not have to separately
record an asset’s useful life.
• Warranty period. This is the period during which the manu-
facturer will pay for repairs to the equipment. If there is a
cost-effective warranty extension option, then note it here.
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• Supplier contact information. This may include several ad-

dresses for the supplier, such as for its field servicing, cus-
tomer service, warranty, and sales departments.
• Impairment circumstances. If there has been a write down
in the value of the equipment due to impairment, then note
the circumstances of the impairment, and when it occurred.
This may require extensive documentation if there have
been several impairments or impairment reversals.
By retaining this additional equipment information, you can more

easily track down assets, determine who is responsible for them,
and determine if the manufacturer is responsible for any repairs.
It is useful to consolidate this record with any manufacturer’s
warranty documents, as well as a copy of key maintenance records.
EXAMPLE
one of its equipment fixed assets:

Asset description: Print-on-demand book printer
Tag number: 1049
Serial number: BF-44078
Location: Printing department
Responsible party: Printing department manager
In service date: May 12, 20X5
Cost: $200,000
Useful life: 4 years
Asset class: Office equipment
Warranty period: May 1, 20X5 to April 30, 20X6. Can be extended an addi-
tional year with a $20,000 payment prior to April 30, 20X6.
Supplier contact information: PrintTech, 18 Gutenberg Way, Mainz, Min-
nesota 55046
Impairment circumstances: Carrying cost reduced by $50,000 in July 20X7,
caused by the printer being rendered largely idle as the result of most
book printing operations being outsourced. There are no immediate
plans to sell the asset.
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Land Record Keeping

There are several unique aspects to a land asset that call for differ-
ent record keeping, primarily relating to the government entity that
has jurisdiction over it, assessed values, and use restrictions. You
should itemize these issues, along with the usual identification in-
formation, in a land record. The key items to record are:
• Description. This is a general description of the property,
and may include notes about the structures erected on it.
• Cost: The purchase price of the land.
• Location. This may be the surveyor’s legal description of
the property, as well as its address.
• County. This is the county in which the land is located, or
the government entity which assesses taxes on the property.
• Zoning classification. If a zoning classification has been as-
signed to the property, then note it here, as well as the spe-
cific limitations of the zoning. Examples are residential,
commercial retail, or heavy industry zoning.
• Easements. Note any legally allowed access to the land by
others.
• Restrictions on use. Note any restrictions other than those
already imposed by the zoning.
• Assessed value. The government will create an assessed
value for the property, on which it then charges a tax rate.
You may want to track the assessed value over time, as
well as a record of any requests for review of the assessed
value, and the results of the requests.
• Land improvements. If there have been any depreciable im-
provements to the land (such as sewer lines or a parking
lot), then note them here, as well as a cross-reference to the
land improvement asset record.
• Buildings on property. If there have been any buildings
constructed on the land, then note them here, as well as a
cross-reference to the buildings’ asset records.
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It may also make sense to consolidate the land record with all land-
related documents, such as survey information and assessment no-
tices.
EXAMPLE
one of its land assets:

Description: Land used for corporate headquarter building
Cost: $2,000,000
Location: 543 Big Circle, Munificent, California 90022
County: El Brazo County
Zoning classification: Commercial office
Easements: None
Restrictions on use: Industrial use prohibited
Assessed value: $2,200,000 as of notification on November 30, 20X4
Land improvements: Landscaping of $150,000, added to capitalized cost of
land. Sewer lines of $175,000, depreciated separately under asset
006499 as a land improvement.
Buildings on property: Corporate headquarters, see asset number 006498
Lease Record Keeping

In many cases with smaller assets such as copiers, a company will
enter into an operating lease where it has the use of an asset for a
specific time period, and then returns the asset to the lessor. In
cases where a company essentially owns the leased asset, the
transaction is known as a capital lease. There are some differences
in the record keeping required for each type of lease, as noted be-
low.
Operating Lease Record Keeping

Under an operating lease, the company is obligated to return the
asset at the end of the lease period, and may have the option to re-
new the lease for an additional period. To be cognizant of these
issues, you should record the following information in an operating
lease file:
219
• Leased asset description. This is a brief description of the

asset, sufficient to identify it.
• Leased asset location. Give a sufficiently accurate location
that you can find the asset when it is time to return it to the
lessor. A location coding system may be sufficient.
• Serial number. There may be no asset tag, since the com-
pany does not own it, so list its serial number instead in or-
der to uniquely identify the asset.
• Lease payment terms. The amount of each payment, when
it is due at the lessor, and any differing amounts to be paid
for the first and last payments of the lease.
• Lessor contact information. There may be multiple ad-
dresses for the lessor, such as a contact address, payment
address, an address to which you make a lease termination
notice, and yet another address to which you return the as-
set upon the expiration of the lease.
• Termination notice date. If a lease contains an automatic
renewal, you should be aware of the notice date by which
you have to notify the lessor of termination. This is an im-
portant item, so post it prominently.
• Lease ending date. Note the date on which the lease ends.
This is a critical date, so consider posting it in numerous
places. You need to terminate any automated payments to
the lessor as of this date.
• Lease extension terms. Describe the terms under which you
can extend the lease duration.
• Lease termination terms. Note the terms under which you
can terminate the lease, such as notification to the lessor by
a certain date in writing, a lease termination fee, and return
of the asset to the lessor by a certain date.
Capital Lease Record Keeping

The information you should record for a capital lease is similar to
the information just described for an operating lease. In addition to
the information just noted for an operating lease, also record the
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standard information that you would use for a fixed asset – its use-
ful life, salvage value, asset class, depreciation method, and the
circumstances of any asset impairment.
You may think that it is sufficient to simply keep copies of the
lease agreements on hand, since most of the information described
in this section is contained within the leases. However, it can be
difficult to locate key information in a voluminous lease document,
so we recommend summarizing the key information in summary
form.
EXAMPLE
one of its land assets:
Leased asset description: Automated scanner

Leased asset location: Document retention warehouse
Serial number: A04781
Lease payment terms: $1,000 per month for 60 months, payable at the lessor
on the 15th of each month
Lessor contact information: Scanners International, 789 17th Street, Denver
Colorado 80222
Termination notice date: August 14, 20X6
Lease ending date: September 15, 20X6
Lease extension terms: $750 per month with maintenance included for five
additional years
Lease termination terms: Ship to lessor address, postage paid, to be received
within five days following the lease termination date
Document Retention
How long should you retain documents related to fixed assets? The
exact requirements will vary, depending upon the rules imposed by
any government that wishes to audit them. Given that these re-
quirements can be quite long, you should consider the following
two policies:
• Do not keep title records on site. Title records are too valu-
able to keep on site, where they may be stolen, lost, or de-
stroyed. Instead, keep copies on site for audit purposes, and
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keep the originals in a secure place, such as a lock box in a

bank.
• Exclude fixed asset records from archiving. An efficient
company likely has an archiving process for shifting its less
necessary documents off-site into lower-cost storage areas,
and then destroying them at pre-planned intervals. You
should exclude all fixed asset records from the archiving
process, to avoid any risk of destroying the paperwork as-
sociated with a fixed asset that may still be on the premises.
Instead, have a separate procedure for eliminating these
documents only when the related assets have been disposed
of and there is no government requirement for further
document retention.
Fixed Asset Reports

There are several reports related to fixed assets that are of use in
monitoring their remaining carrying amounts, where they are lo-
cated, who is responsible for them, and whether they should be re-
placed. The exact format of these reports will vary depending on a
company’s individual circumstances; the general layouts shown
here are intended to be only a general guideline, likely requiring
some modification. Each of the following subheadings deals with a
separate report.
Depreciation Report
The depreciation report is usually available as a standard report
from your accounting software. If you are calculating depreciation
manually, then use the following format to summarize the key in-
formation about depreciation for each asset:
Asset Purchase Periodic Accumulated Carrying

Class Description Cost Depreciation Depreciation Amount
Equipment Drill press $50,000 $1,000 $15,000 $35,000
Equipment Lathe 15,000 300 3,600 11,400
Equipment Stamper 35,000 700 5,600 29,400
Software CAD/CAM 80,000 1,333 33,325 46,675
software
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Asset Purchase Periodic Accumulated Carrying

Class Description Cost Depreciation Depreciation Amount
Software ERP soft- 480,000 8,000 152,000 328,000
ware
Software MRP II 200,000 3,333 36,663 163,337
software
Totals $860,000 $14,666 $246,188 $613,812
The columns in the report are explained as follows:

• Asset class. This is the general category of assets with
which an asset is associated. This is a useful tool for
searching for assets in the report. It is also an easy way to
audit the report, for you should only see certain types of as-
sets linked to certain classes. Thus, there should be no
buildings listed in the computer equipment class (or being
depreciated as computer equipment!).
• Description. This is a brief description of the asset, and is
probably sufficient identification for companies having few
assets. If there are many assets, then consider adding a col-
umn to the report for asset serial numbers.
• Purchase cost. This is the installed cost of the asset, also
known as its gross carrying amount. This forms the basis
for your depreciation calculations.
• Periodic depreciation. This is the amount of depreciation
recorded for each individual asset in the current accounting
period. The total of this column is used for the periodic de-
preciation journal entry.
• Accumulated depreciation. This is the accumulated amount
of depreciation for each asset, from its initial purchase to
the current date. The total accumulated depreciation for all
assets in the report should match the amount of accumu-
lated depreciation listed on the balance sheet.
• Carrying amount. This is the net cost of each asset that has
not yet been depreciated. The total of this column should
match the net fixed asset figure stated in the balance sheet.
Additional columns to consider for the report are:
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• Account number. It is useful to include the account number,

either for each line item or just for a sub-total (if used) for
each asset class. You can then reference the account num-
ber when constructing the depreciation journal entry for
each accounting period.
• Serial number. If there are many fixed assets, then you may
need a serial number to uniquely identify each one, rather
than just using a description.
• Purchase date. The purchase date of an asset is necessary
information for verifying the accuracy of a depreciation
calculation.
• Depreciation method. The depreciation method should be
the same for each asset within an asset class, so stating the
method is a useful audit tool for spotting incorrect methods.
You can contract the method to save space in the report.
For example, list the straight-line method as “SL”.
• Depreciation period. The period over which an asset is de-
preciated should be the same for each asset within an asset
class, so auditors can use the period stated in the report as
evidence that a depreciation period was incorrectly set up.
• Salvage value. If you use salvage value (it is generally eas-
ier not to if salvage values are minor), then list them in the
report. This aids in auditing the depreciation calculations
shown in the report.
• Accumulated impairment. If there has been any impairment
charged against an asset, then state the accumulated amount
in the report. This aids in auditing the depreciation calcula-
tions in the report, since the amount of depreciation will
likely decline following the impairment.
• Depreciation completion date. State the month and year in
which depreciation is completed for each asset. This is use-
ful information for the annual budget, which includes de-
preciation information by month or quarter.
Note that the report is sorted by asset class, so that you can first
search it by general category, and then by individual asset. You
224
then have several options for sorting within each asset class, the
most common ones being by asset name or purchase date. It can be
quite useful to use subtotals for each asset class, which you can
then reference when creating depreciation journal entries by asset
class (such as for furniture and fixtures, or computer equipment).
You should include any intangible assets in this report, if they
have a carrying amount. Even intangible assets with no amortiza-
tion period can be listed, as a reminder that you should periodically
test them to see if amortization is warranted.
An alternative version of this report is to construct it on an
electronic spreadsheet, with a separate column for the depreciation
in each reporting period (which may amount to a lot of columns).
You would probably not print the entire report at one time, but it is
a useful way to lay out and verify depreciation calculations.
Audit Report
Either internal or external auditors may need to periodically verify
the existence of fixed assets, for which they need to verify the lo-
cation and identification of each asset. The following report pro-
vides the essential information needed for this task:
Tag Model Serial

Location Description Number Number Number
Cell 13 Deburring machine 03341 LFX-43 A047J4
Cell 13 Drill press 03325 Alpha 17 JJ00752
Cell 08 Grinder 03329 DOM-5A4 KS6730A
Cell 08 Lathe 03350 Merc-88 K721G
Cell 02 Notching machine 03339 Mark 2 0042189
Cell 13 Power shears 03347 Anders 4 KDL5521
Cell 02 Stamper 03352 Zelda 11 082G54

• Location. The location code can follow a variety of for-
mats, such as building number, or room number, or a more
precise bin location. When selecting the location code, be
aware that extremely precise ones will likely require more
frequent updates, when they are periodically moved. Of
225
course, a greater level of identification precision also

means that you can locate assets more easily in an audit.
• Description. This is a brief description of the asset, which
is supported by the following three items.
• Tag number. If the company affixes identification tags to
its fixed assets, then list the tag number here.
• Model number. This is a field for the supplier’s model
number, which can assist in identifying a machine if there
are several machines from the same supplier on the prem-
ises.
• Serial number. This is a field for the supplier’s unique
identification code for a machine, which is useful when the
company does not apply its own tags to machines, or when
there are several identical machines from the same supplier
on the premises.

• Serial number location. Serial numbers may be located in
extremely difficult-to-reach parts of a machine, so consider
stating where auditors need to look.
• Responsible employee. If someone is responsible for an as-
set, and an auditor cannot find the asset, the next logical
step would be to find the person responsible for it and have
him locate the asset.
• Notes field. If auditors print out the report, they may want
to write notes on it as they conduct the audit. If so, include
a notes field on the far right side of the report.
Note that the report is sorted alphabetically by description, but a

useful alternative sort is by location code (which in the example is
machining centers within the factory). By using a location sort, the
auditor can more easily cluster fixed assets on the report in a man-
ner that matches the flow of his audit work.
An extremely useful feature of this report is to only print it
for those assets above a certain cost, because low-cost assets are
not worth the effort to locate. Doing so can strip away a very large
226
percentage of all assets, which leaves auditors with a small subset

of assets on which to focus. Other selection options are to only
print it for specific locations, or based on the gross carrying
amount or net carrying amount of an asset.
Responsibility Report
If a company assigns responsibility for fixed assets to specific in-
dividuals, then create a report that matches assets with those peo-
ple. This report should be issued to the responsible parties at regu-
lar intervals, so they can verify the existence of the assets assigned
to them. This report is quite similar to the audit report, in that most
of the information on the report is intended to assist in locating an
asset. A sample of the report is:
Tag
Responsible Party Location Description Number
Murchison, A. Cell 13 Deburring machine 03341
Murchison, A. Cell 13 Drill press 03325
Barnett, R. Cell 08 Grinder 03329
Barnett, R. Cell 08 Lathe 03350
Smith, W. Cell 02 Notching machine 03339
Murchison, A. Cell 13 Power shears 03347
Smith, W. Cell 02 Stamper 03352

• Responsible party. This is either the name or employee
number of the individual who is responsible for the assets
listed on the report.
• Location. This is a coded description of where each asset is
located.
• Description. This is the standard equipment description,
which should be sufficient to identify a machine.
• Tag number. This is the primary identification code for a
fixed asset. If tags are not used, then substitute a serial
number field instead.
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• Serial number. This is a field for the supplier’s unique

identification code for a machine, which is useful when the
company does not apply its own tags to machines, or when
there are several identical machines from the same supplier
on the premises.
• Initialing field. The report can be used as a formal ac-
knowledgment of responsibility, in which case you can in-
clude a field on the right side of the report, on which the re-
sponsible party initials next to each fixed asset, showing
that he has observed the asset.
The report shown in the example is sorted alphabetically by ma-

chine, but that is only an efficient report layout if there are very
few assets. For higher-volume situations, a better sort sequence is
by the name of the responsible party, and then by location code.
Asset Replacement Report

It is useful to have an asset replacement report that spotlights those
fixed assets most likely to require replacement in the near future.
The report matches indicators of wear and tear with the age and
recommended replacement ages of equipment. A sample of the re-
port is:
Maintenance
Trend
Asset
Tag Age Replacement Original
Description Number (years) Age (years)* 20X1 20X2 Cost
Deburring machine 03341 8 10 $900 $3,100 $25,000
Drill press 03325 11 15 500 1,500 18,000
Grinder 03329 10 10 850 2,700 40,000
Lathe 03350 5 10 -- 200 11,000
Notching machine 03339 9 10 2,000 3,500 12,000
Power shears 03347 6 5 400 800 8,000
Stamper 03352 3 5 200 200 39,000
* Recommended

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fixed asset. If tags are not used, then substitute a serial
number field instead.
• Asset age. This is the current date minus the acquisition
date, and is an indicator of replacement.
• Recommended replacement age. This is the manufacturer’s
recommended number of years of use before replacement.
This can be misleading if equipment is not heavily used
during its normal lifespan, since low utilization could
greatly prolong its usage period.
• Maintenance trend (two-year). This is the cost of mainte-
nance in each of the past two years, as compiled from the
records for parts usage and maintenance staff time. This
could be expanded to additional years if the information is
sufficiently useful.
• Original cost. The original cost of the asset is presumed to
be its replacement cost, though this may not be correct if
prices have since changed significantly, or if there is a need
for equipment having a different capacity level.

• Cost of replaced components. In some larger equipment, it
may be possible to replace a considerable number of com-
ponents, so that essentially only the housing is original
equipment. If so, it may be useful to aggregate the cost of
new components within a machine, which may indicate a
considerably prolonged asset life.
• Replacement cost. This is better than the original cost listed
in the basic report format, since it gives the reader a better
understanding of what it will cost to replace the asset.
However, it also calls for additional research, which may
not be a viable undertaking without a formal capital budg-
eting analysis.
This report is presented with a sort by machine description, but it

may also be useful to sort it either by asset age or maintenance
229
trend, with the oldest machines or those with the highest mainte-
nance costs listed at the top of the report.
Maintenance Report
From the perspective of the accountant, there are two primary
events in the life of a fixed asset that are worthy of documentation.
These are the initial purchase of the asset (as described in the Capi-
tal Budgeting Analysis chapter) and the replacement or sale of the
asset (as just described in the Asset Replacement Report). But
what about the expenses incurred in between? If fixed assets are
consuming a large part of a company’s potential profits in mainte-
nance costs, management should know about this. The following
report shows the division of maintenance costs between scheduled
and unscheduled costs, where the primary focus of the report is on
large unscheduled maintenance costs. The capacity utilization
shown in the report can be used as a leading indicator for unsched-
uled maintenance, since high utilization levels may be a cause of
unplanned equipment breakdowns.
Scheduled Unscheduled
Maintenance Maintenance Capacity
Description Cost Cost Utilization
Deburring machine $500 $400 70%
Drill press 1,200 -- 10%
Grinder 200 1,000 65%
Lathe 100 -- 45%
Notching machine -- -- 15%
Power shears 800 $3,000 98%
Stamper 300 -- 52%

• Scheduled maintenance cost. This is the cost of planned
maintenance, which is typically the maintenance required
or recommended by the manufacturer at normal mainte-
nance intervals. This cost should vary very little over time,
230
except when there are large overhauls planned at longer in-

tervals than the normal maintenance.
• Unscheduled maintenance cost. This is the cost of mainte-
nance that is unplanned, usually because the machine
failed. This can be a large expense, especially if overtime
or rush delivery charges are involved. It can also be an in-
dicator of a near-term machine replacement.
• Capacity utilization. This is the amount of machine usage
during the reporting period, as a percentage of the total
time available.

fixed asset, and may be needed if there are many similar as-
sets in the report.
• Bottleneck flag. This is a yes/no flag that indicates whether
an asset is considered a bottleneck, and therefore crucial to
the operations (and profitability) of the company. The flag
serves to focus attention on key assets.
• Reason code. It may be useful to include a reason code next
to the unscheduled maintenance cost column, which indi-
cates the reason why the cost was incurred.
It may be useful to run the unscheduled maintenance portion of

this report on a trend line, and bring the results to management’s
attention if there is a sudden or (especially) prolonged increase in
costs for a particular machine. This is a prime indicator that the
machine is either being operated at its maximum capacity, or that it
is approaching failure and requires replacement.
Summary
This chapter has addressed where to record accounting information
about fixed assets, as well as additional information about them in
a set of additional records and reports. The level of record keeping
that you wish to engage in will be driven by the cost of your fixed
assets – a large number of expensive assets that comprise the bulk
231
of the corporate assets should be a warning flag that you should be

engaging in a great deal of documentation! If not, the auditors will
have a difficult time verifying the existence and cost of your fixed
assets. On the other hand, if you have an asset-light corporation (as
is common in the services industries), the cost and number of fixed
assets may be so minimal that anything more than brief asset de-
scriptions could be a waste of time.
232
Review Questions
1. An asset class not normally used for fixed assets is:

a. Office equipment
b. Leasehold improvements
c. Repairs and maintenance
d. Furniture and fixtures
2. A data item of particular importance for equipment record

keeping is:
a. Useful life
b. Warranty period
c. Asset class
d. Cost
3. A data item not used in land record keeping is:

a. Useful life
b. Zoning classification
c. Easements
d. Assessed value
4. The depreciation report should include:

a. The amount of periodic depreciation
b. Location code
c. Responsible party
d. Bottleneck flag
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Review Answers
1. An asset class not normally used for fixed assets is:

a. Incorrect. Office equipment is a commonly used fixed
asset class.
b. Incorrect. Leasehold improvements is a commonly used
fixed asset class.
c. Correct. Repairs and maintenance is an expense ac-
count, and so is not used as a fixed asset class.
d. Incorrect. Furniture and fixtures is a commonly used
fixed asset class.
2. A data item of particular importance for equipment record

keeping is:
a. Incorrect. The useful life is generally used in all fixed
asset record keeping.
b. Correct. The warranty period is used to obtain sup-
plier-paid repairs or replacements for purchased equip-
ment.
c. Incorrect. The asset class is generally used in all fixed
asset record keeping.
d. Incorrect. Cost is generally used in all fixed asset record
keeping.
3. A data item not used in land record keeping is:

a. Correct. Land has no useful life, and so this informa-
tion is not tracked.
b. Incorrect. The zoning classification is used in land re-
cord keeping.
c. Incorrect. Easement information is included in land re-
cord keeping.
d. Incorrect. Assessed value is included in land record
keeping.
234
4. The depreciation report should include:

a. Correct. The amount of periodic depreciation.
b. Incorrect. The location code is used for physical audits
of fixed assets, not for depreciation calculations.
c. Incorrect. The responsible party data item is used to as-
sign responsibility for specific assets, and is not used in
depreciation calculations.
d. Incorrect. The bottleneck flag is used as an indicator of
how critical a machine is to the production process, and
is used in repair and maintenance reports.
235
Chapter 13
Introduction
The use of an adequate set of controls for fixed assets is manda-
tory, simply because of the amount of cash tied up in these assets.
If even a single fixed asset is improperly acquired, accounted for,
or disposed of, it can have a material adverse impact on a com-
pany’s financial results. Theft is also a major concern for high-
value assets that can be easily moved. Further, the ongoing and
natural deterioration of fixed assets over time virtually requires
that you keep an ongoing watch over this declining valuation, in
order to optimize the best time to dispose of them at the best price.
This chapter describes a number of controls that can assist with
these issues.
Controls for Fixed Asset Acquisition

The key focus of controls for the acquisition of key assets is to en-
sure that the company needs the assets. This means that controls
are designed to require an evaluation of how a proposed acquisi-
tion will fit into the company’s operations, and what kind of return
on investment it will generate. A secondary set of controls are also
needed to ensure that all acquisitions are forced to follow this re-
view process. With these goals in mind, consider using these con-
trols:
• Require an approval form. There should be an approval
form, such as the one shown in the Capital Budgeting
Analysis chapter, that requires an applicant to describe the
asset, how it is to be used, and the return on investment that
will be generated (if any). This standardizes the informa-
tion about each fixed asset, and also provides a handy sig-
nature form for various approvals.
• Require independent analysis of the approval form. Some-
one who is skilled in asset analysis should review each
submitted approval form. This analysis should include a
verification that all supporting documents are attached to

the form, that all assumptions are reasonable, and that the
conclusions reached appear to be valid. The person con-
ducting this analysis does not necessarily render an opinion
on whether to acquire the asset, but should point out any
flaws in the proposal. This person should not report to the
person who submitted the proposal, since that would be a
conflict of interest.
• Concentrate asset analyses in an annual review process.
When you review asset purchase requests at varying inter-
vals throughout the year, you have no basis of comparison
against other asset purchase proposals, and so will be less
likely to turn down the requests. A better approach is to
have a formal, annual review of these requests, where you
can compare and contrast them and see which ones make
the most sense. Though it may appear excessively bureau-
cratic, this approach can prevent a company from a number
of unnecessary expenditures.
• Require multi-level approvals for more expensive assets. If
an asset request is really expensive, impose a requirement
for a number of approvals by people in positions of increas-
ing levels of authority. Though clearly time-consuming, the
intent is to make a number of people aware of the request,
so that the organization as a whole will be absolutely sure
of its position before allowing a purchase to proceed.
• Focus more attention on rush requests. Someone may try to
avoid the usual review steps in order to obtain an asset right
now on a rush basis. These are precisely the sorts of situa-
tions where it may make sense to impose a tighter review,
since the rush nature of the purchase may be keeping peo-
ple from due deliberation of the alternatives available. The
exact nature of this control will vary under the circum-
stances, but the key point is to not eliminate all reviews and
approvals just because someone says that an asset must be
bought at once.
237
• Impose a mandatory waiting period. Though controversial,

it may make sense to impose a waiting period before any
asset is purchased, on the grounds that due deliberation
may reveal that some assets are simply not needed, and so
should not be bought. Taken to extremes, such a control
can result in an excessively plodding organization, so use it
with care.
The controls just noted are all very fine for preventing the wrong
assets from being purchased, but how do you keep someone from
circumventing them? Here are several prevention controls to con-
sider:
• Do not issue a purchase order without a signed approval
form. Train the purchasing staff to not order fixed assets
unless the requestor has a signed approval form. Better yet,
route all such purchase orders to a senior executive, such as
the chief financial officer, for approval.
• Reconcile fixed asset additions to approval forms. If asset
purchases are allowed without an authorizing purchase or-
der, then compare all additions listed in the fixed asset gen-
eral ledger accounts to the signed approval forms, to see if
any assets were bought without approval. This is an after-
the-fact control, since an asset will have already been
bought, but proper education of the responsible party can
prevent such purchases from happening again.
• Use prenumbered approval forms. Someone may try to
forge the signatures on an approval form, so consider using
prenumbered forms. Also, store them in a locked cabinet,
and keep track of all forms taken from the cabinet. This
control may be overkill – after all, the presumed penalties
for being caught with a forged approval form would likely
deter most people.
A final control that is quite useful for judging the accuracy of asset
purchase requests is to conduct a post-completion project analysis.
This analysis spots variations between the projections that manag-
238
ers inserted into their original asset purchase proposals and what
eventually transpired. There will always be differences between
these two sets of information, since no one can forecast results per-
fectly. However, you should look for patterns of egregious opti-
mism in the original purchase proposals, to determine which man-
agers are continually overstating their projections in order to have
their proposals approved. If you find problems, this may lead to a
variety of actions to keep a manager from repeating these actions
in the future.
The controls noted here will absolutely slow down the fixed as-
set acquisition process, and with good reason – part of their intent
is to encourage more deliberation of why an asset is being ac-
quired. Nonetheless, these controls will appear onerous to those
people trying to obtain assets that are relatively inexpensive, so it
is certainly acceptable to adopt a reduced set of controls for such
assets, perhaps simply treating them as accounts payable that re-
quire a single approval signature on a purchase order.
Similarly, you can consider a more streamlined set of controls
for assets that must be acquired at once. However, keep in mind
that some managers intent on subverting the system of controls can
characterize everything as a rush requirement, just to avoid the
usual reviews and approvals. Consequently, if you adopt a reduced
set of controls for such purchases, at least conduct an after-the-fact
review of the circumstances of these purchases, to see if the re-
duced controls were actually justified.
Controls for Fixed Asset Construction

Most fixed assets arrive in one shipment, are installed, and placed
in service in short order – quite possibly within a single accounting
period. However, others may require many months or even several
years to construct. In these later cases, you need an additional set
of controls to monitor expenditures over the course of the project,
which are:
• Assign a monitoring cost accountant. For a really large pro-
ject, there should be a designated person who is responsible
for tracking the costs accumulating against the project, and
239
reporting this information to management. The ideal person

for this task is a cost accountant, since this position is
trained in cost accumulation and analysis.
• Conduct milestone reviews. For longer-term asset installa-
tions, there should be a series of milestone events at which
the management team responsible for the project examines
expenditures to date, progress on the project, and any issues
relating to the remaining tasks to be completed. Though
rare, the team may occasionally use the information ob-
tained in this review to cancel the project entirely. A more
common response is a variety of adjustments to improve
the odds of successful completion within the cost budget.
Controls for Fixed Asset Theft

Fixed assets may have a considerable resale value, which makes
the more portable ones subject to theft. Here are several controls
that can be of assistance in preventing or at least mitigating asset
losses due to theft:
• Segregate fixed asset responsibilities. You are making it
much easier for an employee to steal an asset if you give
that person complete responsibility over all aspects of asset
purchasing, recordation, and disposal, since they can alter
documents at will. Consequently, the person who receives a
fixed asset should not be the same person who records the
transaction, while the person who disposes of an asset can-
not also record the sale. Further, the person who audits
fixed assets should not be involved with fixed assets in any
other way.
• Lock out the fixed asset master file. Depending on the na-
ture of your accounting systems, there may be a fixed asset
master file in which detailed information about every fixed
asset is kept. If someone were to steal a fixed asset, they
could cover all traces of the act by removing the asset from
the master file, or at least altering it. Consequently, you
should require password access to this file.
240
• Restrict access to assets. If some assets are especially valu-

able and can be easily removed from the premises, then re-
strict access to them with a variety of security card access
systems, gates, security guards, and so forth.
• Assign assets to employees. If you assign responsibility for
specific assets to employees, and tie some portion of their
annual performance appraisals to the presence and condi-
tion of those assets, then that represents a built-in asset
monitoring system. This control works best at the depart-
ment level, where department managers are assigned re-
sponsibility for the assets in their areas. You should create
a system that issues a periodic report to each responsible
person, detailing the assets under their control, and remind-
ing them to notify a senior manager if any assets are miss-
ing. Also, if you shift responsibility for assets from one
person to another, you need a process for doing so, where
the newly-responsible person formally evaluates the condi-
tion of the asset and takes responsibility for it.
• Look for duplicate serial numbers. Though rare, it is possi-
ble that employees may be stealing fixed assets from the
company and selling them back to the company through a
dummy corporation. To detect this, enter the asset serial
number in the fixed asset record for each asset, and then
run a report that looks for matching serial numbers. If you
find a duplicate number, this means that an asset was stolen
and sold back to the company.
• Conduct a fixed asset audit. Have an internal auditor con-
duct an annual audit of all fixed assets to verify where they
are located, the condition they are in, and whether they are
still being used.
Tip:
If the auditors search for every fixed asset in a company’s account-
ing records, the audit may be prolonged.
241
To shorten it, they should concentrate on the 20 percent of assets

that usually make up about 80 percent of the total cost of all fixed
assets, with a spot check of other assets falling outside this key
group.
• Affix an identification plate to all assets. Solidly affix an

identification plate to any fixed asset that can be moved, so
that you can clearly identify it. Better yet, engrave an iden-
tification number into the asset, which eliminates the risk of
someone removing the identification plate. Another alterna-
tive is to affix a radio frequency identification (RFID) tag
to each asset, so that they can be more easily located with
an RFID scanner. If you use any form of identification tag,
be sure to record the unique number on each tag in the ap-
propriate asset record, so that the information in the record
can be traced back to the actual asset.
• Link RFID tags to alarm system. Install an RFID scanner
next to every point of exit, which will trigger an alarm if
anyone attempts to remove an asset that has an RFID tag
attached to it.
Controls for Fixed Asset Valuation

Fixed assets gradually lose their value over time, so you need con-
trols to monitor what they are worth. The results of these controls
may lead to further actions, such as an impairment or the disposal
of an asset. The controls are:
• Conduct asset impairment reviews. Generally accepted ac-
counting principles mandate that you write down the book
value of a fixed asset if the value of the asset falls below its
book value. To do this, you need a regularly scheduled
valuation review, possibly involving the services of an out-
side appraisal firm.
Tip:
242
Asset impairment reviews can be quite expensive, both in terms of

staff time and the cost of appraisers, so only review the most ex-
pensive fixed assets. There is only a small potential valuation de-
cline in lower-cost assets, so there is no point in reviewing them.
The cutoff point for conducting an asset impairment review may be
much higher than the capitalization limit used to record fixed as-
sets. For example, the capitalization limit might be $5,000, while
the impairment review cutoff might be $100,000.
• Conduct asset disposition reviews. The goals of this review

are to decide whether a company continues to need a fixed
asset, and if so, how to obtain the highest price for it. If you
do not use this control, assets tend to remain on the prem-
ises long after they are no longer needed, and lose value
during that time. The best group for conducting this analy-
sis is the industrial engineering staff, since they are respon-
sible for the production layout, and most fixed assets are
located in this area.
• Use appraisers to value dissimilar exchanges. The account-
ing standards allow you to record a gain or loss on the dif-
ference in value of dissimilar assets if you exchange them
with a third party. Since fair value can be a matter of opin-
ion, this can result in the creation of an artificial gain or
loss. Consider using the valuation services of an outside
appraisal firm to eliminate this problem.
Tip:
Outside appraisal firms are expensive, and do not provide actual
value to a company that improves its profits. Instead, they simply
give an impartial and presumably expert opinion of asset values
that can be used to improve the accuracy of accounting records.
Consequently, if you have the choice of using an internal or exter-
nal appraisal, use the internal one for assets that cannot possibly
have a large valuation.
243
Any difference in value that an outside appraiser would provide

would not be worth the cost of their services in these cases.
Controls for Fixed Asset Depreciation

Depreciation calculation errors are extremely common, since there
are opportunities to incorrectly enter the asset amount, useful life,
salvage value, and depreciation method in whatever calculation
spreadsheet or software is being used. Here are several controls
that can mitigate this problem:
• Conduct separate review of master file additions. Have a
second person review any records added to the fixed asset
master file. This review should involve a comparison of the
amounts paid to the amount listed in the master file, to en-
sure that the amount being depreciated is correct. Also, ver-
ify that the asset classification in which each asset is placed
is the correct one, since this usually drives the depreciation
method used and the useful life over which it will be depre-
ciated. Further, verify that any salvage value used has been
properly substantiated. Finally, verify that the recorded as-
set location is correct, so that anyone attempting to locate
the asset in the future will be able to find it.
• Audit depreciation calculations. Have the internal audit
staff periodically review a selection of the depreciation cal-
culations, to see if an asset is being depreciated over the
correct useful life, with the correct depreciation method,
and with a verifiable salvage value. Errors will be more
common if this information is being maintained on an elec-
tronic spreadsheet, given the greater risk of manual errors
in this format.
• Send copy of disposal form to accounting. If there is an as-
set disposal form that must be filled out prior to the dis-
posal of a fixed asset, then route a copy of it to the account-
ing department, so that it can write off the asset and stop
recording a periodic depreciation charge for it.
244
Controls for Fixed Asset Disposal

There tends to be a considerable amount of fixed asset “leakage”
out of a company, especially for smaller and more mobile assets,
such as computers. In many cases, the resale value of these items
near the end of their useful lives is so small that a company may
very well be justified in giving them away to employees or simply
dropping them into the scrap bin. However, there may be a consid-
erable amount of residual value remaining in some assets, so con-
sider using the following controls to recapture some of that value:
• Conduct asset disposition reviews. The goals of this review
are to decide whether a company continues to need a fixed
asset, and if so, how to obtain the highest price for it. If you
do not use this control, assets tend to remain on the prem-
ises long after they are no longer needed, and lose value
during that time. The best group for conducting this analy-
sis is the industrial engineering staff, since they are respon-
sible for the production layout, and most fixed assets are
located in this area. [this control was also described earlier
as a valuation control]
• Require signed approval of asset dispositions. Create a
form that describes the asset to be disposed of, the method
of disposition, and the cash to be received (if any). The per-
son whose authorization is required could be a specialist in
asset disposition, or perhaps the purchasing manager, who
might have some knowledge of asset values. The point of
this control is to require a last look by someone who might
know of a better way to gain more value from a disposal.
• Monitor cash receipts from asset sales. Most fixed assets
are sold for cash, and sometimes for considerable amounts
of cash. Given the amount of funds involved, it can be quite
a temptation for employees to find ways to either not record
asset sales or falsify sale documents to record smaller sales,
and then pocket the undocumented cash. You can monitor
this by requiring that a bill of sale from the purchasing en-
tity accompany the documentation for each asset sale. It is
also useful to periodically audit asset sale transactions, if
245
only to show the staff that these transactions are being

monitored.
The Control of Laptop Computers

There are millions of laptop computers assigned to employees
throughout the world, and they represent a massive tracking prob-
lem for any accountant assigned to monitor them. They are moder-
ately expensive, easily damaged, difficult to track, and employees
routinely take them home at night. How do you impose controls
over them? The routine controls noted in this chapter do not work
for laptops, because those controls are primarily designed for liter-
ally “fixed” assets.
Laptops require an entirely different controls approach. The
key factors in designing a different control system for them are that
they have a cost that hovers at or below the normal capitalization
limit for most firms, and their values decline to near zero within
just a few years. With these points in mind, consider setting the
corporate capitalization limit somewhere above the laptop cost, so
that your asset records are not burdened with them. Second, assign
specific responsibility for each laptop to the employee to whom it
was issued, and tell them the corporate policy is to replace all lap-
tops every three years. Finally, give the old laptops to employees at
the time of replacement. The laptops very likely have minimal
value after three years anyways, so the company loses nothing by
giving them away. Also, since the employees know they will soon
own these laptops themselves, they will be much more inclined to
safeguard them.
This approach makes for a vastly easier control environment
for the accountant, probably reduces the likelihood of damage to
laptops, and makes employees extremely happy.
Summary
This chapter has outlined a large number of fixed asset controls. It
requires a considerable amount of judgment to decide how many of
them to use, since an excessive level of control is burdensome,
while minimal controls lead to profligate spending and lost assets.
246
The answer to this conundrum usually lies in the nature of the as-
sets themselves. For example, a hydroelectric company is incredi-
ble unlikely to lose its turbines, and so can dispense with most of
the controls related to asset theft for those items. On the other
hand, given the massive cost of turbines, it needs an exceptional
level of control over its purchases. Conversely, a company whose
only fixed assets are laptop computers should seriously consider
treating them as office supplies, given how difficult it would oth-
erwise be to keep track of them, and how inexpensive they are to
replace. Thus, you must tailor controls to the circumstances.
Tip:
This chapter has made it clear that you can implement quite a large
number of controls over fixed assets. If you were to apply the same
controls over all fixed assets, the administrative burden would be
considerable. To reduce it, consider increasing the capitalization
limit (the cost at which you begin recording an expenditure as an
asset, rather than an expense) to the highest possible point. While
this will result in more expenditures being charged to expense in
the short term, it also reduces the administrative burden imposed
by the control system.
247
Review Questions
1. You would impose a mandatory purchase waiting period in or-

der to:
a. Negotiate better terms with the supplier
b. Avoid early depreciation of the asset
c. Allow more time for deliberation about the need for a
requested asset.
d. Wait for the next scheduled board meeting
2. A good control over the construction of a fixed asset is:

a. To look for duplicate serial numbers
b. To send a copy of the disposal form to accounting
c. A milestone review
d. To focus more attention on rush requests
3. When you conduct a physical count of fixed assets, which of

these activities would you not perform?
a. Verify the location of assets
b. Verify the condition of assets
c. Ascertain whether the assets are being used
d. Review their purchase documentation
4. Control over laptop computers should not include:

a. Setting the capitalization limit above their cost
b. Assigning responsibility for them to their users
c. Giving the laptops to employees after a fixed period of
time
d. Setting the capitalization limit below their cost
248
Review Answers
1. You would impose a mandatory purchase waiting period in or-

der to:
a. Incorrect. The negotiation of better supplier terms
should be independent of a delay in the purchase.
b. Incorrect. You would avoid early depreciation of an as-
set by delaying its purchase, but this also delays your
productive use of the asset, which is presumably harm-
ful to the company.
c. Correct. Allow more time for deliberation about the
need for a requested asset.
d. Incorrect. Waiting for the next scheduled board meeting
would only apply if a fixed asset was sufficiently ex-
pensive to require the approval of the board.
2. A good control over the construction of a fixed asset is:

a. Incorrect. A duplicate serial number search is a control
over the theft of fixed assets.
b. Incorrect. Sending a copy of the disposal form to ac-
counting is a control for depreciation calculations.
c. Correct. A milestone review is a good control over the
construction of a fixed asset.
d. Incorrect. Focusing more attention on rush requests is a
control over the initial purchase of fixed assets.
3. When you conduct a physical count of fixed assets, which of

these activities would you not perform?
a. Incorrect. Verifying the location of assets is a standard
physical count task.
b. Incorrect. Verifying the condition of assets is a standard
physical count task.
c. Incorrect. Ascertaining whether assets are being used is
a standard physical count task.
d. Correct. You would not review purchase documenta-
tion as part of a physical count of fixed assets.
249
4. Control over laptop computers should not include:

a. Incorrect. Setting the capitalization limit above the cost
of laptop computers reduces the administrative burden
on the accounting staff.
b. Incorrect. You should assign responsibility for laptops
to their users, so they are more likely to take care of
them.
c. Incorrect. Giving laptops to employees after a fixed pe-
riod of time will give employees a strong incentive to
take care of them.
d. Correct. Setting the capitalization limit below the cost
of laptops increases the administrative burden for the
accounting staff, and so is not a cost-effective control.
250
Chapter 14
Introduction
There are a number of possible transactions that can potentially be
generated over the useful life of a fixed asset, ranging from the ini-
tial budgeting for it to its eventual disposal. Given the significant
cost of fixed assets, you should adhere to a carefully-defined set of
policies and procedures for these transactions, so that you only ac-
quire those assets really needed, account for them correctly, and
eliminate them only when it makes economical sense to do so.
Without the policies and procedures listed in this chapter, you will
have a heightened risk of investing in assets that you do not need,
or of accounting for them incorrectly.
Capital Budgeting Policies and Procedures

There is a considerable need for policies and procedures in the area
of capital budgeting, since this is a major control point over fixed
assets into which all purchase requests must be funneled. If you do
not impose policies and procedures here, then there is a heightened
risk of unauthorized fixed asset purchases being made. There are
two key policies to enforce, one requiring the use of a review proc-
ess, and the other establishing a capitalization limit, which defines
the minimum asset cost that must undergo the review. They are:
Policy: Employees must submit a capital budgeting request for any as-
set purchase exceeding the corporate capitalization limit.
Policy: The corporate capitalization limit is $____. Any expenditure

above this amount where the asset has a useful life of at least one year
is to be classified as a fixed asset, while all other expenditures are to be
charged to expense in the period incurred.
Once a fixed asset is approved through the capital budgeting proc-

ess, you may still elect to add a specific approval limit for a pur-
chase transaction, thereby adding another layer of control to the

system of acquisition. Such a policy might be:
Policy: An asset that has been approved through the capital budget can
be authorized for purchase by the responsible manager if it is equal to
or less than $____, and by the chief financial officer if it is greater than
this amount.
In addition to these baseline policies, you could consider using the

following policy, which requires senior management to periodi-
cally review the size of the capitalization limit. Ideally, you want
to set a level that balances the volume of fixed asset record keeping
with charging an excessive amount to expense.
Policy: The corporate capitalization limit shall be reviewed at intervals

of __ year(s).
It is highly advisable to have a strong system in place for review-

ing the results of fixed asset purchases, so that senior management
can review and act upon any flaws in the capital budgeting process
that are causing inappropriate purchases to be made, or to spotlight
those managers who consistently overestimate projected results in
their capital budgeting proposals. The following policy is designed
to trigger such reviews.
Policy: The results of all capital purchases in excess of $_____ shall be

reviewed and reported to management within __ months of final instal-
lation.
There should be two procedures for users of the capital budgeting

process. One procedure contains instructions for how to complete
the capital budgeting application form, and is highly recommended
if the application process is complex. A sample procedure is:
1. Obtain a capital budgeting application form from the
budget analyst.
2. Complete the project name and description in the header
fields of the form. Leave the submission date and project
252
number fields blank (the budget analyst will complete these

fields for you).
3. Itemize both the initial cash flows required for the project
and any subsequent cash flow changes resulting from it,
aggregated by year. You should include expenditures for
the purchase of the requested asset, as well as the cash flow
impact of any changes in working capital (particularly in-
ventory), incremental changes in gross profits, and the im-
pact of any changes in depreciation on income taxes.
4. Fully document any legal or risk mitigation reasons for ac-
quiring the asset, as well as the date by which the company
will be out of compliance if it does not make the invest-
ment.
5. Note the change in throughput at the bottleneck operation
and any change in operating costs that is tied to the pro-
posed investment.
6. Note the net present value associated with the proposed in-
vestment, and attach a detailed derivation of the net present
value. Contact the budget analyst for the discount rate and
tax rate to use in the net present value calculation.
7. Attach to the proposal a detailed itemization of all cash
flow estimates related to the asset, as well as your assump-
tions regarding changes in revenues, profit margins, tax
rates, and other business conditions that may alter the out-
come of owning the asset.
8. Obtain the approval signature of the department manager
who will be responsible for the asset.
9. Forward the completed form to the budget analyst.
The other procedure for the capital budgeting process is oriented

toward the analyst who reviews completed capital budgeting appli-
cation forms. It is more general in nature, and is designed to give
the analyst guidelines for how to review an application, as well as
specific issues to address. A sample procedure is:
1. Upon receipt of a completed capital budgeting application
form, assign a project number to it and fill in the project
253
number and submission date fields in the header section of

the form.
2. Review the form to see if any fields have not been com-
pleted, or have been insufficiently completed. If there are
issues, contact the submitter and go over the information
that is missing. Hold any further review until the applica-
tion has been re-submitted.
3. Review the calculations that accompany the application to
verify that they are correct, and verify that the totals in the
supporting documentation are used in the lead page of the
application.
4. Review all assumptions noted in the supporting documenta-
tion to see how they compare to the assumptions used in
other applications, both currently and in the recent past. If
the assumptions vary significantly from those used else-
where, contact the submitter for justification.
5. Review all cash flow projections with the submitter, as well
as the purchasing, engineering, and sales departments to see
if the amount and timing of the projected cash flows are
reasonable.
6. Review the post implementation reviews of projects that
were previously submitted by the same person, and note in
the application if this person has a history of projecting re-
sults that cannot be realized, as well as the extent of these
variances.
7. If the project appears to have a high degree of risk, then
note this issue in the application, and discuss with the con-
troller whether you should apply a higher discount rate to
the net present value calculation to incorporate risk more
fully into the cash flows associated with the application.
8. Following your review, and any adjustments by the submit-
ter, evaluate whether you believe the application should be
approved, and state your recommendation in the applica-
tion, along with your reasons.
9. Copy the application and store the copy.
254
10. Forward the original of the application to the next person

on the approval list, and request that it be returned to you
following that person’s review.
11. Monitor the progress of the approvals through the com-
pany, and shift the document to the next approver as
needed.
12. If the application is rejected, communicate this information
to the submitter, as well as the reasons why it was rejected.
13. If the application is approved, communicate this informa-
tion to the submitter, and forward the approval to the ac-
counting and purchasing departments.
It is highly advisable to conduct a post installation review to see if

an approved project has generated the results predicted in the
original capital budgeting application. This procedure is intended
for the budget analyst, and so can be quite specialized, with refer-
ences to specific types of analysis to conduct. You may find that
the following procedure will require significant alterations to meet
the needs of your business:
1. Once a fixed asset has been installed for at least ____
months, schedule a post implementation review.
2. Compare the business assumptions detailed in the applica-
tion to actual business conditions, and quantify how these
changes impacted the result of the project.
3. Compare the forecasted expenditures in the application to
actual expenditures, and investigate why any additional ex-
penditures were needed.
4. Compare the forecasted positive cash flows in the applica-
tion to actual positive cash flows, and investigate any sig-
nificant variances.
5. Compare the forecasted changes in throughput with actual
results, and investigate any significant variances.
6. Validate with corporate counsel any legal reasons given for
an asset purchase, and whether that legal basis for the deci-
sion has since changed.
255
7. Validate with the corporate risk manager any risk-related

reasons given for an asset purchase, and whether this basis
for the decision has since changed.
8. Route a preliminary copy of your findings to the project
sponsor for comments, and add his comments to your find-
ings.
9. Forward a summary of your findings to the senior man-
agement team, along with any recommendations regarding
how to improve the capital budgeting process in the future.
10. If necessary, conduct another analysis at a longer interval,
such as annually, to see if the project results have changed.
Asset Recognition Procedures

One of the areas in which a procedure can be quite useful is for the
initial recognition of a fixed asset in your accounting system. This
involves not just capitalizing the cost of the asset, but also creating
a permanent record for each asset. We deal with these issues with
several procedures. The first is for the initial recognition of the cost
of the asset in your accounting system, as follows:
1. Determine the base unit for the asset. This determination is
based upon a number of factors, such as whether the useful
lives of various components of the asset are significantly
different, at what level you prefer to physically track the
asset, and the cost-effectiveness of tracking assets at vari-
ous levels of detail. Reviewing the base units used for other
assets may assist in this determination. Consult with the
controller as needed. (see the Initial Fixed Asset Recogni-
tion chapter for more information about base units)
2. Compile the total cost of the base unit. This is any cost in-
curred to acquire the base unit and bring it to the condition
and location intended for its use. These activities may in-
clude the construction of the base unit and related adminis-
trative and technical activities.
3. Determine whether the total cost of the base unit exceeds
the corporate capitalization limit. If it does not, then charge
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the expenditure to expense. Otherwise, continue to the next

step.
4. Assign the base unit to the most appropriate asset class for
which there is a general ledger category (such as furniture
and fixtures, office equipment, or vehicles).
5. Record a journal entry that debits the asset account for the
appropriate asset class and credits the expenditure account
in which the cost of the base unit had originally been
stored.
If you always purchase and install fixed assets quickly, then you do
not need a procedure for interest capitalization. However, if there
are situations where you are constructing an asset over a prolonged
period of time, consider adding the following procedure:
1. Construct a table that includes the amounts of expenditures
made during a construction period and the dates when the
expenditures were made.
2. Determine the date on which interest capitalization ends,
which should be the date on which the asset has been
brought to the condition and location intended for its use.
3. Calculate the capitalization period for each expenditure,
which is the number of days from the expenditure to the
end of the interest capitalization period.
4. Calculate the capitalization rate, which is the interest rate
applicable to the company’s borrowings during the con-
struction period. If you have incurred a specific borrowing
to finance the asset, then use the interest rate on that bor-
rowing.
5. Multiply the capitalization rate by each expenditure, and
multiply the result by the fraction of a year represented by
the capitalization period for each expenditure, to arrive at
the interest to be capitalized for that expenditure.
6. If the total calculated interest capitalization is more than the
total interest cost incurred by the company during the cal-
culation period, then only capitalize the total interest cost
incurred by the company during the calculation period.
257
7. Record the interest capitalization as a debit to the project’s

fixed asset account and a credit to the interest expense ac-
count.
The next procedure addresses the creation of an asset record. The

record format you use may be similar to one of the formats listed
in the Fixed Asset Record Keeping chapter, or you may have a
more customized format that more closely matches the needs of
your business. The exact information listed in this procedure will
vary, depending on the information that you want to record. The
following procedure is designed to create a record for a manufac-
turing asset:
1. Create a new record for the ____ asset and assign the next
sequential record number to this document.
2. Describe the asset in one sentence. If this asset is similar to
other company assets, then use the same description format.
Otherwise consider using a manufacturer-provided descrip-
tion.
3. List the number on the company-provided tag (if any) af-
fixed to the equipment. If no tag was used, enter “No Tag.”
4. Enter the manufacturer-provided serial number on the
equipment. If you cannot find the serial number, contact the
manufacturer to find out where it should be located. If there
is no serial number, enter “No Serial Number.”
5. Note the location of the asset. Where possible, specify the
location at least by building, and preferably by room. If it is
located in the production area, specify the work center in
which it is located.
6. State the name or at least the position title of the person
who is responsible for the asset.
7. State the month and year on which the asset was ready for
its intended use, whether or not it was actually used as of
that date.
8. Note the total initial capitalized cost of the asset. This
should match the amount recorded in the general ledger or
fixed asset journal for the asset. Do not use the amount
258
listed on the supplier invoice, since other costs may also

have been added.
9. Assign the asset to an asset class by comparing its charac-
teristics to the standard asset classes used by the company.
If in doubt, review related assets to determine the classes to
which they were assigned.
10. State the useful life of the asset. You should use the desig-
nated useful life for the asset class into which the asset has
been categorized. If the manufacturer recommends a sub-
stantially different useful life, then discuss with the control-
ler whether you should create a new asset class for the as-
set, or to depart from the standard useful life used for the
asset class to which you have assigned the asset.
11. State the warranty period. This may be a standard warranty
provided by the manufacturer, or an extended warranty that
the company purchased.
12. List the manufacturer’s contact information. This may in-
clude the e-mail, telephone, and address for the supplier’s
field servicing, customer service, warranty, and sales de-
partments.
13. Present the record to the controller, who should review and
approve it. Correct any issues noted by the controller.
14. Following approval, print the asset record and store it by
asset class and then by record number in the fixed asset re-
cord binder.
You can use the preceding procedure for equipment record keeping
as the basis for a procedure for a variety of other types of fixed as-
set records.
Asset Revaluation Policies and Procedures

Under IFRS, you are allowed to revalue fixed assets, but only for
entire asset classes – you cannot selectively revalue some assets
and not others within the same asset class. If you intend to use re-
valuation, consider using the following policy, which specifies
which classes are to be revalued:
259
Policy: The company will use the revaluation model to adjust the carry-
ing amount of its fixed assets in the ____, ____, and ____ asset classes.
It will use the cost model for the carrying amount of all other fixed as-
set classes.
Use the following procedure to revalue fixed assets:

1. Consult the asset class revaluation schedule to determine
when the next revaluation is to be completed.
2. Run a detailed schedule of the fixed assets within the asset
classes to be revalued.
3. Hire an independent appraiser to conduct the revaluations,
and forward the detailed schedule to the appraiser.
4. In cases where the appraiser is unable to derive a market
valuation, use estimates of future cash flows associated
with the assets in question, discounted to their present val-
ues. Use the company’s incremental cost of capital as the
discount rate.
5. If there is an upward revaluation adjustment, debit the fixed
asset account for the amount of the incremental increase
and credit a gain in other comprehensive income. If the in-
crease reverses a revaluation decrease for the same asset,
then recognize the gain in profit or loss to the extent of the
previous loss, and record any remaining gain in other com-
prehensive income.
6. If there is a downward revaluation adjustment, recognize
the loss in profit or loss with a debit, and credit the fixed
asset account. If the decrease reverses a previous revalua-
tion increase for the same asset, then recognize the loss in
other comprehensive income to the extent of the previous
gain, and record any remaining loss in profit or loss.
7. If there is a revaluation adjustment, eliminate all existing
accumulated depreciation by debiting the accumulated de-
preciation account and crediting the offsetting amount to
the fixed asset account.
8. If there is a revaluation adjustment, examine the deprecia-
tion schedule being used for the asset to see if its useful
life, depreciation method, or salvage value should be
260
changed. Because of the change in the carrying amount of

the asset caused by the revaluation, the amount of prospec-
tive depreciation expense recognized per period should
change, even in the absence of any other changes in as-
sumptions.
Asset Exchange Policies and Procedures

The exchange of assets between entities is relatively rare, so com-
panies tend to address them on an ad hoc basis, rather than formu-
lating specific policies and procedures. If there is any expectation
of even an occasional asset exchange, you should consider formal
documentation of the process, so that you account for them consis-
tently.
A good starting point for a formalized asset exchange system is
a policy that requires an outside appraisal of every received asset
over a certain estimated value. You should set the minimum level
in order to avoid wasting money on too many appraisals. The first
of the two policies shown below sets a minimum estimated value,
but this can admittedly be difficult when the whole point of the ap-
praisal is to determine that value. Accordingly, you could consider
the second policy, which instead restricts the appraisal to certain
asset classes. The assumption in this later case is that the asset val-
ues in certain asset classes are significantly higher, and so should
be appraised.
Policy: An independent appraiser shall determine the value of assets

received as part of a non-monetary exchange, if the estimated value of
the assets received exceeds $____.
Policy: An independent appraiser shall determine the value of assets

received as part of a non-monetary exchange if the assets received are
to be aggregated into either the buildings, land, production equipment,
or vehicles asset classifications.
If you acquire a fixed asset through a non-monetary exchange, then

use the next procedure to arrive at the proper recorded cost for it:
261
1. The cost of the asset received is the fair value of the asset
you have surrendered to the other party. Recognize a gain
or loss on the difference between the recorded cost of the
asset surrendered and the asset received.
2. If you cannot determine the fair value of the asset surren-
dered, then instead use the fair value of the asset received.
Recognize a gain or loss on the difference between the re-
corded cost of the asset surrendered and the asset received.
3. If you cannot determine the fair value of either asset, then
record the cost of the asset received at the cost of the asset
surrendered.
4. If the asset exchange involves the payment of cash that is
25 percent or more of the fair value of the exchange, then
recognize the transaction at its fair value, using either steps
1 or 2 in this procedure.
5. If the asset exchange involves the payment of cash that is
less than 25 percent of the fair value of the exchange, then
(if you are the recipient of the cash) record a gain to the ex-
tent that the amount of cash received exceeds a proportion-
ate share of the cost of the surrendered asset. If the transac-
tion results in a loss, then record the entire loss at once. If
you are paying the cash, then record the asset received at
the sum of the cash paid plus the cost of the asset surren-
dered.
Depreciation Policies and Procedures

If the accounting staff is pressured to report altered earnings (either
up or down), one way to do so is to alter the useful lives, salvage
values, and depreciation methods used to derive the depreciation
expense. To keep this from happening, there are a variety of poli-
cies that restrict the use of several techniques that can alter report-
ing earnings. For example:
Policy: Salvage value shall be set at zero for all depreciation calcula-
tions, unless the expected amount of salvage value is at least $____.
262
The preceding policy keeps the accounting staff from deferring

depreciation by assuming that assets will have salvage values.
Policy: All fixed assets shall be assigned to one of the following asset
classes, and their useful lives and depreciation methods shall conform
to the classes to which they are assigned.
Asset Class Useful Life Depreciation Method

Computer equipment 3 years Straight line
Furniture and fixtures 7 years Straight line
Leasehold improvements Life of lease Straight line
Office equipment 5 years Straight line
Vehicles 5 years Straight line
The preceding policy is highly recommended, and is used to keep

the accounting staff from assigning special useful lives or depre-
ciation methods to specific assets.
Policy: The mid-month convention shall not be used when recording

the depreciation for any fixed asset.
The preceding policy eliminates the use of a half-month of depre-

ciation during the first and last months of depreciation for a fixed
asset, which reduces the computational complexity of depreciation
calculations.
If you are charging a natural resource asset to expense through
a depletion calculation, you should periodically re-evaluate the es-
timate of the remaining amount of the natural resource to be ex-
tracted. The following policy controls the timing of this re-
evaluation:
Policy: The remaining recoverable quantity of any natural resources re-

corded as assets shall be reviewed at least once a year, as well as when-
ever the circumstances indicate a significant change in the most current
estimate.
You should adopt a detailed depreciation procedure that specifies

exactly how to categorize each fixed asset and how you should de-
263
preciate it based on the asset class to which you assign it. The pro-
cedure for setting up depreciation for an individual fixed asset is:
1. Match the fixed asset to the company’s standard asset class
descriptions listed in the policies and procedures manual. If
you are uncertain of the correct class to use, examine the
assets already assigned to the various classes, or consult
with the controller.
2. Assign to the fixed asset the useful life and depreciation
method that are standardized for the asset class of which it
is a part.
3. Consult with the purchasing or industrial engineering staffs
to determine whether the asset is expected to have a salvage
value at the end of its useful life. If this salvage value ex-
ceeds the company’s policy for minimum salvage values,
make note of it in the depreciation calculation.
4. Create the depreciation calculation based on the useful life
and depreciation mandated for the asset class, using the as-
set cost less any salvage value.
The preceding procedure is based on the assumption that you are

not using an integrated fixed asset software package that automati-
cally creates a deprecation calculation when you have recorded the
baseline data for a new asset. This procedure assumes that you are
calculating depreciation separately (probably on an electronic
spreadsheet), and so have to determine the correct depreciation
type and duration for each individual asset.
The procedure thus far has only addressed the calculation of
depreciation for a single fixed asset. Once each calculation is set
up, you will not need to address it again until either the end of the
useful life of the asset or when there is a change in estimate. How-
ever, you also need to deal with the aggregation of the depreciation
for all fixed assets into a periodic journal entry, which is addressed
in the following procedure:
1. Print the monthly depreciation report, sorted by asset class.
2. Compare the depreciation totals to the trend line of depre-
ciation for the preceding periods to look for any unusual
264
changes. Investigate and verify the calculations causing any

such changes.
3. Scan the report to see if fixed assets appear to be assigned
to the correct asset classes. Investigate and correct as nec-
essary.
4. Create the monthly depreciation journal entry, using the
standard depreciation template. The standard entry is to re-
cord a debit for the depreciation expense [in total or by de-
partment], and to record a credit to the accumulated depre-
ciation account for each asset class. This information
comes from the totals on the depreciation report.
5. Enter the journal entry into the accounting software.
6. Attach the depreciation report to the journal entry form and
file it in the journal entries binder.
The preceding procedure assumes that you have a relatively small

number of fixed assets, so that a brief review and comparison of
assets as part of the depreciation calculation is cost-effective. If
there are many fixed assets, then skip the step to verify asset class
assignments, and leave that task for the internal audit team or ac-
counting staff to conduct at another time.
If you are using depletion to charge the cost of a natural re-
source to expense, the calculation is somewhat different from the
normal depreciation procedure, as shown below:
1. Compute the depletion base, which includes the acquisi-
tion, exploration, development, and restoration costs asso-
ciated with the asset.
2. Compute a unit depletion rate by subtracting the salvage
value of the asset from its depletion base and dividing it by
the total number of measurement units that you expect to
recover.
3. Calculate the depletion to charge to expense by multiplying
the actual units of usage by the unit depletion rate.
4. Record the depletion expense with a debit to depletion ex-
pense and a credit to the accumulated depletion contra ac-
count.
265
Impairment Policies and Procedures

Both GAAP and IFRS require that you periodically review fixed
assets for impairment. This should be a formal, documented proc-
ess that steps the user through the specifics of the required testing.
You can use the following policy to set the timing for impairment
testing, as well as to limit the number of assets that are subject to
the testing:
Policy: All fixed assets having a gross carrying amount greater than
$____ shall be tested for impairment at least once a year, or when it ap-
pears that the carrying amount may not be recoverable.
The following procedure describes the basic steps to follow when

reviewing fixed assets for possible impairment:
1. Sort the fixed asset register in declining order by net carry-
ing amount (i.e., gross cost less accumulated depreciation
and accumulated impairment).
2. Select for testing any fixed assets having a net carrying
amount greater than $____. Export these items to a spread-
sheet.
3. Determine the sum of the undiscounted cash flows ex-
pected from each asset over its remaining useful life and fi-
nal disposition, and add this amount next to each asset in
the spreadsheet.
4. If the cash flows total is less than the net carrying amount,
then the difference is an impairment. Note this amount in
the spreadsheet.
5. Forward the spreadsheet to the controller, who will review
and approve the calculations. The controller authorizes a
journal entry to reduce the net carrying amount of the asset
to its fair value, as represented by the remaining cash flows.
6. If impairment was recorded for an asset group, then appor-
tion the impairment amount among the assets in the group
on a pro rata basis that is based on the carrying amounts of
the assets.
266
7. Adjust the remaining depreciation on the asset(s) to reflect

its (their) reduced carrying amount.
Asset Retirement Obligation Policies and Procedures

There is an obligation to record a liability for any asset retirement
obligations, particularly under GAAP. This is an area that the ac-
counting staff may miss, since it does not involve an up-front ex-
penditure that would appear in the accounts payable system. Ac-
cordingly, consider using the following policy to force the account-
ing staff to consider the need for an asset retirement obligation.
Policy: There shall be a formal evaluation of the need for an asset re-
tirement obligation at the initial recognition of all fixed assets in the
____ asset classes. You shall also evaluate adjustments to these obliga-
tions at least annually, or whenever the circumstances indicate a poten-
tial change in the obligation.
Use the following procedure to initially account for an asset re-

tirement obligation:
1. Determine whether there is an obligation to engage in asset
retirement expenditures at the end of the useful life of the
asset under review.
2. Estimate the number of years before which the company
will engage in asset retirement activities and incur related
expenditures.
3. Estimate the timing and amounts of the cash flows associ-
ated with any required asset retirement obligations. If there
are a range of probabilities, incorporate them into a
weighted-average estimate of cash flows.
4. Calculate the credit-adjusted risk-free rate.
5. Discount the estimate of cash flows to their present value
using the credit-adjusted risk-free rate.
6. Record the present value of the asset retirement obligation
as a credit to the asset retirement obligation liability ac-
count, and a debit to the fixed asset account to which the
obligation relates.
267
7. Create a table for this initial liability layer that shows in-
creases in the carrying amount of the liability over time,
with the incremental increases attributed to accretion ex-
pense. Include in the table the straight-line depreciation of
the initial carrying amount of the liability.
8. Using the information in the table, set up accretion expense
as a debit to the accretion expense account and a credit to
the asset retirement obligation liability. Also, record the
depreciation expense as a debit to the depreciation expense
account and a credit to the accumulated depreciation ac-
count.
Intangible Asset Policies and Procedures

Most policies and procedures that apply to tangible fixed assets
should also apply to intangible assets. One area that requires addi-
tional accounting effort is the proper valuation of an intangible as-
set, which is an area persistently targeted by auditors. You may
consider using the following policy, which incorporates the input
of the auditors into the initial valuation of intangible assets,
thereby reducing the risk of an auditor-mandated change in valua-
tion at a later date:
Policy: The company’s external auditors shall be apprised of the meth-

odology used to assign values to intangible assets at the time of initial
asset recognition, as well as the amount to be recognized.
Under IFRS, you are allowed to revalue intangible fixed assets un-
der very limited circumstances. Use the following procedure to re-
value such assets:
1. Consult the asset class revaluation schedule to determine
when the next revaluation is to be completed.
2. Run a detailed schedule of the intangible assets within the
asset classes to be revalued.
3. Hire an independent appraiser to conduct the revaluations,
and forward the detailed schedule to the appraiser.
268
4. In cases where the appraiser is unable to derive a market

valuation by reference to an active market, you cannot re-
value the intangible asset. Stop any additional revaluation
activities for these assets.
5. If there is an upward revaluation adjustment for those
qualifying intangible assets, debit the fixed asset account
for the amount of the incremental increase and credit a gain
in other comprehensive income. If the increase reverses a
revaluation decrease for the same asset, then recognize the
gain in profit or loss to the extent of the previous loss, and
record any remaining gain in other comprehensive income.
6. If there is a downward revaluation adjustment for those
qualifying intangible assets, recognize the loss in profit or
loss with a debit, and credit the fixed asset account. If the
decrease reverses a previous revaluation increase for the
same asset, then recognize the loss in other comprehensive
income to the extent of the previous gain, and record any
remaining loss in profit or loss.
7. If there is a revaluation adjustment, eliminate all existing
accumulated amortization by debiting the accumulated am-
ortization account and crediting the offsetting amount to the
intangible fixed asset account.
8. If there is a revaluation adjustment, examine the amortiza-
tion schedule being used for the intangible asset to see if its
useful life should be changed. Because of the change in the
carrying amount of the asset caused by the revaluation, the
amount of prospective amortization expense recognized per
period should change, even in the absence of any other
changes in assumptions.
Transfer Policies
In a larger company with multiple locations, it is possible that
some fixed assets may be transferred among the various locations.
If so, it becomes difficult for the accounting department to keep
track of the assets, which in turn makes it difficult for the auditors
to verify that they exist. This is a lesser issue in smaller, one-
269
location companies. If you find it necessary to formally document

the transfer of fixed assets, consider using the following policy:
Policy: The written approval of both the issuing and receiving manag-
ers are required for the transfer of fixed assets. These managers are de-
fined as the persons who are relinquishing and accepting responsibility
for the transferred assets, respectively. The accounting department shall
be notified of all fixed asset transfers.
Disposal Policies and Procedures

There is a significant risk of fraud in the disposal of fixed assets,
for employees may be able to sell assets without the approval of
senior management, as well as pocket the proceeds. There should
be a strict procedure in place for the disposal of fixed assets, which
is supported by the following policy:
Policy: The approval of the chief financial officer is required for all as-
set dispositions with a gross book value equal to or less than $____.
The approval of the chief executive officer is required for all asset dis-
positions with a gross book value of greater than $____.
The disposal of an asset may require the participation of a number

of employees in the accounting and purchasing departments, so a
broad-based disposal procedure may require the use of several
smaller procedures that are linked together to provide comprehen-
sive coverage of the transaction. The following procedure assumes
that a company is relatively small, so that only a few people are
involved. It is written from the standpoint of a person in the ac-
counting department.
1. Upon notification that an asset is to be sold or otherwise
disposed of, send an asset disposal form to the person re-
sponsible for that asset, with instructions for how to com-
plete it.
2. When the responsible person returns the form, verify that a
designated manager has signed the form to indicate ap-
proval of the proposed transaction.
270
3. Forward the approved disposal form to the purchasing de-

partment, which handles the disposal.
4. Upon disposal of the asset, the purchasing manager signs
the disposal form and returns it to the accounting depart-
ment, along with a bill of sale and check payment (if sold),
or a receipt from a charitable organization, or disclosure of
any other disposal method.
5. If the asset was sold, forward the check payment and the
bill of sale to the controller. The controller removes the as-
set from the general ledger, along with all associated accu-
mulated depreciation, and records a gain or loss on the sale.
The controller also notifies the fixed asset clerk to note the
disposal in the detail record for the asset, and forwards the
check to the cashier for inclusion in the daily bank deposit.
6. The controller files a copy of the journal entry and support-
ing documentation in the journal entry binder.
Record Keeping Policies

There is a tendency to engage in the minimum amount of record
keeping for fixed assets, usually just sufficient to record the
amounts required under either GAAP or IFRS: the initial cost, as-
set retirement obligations (under GAAP), depreciation, impair-
ment, revaluation (under IFRS), and derecognition. However, this
level of record keeping ignores a number of other issues, such as
who has responsibility for each asset, where it is located, its condi-
tion, and any active warranties. You can address this issue at a
general level with the first of the following two policies, or in more
detail with the second policy. The second version is perhaps too
detailed for a policy, but has the advantage of mandating very spe-
cific types of record keeping.
Policy: A detailed accounting and condition record shall be created and

maintained for each fixed asset acquired.
Policy: A detailed record shall be created and maintained for each fixed
asset acquired, which shall include information about the assessed
value, classification, cost, depreciation method, easements, impairment,
271
location, supplier, useful life, warranties, and zoning associated with

the asset.
If you are concerned about the risk of loss to key fixed asset re-
cords, you might also consider the following policy, which man-
dates off-site storage for certain types of records.
Policy: Original title documents shall be stored in certified fire-proof

bank vaults. Copies of purchase and disposal documents shall be main-
tained in off-site fire-proof storage facilities.
Given the high cost of fixed assets, you should have an especially
robust document destruction policy for the documents related to
them. These documents should not be commingled with other ac-
counting records, and should require specific approval before be-
ing destroyed. The following policy addresses these issues:
Policy: The records for fixed assets shall be stored separately from
other accounting records, and their destruction must be approved in
writing by the corporate controller.
Tracking Policies and Procedures

A considerable control weakness in many companies is that they
do not have a system in place for reviewing the existence and con-
dition of their fixed assets. Over time, a considerable disparity may
develop between management’s perception of its fixed asset base
and what actually exists. The following policy is useful for man-
dating a periodic review of the existence and location of fixed as-
sets, but does not trigger any action to review the condition of
equipment:
Policy: An annual audit of all fixed assets exceeding a gross cost of

$____ shall be conducted, and the results communicated to manage-
ment.
You could use the results of the audit mandated in the preceding
policy to generate a fixed asset location report, which could then
272
be used to examine the condition of the assets. The following pol-

icy addresses this issue:
Policy: An annual review of the condition of all fixed assets exceeding

a gross cost of $_____ shall be conducted, and the results communi-
cated to management.
In a larger business with multiple locations and many fixed assets,

a fixed asset audit can be a large-scale endeavor that requires the
full-time commitment of several people, as well as tight coordina-
tion between them to ascertain the existence and condition of fixed
assets. The following procedure assumes that a larger-scale audit is
needed:
1. Notify all department managers that you are freezing asset
transfers between departments for the duration of the audit.
2. Verify that all asset transfer documents have been properly
approved and entered into the fixed asset tracking database.
3. Print the fixed asset location report, sorted for the facility in
which you plan to conduct the audit.
4. As you move through the facility, match the tag number
and/or serial number of each asset to the report. Check off
those found, and note their condition.
5. If you find what appear to be fixed assets that are not on the
report, note their identification information and locations.
See if these are leased assets or assets that are supposed to
be in other locations.
6. Compile a list of exceptions and review them with the per-
son responsible for the facility in which you conducted the
audit.
7. Have the responsible persons report to you regarding miss-
ing assets, and verify their assertions.
8. Process the asset transfer documentation for any fixed as-
sets that are proven to have been shifted to another location
without any supporting documentation.
9. Report exceptions to the managers of the responsible per-
sons for further action.
273
10. Notify the accounting department of any fixed assets that

have been confirmed to be permanently missing, with a re-
quest to eliminate them from the general ledger, along with
the recognition of any gain or loss, as needed.
11. Notify the internal audit staff of assets that have been con-
firmed to be permanently missing, as well as of any other
control problems found, with a request for them to review
the controls that caused these problems to arise.
12. Report to the chief financial officer, maintenance manager,
and budget analyst the condition of all fixed assets found,
which is used to update the forecasts for future asset pur-
chases, as well as the need for additional maintenance.
This procedure works best if a qualified maintenance technician

accompanies the auditor, in order to determine the condition of the
assets found. If this is not possible, then it may make sense to
avoid tracking the condition of assets, on the grounds that the audi-
tor is not qualified to do so.
The Fixed Asset Manual

If you have a large amount of transactional activity with your fixed
assets, it may make sense to codify the preceding policies and pro-
cedures into a fixed asset manual, and issue it to all employees in
the company who deal with fixed assets. This manual should con-
tain the following items:
• Responsibilities. Describe who is involved with fixed as-
sets. This includes the titles of the positions that are directly
responsible for fixed assets, as well as contact information
for the accountant responsible for fixed asset transactions,
the budget analyst who handles capital budgeting propos-
als, and so forth. Also, describe the tasks of anyone who is
assigned direct responsibility for specific fixed assets, such
as reporting changes in location or missing assets.
• Fixed asset policies. Itemize all policies related to fixed as-
sets.
274
• Fixed asset procedures. Itemize all procedures related to

fixed assets, possibly included flow charts to visually illus-
trate the flow of transactions.
• Fixed asset forms. List all forms that users of the manual
may need in order to complete various fixed asset transac-
tions, such as a capital budgeting application form, asset
transfer form, and asset disposal form.
• Fixed asset reports. Show examples of all reports related to
fixed assets that are available in the accounting system, and
how to obtain them. Such reports may include a deprecia-
tion report, audit report, responsibility report, asset re-
placement report, and maintenance report.
• Asset tagging system. If you use asset tags, describe who
distributes and affixes tags, where to locate them on an as-
set, and how they are recorded.
• Fixed asset account numbers. List the account numbers in
the general ledger in which fixed assets, accumulated de-
preciation, and depreciation expense are stored, and de-
scribe the transactions in which they are used.
• Journal entries. Though only for the use of a few people
within the accounting department, it may be useful to in-
clude the standard journal entry templates to use for various
transactions, along with examples of how they are used.
• Glossary. Include a list of all special terminology related to
fixed assets, with definitions.
• Feedback. If users find a mistake in the manual, or want
additional information included in future versions, there
should be a name and address noted in the manual that they
can contact with their feedback.
It is easiest to keep the fixed asset manual up-to-date by not issuing

it in paper form at all – instead, post a link to a PDF version of the
document on the company’s website, and notify users whenever
you have made a change to the document. Also, consider posting
all forms related to fixed assets on the company website.
275
Summary
This chapter has presented a broad array of policies and procedures
that can be used as guidelines for the development of your own
fixed asset manual. However, please note that these are only guide-
lines. Every company has its own unique methods of operation,
with a different blend of fixed assets, and may operate in an indus-
try where there are varying concentrations of fixed assets. You
may find that some policies and procedures are superfluous, while
other areas require a greater degree of control. Thus, though the
information in this chapter may form the basis for a fixed asset
manual, you should expect to modify it to a certain extent.
276
Review Questions
1. Policies and procedures are needed for capital budgeting, be-

cause:
a. You need to create a permanent record of purchased as-
sets
b. There is a risk of unauthorized purchases being made
c. Of the need for asset appraisals
d. You should categorize purchases into asset classes im-
mediately
2. A policy for the structure of asset classes should not standard-

ize:
a. Useful life
b. Depreciation method
c. Salvage values
d. Content description
3. If you wanted to reduce the computational complexity of de-

preciation, you would have a policy:
a. To eliminate the mid-month convention
b. To require accelerated depreciation
c. To require units of production depreciation
d. To re-evaluate the useful life of fixed assets every year
4. Storing title documents in a vault is a (an) ____ policy.

a. Asset recognition
b. Asset impairment
c. Asset retirement obligation
d. Record keeping
277
Review Answers
1. Policies and procedures are needed for capital budgeting, be-

cause:
a. Incorrect. Creating permanent records is a requirement
for asset recognition.
b. Correct. There is a risk of unauthorized purchases be-
ing made.
c. Incorrect. Asset appraisals are needed for asset revalua-
tions and exchanges.
d. Incorrect. Asset classification is most useful for setting
up asset depreciation.
2. A policy for the structure of asset classes should not standard-

ize:
a. Incorrect. The useful life is standardized by asset class.
b. Incorrect. The depreciation method is standardized by
asset class.
c. Correct. Salvage values are specific to individual fixed
assets.
d. Incorrect. A content description is used to standardize
the types of assets recorded within an asset classifica-
tion.
3. If you wanted to reduce the computational complexity of de-

preciation, you would have a policy:
a. Correct. Eliminating the mid-month convention pre-
vents the half-month depreciation at the beginning and
end of an asset’s useful life.
b. Incorrect. Accelerated depreciation requires more com-
plex depreciation calculations.
c. Incorrect. The units of production method requires
more complex depreciation calculations.
d. Incorrect. Altering the useful life of fixed assets in-
creases the complexity of depreciation calculations.
278
4. Storing title documents in a vault is a ____ policy.

a. Incorrect. Asset recognition policies involve the initial
recordation of asset cost.
b. Incorrect. Asset impairment policies address which as-
sets are to be tested for impairment.
c. Incorrect. Asset retirement obligation policies cover the
frequency of obligation reviews.
d. Correct. It is a record keeping policy.
279
Chapter 15
Fixed Asset Tracking
Introduction
This chapter addresses the various options that are available for
tracking and monitoring your fixed assets. This may not seem like
an issue, since fixed assets are, by definition, “fixed” and therefore
require no tracking. However, in reality, a fixed asset is really an
expenditure whose cost is greater than a company’s capitalization
limit, and which is expected to have a useful life of at least one
year – there is no mention in this definition of a fixed asset having
to be bolted in place. Indeed, the reverse may be the case for some
assets; for example, a high-quality video camera may easily qualify
as a fixed asset, and yet be designed to be ultra-portable. Thus,
there are valid cases where fixed assets will be moved on a regular
basis, and where you need to know where they are located. In addi-
tion, there are situations where you are less concerned with the lo-
cation of an asset, and more so with its current operating condition.
This chapter addresses how to track both the location and condition
of fixed assets.
Tag Tracking
The traditional approach to tracking assets is to epoxy a metal tag
onto each fixed asset. The tag has an asset number engraved on it;
the asset number corresponds to a record number in a computer
database or a manual record that itemizes the name, description,
location, and other key information about a fixed asset.
The advantage of the metal tag is that it is almost indestructible
and provides a unique identifier. However, a determined thief can
remove the tag, and it may be considered a detriment to the resale
value of an asset. Another problem is that the tag may be deliber-
ately located in an inaccessible spot, where a thief would be less
likely to look for it.
Some variations on the tag tracking concept that have differing
advantages and disadvantages are:
• Etching. You can etch the asset number directly onto the
surface of a fixed asset. This makes it nearly impossible to
remove the asset number, but also defaces the asset, and
may reduce its resale value. The defacing problem may be
reduced if you etch in an interior spot on the asset.
• Paper tags. If you intend to resell a fixed asset at a later
date and do not want to deface it with a metal tag, then af-
fix a plastic-laminated paper tag instead (or a paper tag that
has been covered with tape). The lamination tends to re-
duce the amount of damage to the tag. The problem with
this approach is that the tags may fall off, or can be easily
removed by a thief.
• Serial numbers. If most fixed assets already have a manu-
facturer’s serial number attached to them, then you can use
this information instead. Serial numbers are generally af-
fixed quite securely, and so are a good alternative. How-
ever, they may be located in out-of-the-way places, and
they may involve such long character strings that they do
not fit in the tag number field in the company’s tag tracking
software.
Some companies do not bother with asset tagging, if their assets

are few or so immovable that they are easily tracked without any
identification method at all. Also, companies dealing with large
numbers of low-cost fixed assets may view them as essentially of-
fice supplies that will be replaced every few years (such as laptop
computers), and which are therefore not worth the effort of such a
formalized tracking system.
Tip:
If you expect to sell a fixed asset at the end of its useful life and
applying a metal tag to it may impair its resale value, then use the
asset’s existing serial number instead of an asset tag, or use a tag
that can be easily removed.
281
Bar Code Tracking

Some asset tags can contain quite a long strong of digits, especially
if you use the manufacturer’s serial number as a substitute for an
asset tag. It is easy to transpose these numbers when copying them
down, which leads to identification errors. It is also a slow process
to write down tag numbers. A faster, more efficient, and less error-
prone technique is to instead track fixed assets using bar coded la-
bels.
Bar code tracking involves printing a bar code that contains the
tag number (and sometimes additional information), laminating the
label to prevent tearing, affixing it to a fixed asset, and using a
portable scanner to read the label. The person performing the scan-
ning may also punch in a location code, and perhaps an asset con-
dition code, and then uploads the record to the fixed assets data-
base, where it is matched to the fixed asset record using the tag
number.
Tip:
Do not apply too many lamination layers to a bar code label, or
else the bar code scanner will not be able to read the label.
It is possible for bar code labels to fall off an asset and be lost, and
they can easily be removed by a thief. Thus, they do not necessar-
ily provide a permanent tag. However, they present an extremely
efficient method for quickly recording asset locations, as you may
do during an annual fixed asset audit.
Tip:
If you use bar code tracking, then put the bar code in an easily ac-
cessible part of the asset, so that you can access it with a portable
bar code scanner. In addition, securely affix a metal asset tag in a
less accessible part of the asset, where a thief is less likely to see it.
282
Bar coding is especially useful when you are dealing with large
numbers of fixed assets that are not easily differentiated from each
other, such as cubicle walls.
RFID Tracking – Active Transmission

The trouble with the bar coding solution just described is that
someone needs to locate the asset, then locate the bar code on the
asset, then scan it with a portable scanner, and then upload the con-
tents of the scanner to the computer system in order to log the asset
into the system. This means that you have to go to the asset in or-
der to track it, which can be fairly labor-intensive. An alternative
that eliminates these problems to a great extent is radio frequency
identification (RFID).
In an RFID system, you affix an RFID tag to each asset, which
periodically transmits its location through RFID receiving stations
to a central database for viewing. The system determines the loca-
tions of assets based on their relative signal strengths as received
by the RFID receiving stations that are located throughout the fa-
cility. The RFID tags have their own batteries, which can last as
long as five years before requiring replacement. A variation on the
RFID concept is the transmission of ultrasound signals. Ultrasound
does not penetrate room walls, and so does not create the false-
location signals that may sometimes arise in an RFID system.
If most of your fixed assets are bolted down or so heavy as to
be essentially immovable, then there is clearly no need to install an
RFID tracking system. Instead, only use it to track those assets that
will probably be moved from time to time, and for which there is
an absolute need to know their locations (such as medical equip-
ment in a critical care facility). In this later case, the RFID system
may actually reduce your investment in fixed assets, since you will
be able to avoid purchasing additional fixed assets that might oth-
erwise have been held in reserve to cover for assets that could not
be located. An RFID system also makes it easier for the mainte-
nance staff to locate equipment that is scheduled for maintenance,
eliminates the time spent searching for equipment, speeds up the
283
auditing of fixed assets, and prevents managers from hoarding

equipment.
RFID Tracking –Passive Transmission

The RFID tracking system just noted incorporates battery-powered
RFID tags that transmit their own signals to RFID receivers, so
that a signal is being generated at regular intervals. An alternative
system employs RFID tags that contain no batteries at all. Instead,
these tags use the power from a nearby RFID transceiver to trans-
mit a signal. These tags are less expensive, and also can potentially
last for many years without replacement. This passive transmission
system is ideal for monitoring the movement of fixed assets past a
fixed point, such as a building exit point. If you place an RFID
transceiver at that point, it can trigger an alarm when a fixed asset
is moved past it, or can activate a camera that photographs both the
person moving the asset and the asset itself, along with a time and
date stamp on any images taken.
This monitoring function is ideal for detecting the theft of as-
sets. It also provides documentation of theft, which can assist in
settling a claim with the company’s insurer.
You should use passive RFID tags on those fixed assets that
are easily movable and which have a high resale value (such as
laptop computers and other office equipment).
Wireless Monitoring
You may know exactly where your fixed assets are located, but are
concerned with their ongoing condition, so that you can plan for
their timely replacement. The traditional approach is to have a pe-
riodic maintenance system in place, so that the maintenance staff
provides feedback about the wear and tear on equipment. This ap-
proach may be sufficient, but what if equipment breaks down be-
tween periodic maintenance visits? Or what if maintenance is ex-
tremely rare, or if the equipment is so difficult to reach that main-
tenance requires disassembly of the machine? A possible solution
is to install a wireless monitor. These monitors can be configured
to continually review a number of factors, such as the inclination
284
of a device, or its humidity, temperature, position, or

pitch/yaw/roll. Any or all of these factors can indicate that a fixed
asset should be replaced, and can provide immediate warning of
the situation, since there is usually a noticeable change in such fac-
tors as temperature or vibration levels just prior to equipment fail-
ure.
The usual configuration of a wireless sensor system is to attach
a sensor to the equipment to be monitored, and link it by a wireless
router to the company’s computer system. The monitor may be
configurable to only sample at relatively long intervals, thereby
saving on battery power, and then only transmitting a warning to
the router when a measurement has exceeded a predetermined trig-
ger point. The computer system then sends a warning e-mail to a
designated recipient, who can then take further action.
Creating a wireless monitoring system requires an initial in-
vestment, as well as the periodic replacement of monitor batteries,
but it allows management to determine much more precisely the
date on which it should replace equipment. Thus, some equipment
replacements can be delayed, while there is also a reduced risk of
sudden equipment failure, which would otherwise call for an ex-
pensive replacement on an emergency basis.
Summary
Which of the preceding asset tracking alternatives make the most
sense for your specific situation? It will depend on a variety of fac-
tors, such as:
• Asset condition monitoring. If you have assets that are at
risk of failure, then consider wireless monitoring. This sys-
tem is most commonly used for larger industrial machinery
where you have little concern about an asset being moved.
• Fixed asset cost. If you are dealing with fixed assets that
barely exceed your capitalization limit, then it may not
make sense to monitor them at all. The key factor here is
not the cost of the tags, but of the additional labor you ex-
pect to incur for subsequent monitoring of those tags. Thus,
285
if you consider a fixed asset to be inexpensive and easily

replaceable, a tagging system may be unnecessary.
• High-usage assets. If you have fixed assets that are heavily
used, and which are typically moved among multiple loca-
tions, then consider an active transmission RFID system.
This is the most expensive tracking alternative, so evaluate
how cost-effective it is before proceeding with an installa-
tion.
• Periodic audits. If you are mostly concerned about having
an efficient method for compiling a fixed asset count, then
consider using a bar coded tagging system. This is the pri-
mary situation in which bar coding fixed assets makes
sense.
• Probability of theft. If there is a reasonable chance that as-
sets may be stolen, then consider a combination of etching
your asset number directly onto such assets, and affixing
passive transmission RFID tags to them, with RFID trans-
ceivers mounted at the building exits.
Thus, the best method of asset tracking depends upon your circum-
stances – there is no single tracking method that is optimal in all
situations.
286
Review Questions
1. A durable form of tag tracking does not include:

a. A metal plate
b. Etching
c. Plastic-laminated tags
d. Cardboard tags
2. You might elect not to use asset tagging when:

a. Assets are immovable
b. Assets are highly mobile
c. Assets have high cost
d. Assets have high resale values
3. The key structural difference between an active and passive

RFID tag is that:
a. The passive tag has to be manually activated
b. There is no battery in a passive RFID tag
c. A passive tag must be plugged into an electrical outlet
d. An active tag contains less expensive parts
4. The following is not a tagging technique to prevent asset theft:

a. Etch a tag number into the asset
b. Use bar coded tags
c. Use passive RFID tags
d. Affix a metal tag in a less-accessible part of an asset
287
Review Answers
1. A durable form of tag tracking does not include:

a. Incorrect. A metal plate is a durable form of tag track-
ing.
b. Incorrect. Etching is a durable form of tag tracking.
c. Incorrect. Plastic-laminated tags are a durable form of
tag tracking.
d. Correct. A cardboard tag can be easily damaged or
lost.
2. You might elect not to use asset tagging when:

a. Correct. When assets are immovable, there is no point
in tagging them.
b. Incorrect. Mobile assets are the scenario for which asset
tagging is primarily intended.
c. Incorrect. A high-cost asset requires extra controls,
which may include the use of asset tags.
d. Incorrect. Any asset with a high resale value is subject
to theft, and so may have multiple tags affixed to it.
3. The key structural difference between an active and passive

RFID tag is:
a. Incorrect. A passive tag is automatically activated by
any nearby RFID transceiver.
b. Correct. There is no battery in a passive RFID tag.
c. Incorrect. A passive RFID tag is not powered from an
electrical outlet.
d. Incorrect. An active tag is much more expensive than a
passive tag.
288
4. The following is not a tagging technique to prevent asset theft

or aid in its recovery:
a. Incorrect. An asset is less likely to be stolen when the
tag number is permanently etched into the surface of
the asset, usually in a prominent place.
b. Correct. Bar coded tags are usually easily removed by
a thief.
c. Incorrect. You can couple passive RFID tags with an
alarm system that is triggered when the assets are car-
ried through an exit location.
d. Incorrect. If a metal tag is affixed to a less-accessible
part of an asset, a thief is less likely to find and remove
it, so you can still identify it at a later date.
289
Chapter 16
Introduction
It is useful for the accountant to be aware of a number of possible
measurements related to fixed assets. These metrics are useful for a
general understanding of the adequacy of a company’s investment
in fixed assets, as well as the return on investment from them, and
whether they are being adequately utilized.
If you are deeply involved with the monitoring of individual
assets you may not need these ratios, but consider using them when
you need a fast opinion regarding the fixed assets of other compa-
nies, especially potential acquisitions where there is little time to
conduct a detailed investigation into a business’ fixed assets.
The ratios described in this chapter are clustered into three
groups. The first group is used to investigate whether a business
has an adequate investment in fixed assets or is maintaining them
properly. The second group addresses the return on investment that
a company is achieving from its fixed assets. The final group is
primarily concerned with the level of asset utilization. All three
groups of metrics can provide valuable insights into a company’s
fixed assets.
Sales to Fixed Assets Ratio

It requires a large amount of fixed assets to compete in some in-
dustries, such as computer chips and automobiles. You can use the
sales to fixed assets ratio to determine how a company’s expendi-
tures for fixed assets compare to those of other companies in the
same industry, to see if it is operating in a more lean fashion than
the others, or if there may be opportunities to scale back on its
fixed asset investment. This is quite useful to track on a trend line,
which may show gradual changes in expenditure levels away from
the historical trend. The ratio is most useful in asset-intensive in-
dustries, and least useful where the required asset base is so small
that the ratio would be essentially meaningless.
The ratio can also be misleading in cases where a company

must invest in an entire production facility before it can generate
any sales; this will initially result in an inordinately low sales to
fixed assets ratio, which gradually increases as the company maxi-
mizes sales for that facility, and then levels out when it reaches a
high level of asset utilization.
To calculate the sales to fixed assets ratio, divide net sales for
the past twelve months by the book value of all fixed assets. The
formula is:
Trailing 12 months’ sales

Book value of all fixed assets
Book Value:
Book value is an asset's original cost, less any depreciation that has
The fixed asset book value listed in the denominator is subject to

some variation, depending on what type of depreciation method is
used (see the Depreciation and Amortization chapter). If an accel-
erated depreciation method is used, the denominator will be unusu-
ally small, and so will yield a higher ratio.
EXAMPLE
Mole Industries manufactures trench digging equipment. It has a relatively low

sales to fixed assets ratio of 4:1, because a large amount of machining equip-
ment is needed to construct its products. Mole is considering expanding into
earth-moving equipment, and calculates the sales to fixed assets ratio for com-
peting companies, based on their financial statements. The ratio is in the vicinity
of 3:1 for most competitors, which means that Mole will need to invest heavily
in fixed assets in order to enter this new market. Mole estimates that the most
likely revenue level it can achieve for earth moving equipment will be $300 mil-
lion. Based on the 3:1 ratio, this means that Mole may need to invest $100 mil-
lion in fixed assets in order to achieve its goal.
291
Mole’s CFO concludes that the company does not currently have the financial
resources to invest $100 million in the earth moving equipment market, and rec-
ommends that the company not enter the field at this time.
Repairs and Maintenance Expense to Fixed Assets Ratio

When you are reviewing the potential acquisition of a product line
or entire company, it is useful to review their ratio of repair and
maintenance expense to fixed assets, especially on a trend line. If
the ratio is increasing over time, there are several ways to interpret
it:
• Old assets. The acquiree is relying on an aging fixed asset
base, since it must spend more to keep them operational.
This is the worst-case scenario, since the buyer may be
faced with a wholesale replacement of the acquiree’s fixed
assets.
• High utilization. The acquiree is experiencing very high as-
set usage levels, which calls for higher maintenance costs
just to keep the machines running fast enough to meet de-
mand. You can spot this condition by looking for a high
sales to fixed assets ratio (see the preceding ratio). A high
profit level is also likely.
• Preparing for sale. If there is a sudden spike in the ratio in
the recent past, it may be because the owner of the acquiree
is simply preparing it for sale, and so is either catching up
on delayed maintenance or is bringing machinery up to a
high standard.
• Accounting changes. It is possible that the repairs and
maintenance expense has been moved among different ac-
counts, such as from the cost of goods sold account or an
overhead cost pool to its own account, which means that
there could appear to be a sudden jump in expenses that is
not really the case.
This ratio is least useful when the bulk of the repairs and mainte-
nance expense is comprised of salaries paid to a relatively fixed
292
group of repair technicians. In this case, the expense is essentially

a fixed cost, and so cannot be expected to vary much over time,
other than for scheduled pay rate changes.
A problem that this ratio does not reveal is when an acquiree
simply lets its machinery decline by not investing in repairs and
maintenance; this means that the ratio would remain flat or could
even decline over time. In this case, you must look elsewhere for
an indicator, such as declining sales or an inability to meet cus-
tomer delivery schedules.
To calculate the repairs and maintenance expense to fixed as-
sets ratio, divide the total amount of repairs and maintenance ex-
pense by the total amount of fixed assets before depreciation. The
amount of accumulated depreciation that may have built up on
older assets would otherwise bring the denominator close to zero
for some acquirees, so it is better not to use depreciation at all. The
formula is:
Total repairs and maintenance expense

Total fixed assets before depreciation
EXAMPLE
Mole Industries is investigating the purchase of Grubstake Brothers, a manufac-

turer of backhoes. Its acquisition analysis team uncovers the following informa-
tion:
20X1 20X2 20X3 20X4

Sales $15,000,000 $14,500,000 $13,200,000 $12,900,000
Profit $1,000,000 $200,000 $(150,000) $(420,000)
Repairs expense $400,000 $240,000 $160,000 $80,000
Fixed assets $5,400,000 $6,000,000 $6,050,000 $6,100,000
Repairs to fixed assets
7% 4% 3% 1%
ratio
The information in the table strongly indicates that the decline in Grubstake’s
profitability over the past few years has led its management to cut back on repair
and maintenance expenditures. Thus, if Mole elects to buy Grubstake, it can
expect to invest a considerable amount to replace fixed assets.
293
Accumulated Depreciation to Fixed Assets Ratio

If a company is not replacing its fixed assets, then the proportion
of accumulated depreciation to fixed assets will increase over time.
The ratio is quite useful for analyzing prospective acquisitions,
since it is an easy way to see if an acquiree is not reinvesting in its
business. This information is especially useful when tracked on a
trend line, since it shows gradual changes in the ratio that might
not otherwise be immediately apparent.
There are several situations where this ratio is not useful. For
example, a business may be using accelerated deprecation, which
results in a large amount of accumulated depreciation despite hav-
ing relatively new assets. The ratio can also be problematic if a
company is not removing assets and accumulated depreciation
from its books as soon as it disposes of them. It is also possible
that a company has chosen to switch to leased assets under operat-
ing leases, where the fixed assets do not appear on the company’s
balance sheet. Finally, a company may acquire assets that have
very long useful lives (such as hydroelectric facilities), where the
gradual accumulation of depreciation is a natural part of the busi-
ness. Be aware of these situations when deciding whether to use
the ratio.
To calculate the accumulated depreciation to fixed assets ratio,
divide the total accumulated depreciation by the total amount of
fixed assets (before depreciation). The formula is:
Accumulated depreciation
Total fixed assets before depreciation deduction
EXAMPLE
Mole Industries is conducting an investigation of Vertical Drop, a heavy-lift

helicopter company that installs cell towers and power poles, with the intent of
buying the company. The primary asset of Vertical Drop is its fleet of Sikorsky
helicopters, which must be properly maintained and replaced at regular intervals.
Mole collects the following information about Vertical Drop’s fixed assets:
294
20X1 20X2 20X3 20X4

Accumulated depreciation $4,900,000 $6,000,000 $9,400,000 $10,450,000
Fixed assets 32,700,000 33,400,000 31,350,000 29,875,000
Accumulated depreciation
15% 18% 30% 35%
to fixed assets ratio
The ratio calculation in the table indicates that Vertical Drop essentially stopped
purchasing replacement helicopters two years ago, which means that Mole may
be faced with large-scale replacements if it buys the company.
Cash Flow to Fixed Asset Requirements Ratio

Does a company have sufficient cash to pay for its upcoming fixed
asset purchases? The cash flow to fixed asset requirements ratio is
useful both as a general internal analysis of a company’s future
prospects, and also as a means for determining the health of a pos-
sible acquisition. The ratio must be greater than 1:1 for a company
to have sufficient cash to fund its fixed asset needs. If the ratio is
very close to 1:1, then a company is operating very close to the
edge of its available cash flows, and should consider bolstering its
cash position with a line of credit. The ratio is less useful if the
company in question has substantial cash reserves, since it can al-
ways draw upon these reserves to fund its fixed asset requirements,
irrespective of short-term cash flows.
To calculate the cash flow to fixed asset requirements ratio, di-
vide the expected annual cash flow by the total expenditure that
has been budgeted for fixed assets for the same period. You can
calculate the cash flow figure in the numerator by adding non-cash
expenses (such as depreciation and amortization) back to net in-
come, and subtracting out any non-cash sales (such as sales accru-
als). You should also subtract from the numerator any dividends
and principal payments on loans. The formula is:
Net income + Noncash expenses – Noncash sales – Dividends –

Principal payments
Budgeted fixed asset expenditures
295
EXAMPLE
Mole Industries has just compiled the first iteration of its budget for the upcom-
ing year, which reveals the following information:
Budget Line Item Amount

Net income $4,100,000
Depreciation and amortization 380,000
Accrued sales 250,000
Dividend payments 100,000
Principal payments 800,000
Budgeted fixed asset expenditures 3,750,000
Based on this information, Mole’s controller calculates the ratio of cash flow to
fixed asset requirements as:
$4,100,000 Net income + $380,000 Depreciation and amortization

- $250,000 Accrued sales - $100,000 Dividends - $800,000 Principal payments
$3,750,000 Budgeted fixed asset expenditures
$3,330,000 Cash flows

$3,750,000 Budgeted fixed asset expenditures
= 89%
The ratio is less than one, so Mole will either need to draw upon its cash re-
serves to pay for the fixed assets, cut back on its fixed asset budget, or revise
other parts of the budget to increase cash flow.
Return on Assets Employed

A common metric is the return on assets employed, which meas-
ures the return to investors on all of the assets in a company.
Though this metric includes all assets, rather than just fixed assets,
we include it here because fixed assets may be the predominant
portion of all assets.
The return on assets employed measures how efficiently a
company can use its assets to generate an adequate profit. A com-
mon result of using this metric is that management endeavors to
296
shrink the amount of assets it uses; doing so releases the cash that
would otherwise have been invested in the assets.
The return on assets employed metric is not especially useful
for persistently low-profit companies, since the ratio will be sub-
ject to a great deal of fluctuation when the numerator is close to or
below zero. Also, the fixed asset component of the denominator
may not reflect the current value of the assets, since accelerated
depreciation can yield an artificially low book value. Thus, if fixed
assets comprise the bulk of the denominator and accelerated depre-
ciation is being used, do not be surprised if a company is reporting
an unusually high return on assets employed.
To calculate the return on assets employed, divide net profits
by the total of all assets, where fixed assets are recorded net of all
depreciation. The formula is:
Net profit
Total assets
EXAMPLE
Mole Industries has acquired Grubstake Brothers, a manufacturer of backhoes.

Mole’s CFO wants to know how much Grubstake’s return on assets employed
can be improved, so that Mole can generate sufficient cash to pay back its pur-
chase price. The CFO examines the production bottleneck operation and con-
cludes that $1,300,000 of fixed assets located downstream from the bottleneck
represent unnecessary excess capacity, and can be safely eliminated. This
change will yield the following alteration in the return on assets employed
(ROAE) for Grubstake:
Initial ROAE Revised ROAE

Net profit $200,000 $300,000
Total assets $8,000,000 $6,700,000
Proposed fixed asset reduction $(1,300,000)

Depreciation reduction from
$(100,000)
proposed fixed asset reduction
Return on assets employed 2.5% 4.5%
297
Thus, the sale of selected fixed assets improves the return on assets employed,
not only because of the asset reduction in the denominator, but also because of
the related reduction in depreciation in the numerator that improves the net
profit of Grubstake.
Return on Operating Assets

This metric is a variation on the return on assets employed that was
just covered. The return on operating assets only includes in the
denominator those assets that are actively used to create revenue.
Thus, the formula is:
Net profit
Total assets used to generate revenue
There are several reasons for using this metric, which are to focus
the attention of management on:
• Minimizing the number of assets needed to generate reve-
nue
• Minimizing the total new investment in assets
• Spotting and eliminating those assets designated as not con-
tributing to the generation of revenue
This metric can result in an interesting amount of political maneu-

vering, since managers may be tempted to exclude assets from the
denominator in order to improve the results of the metric, but will
then face pressure to dispose of the excluded assets.
EXAMPLE
The production facility for the Ditch Magic product line of Mole Industries has
fallen on hard times. The facility used to have a sterling return on operating as-
sets of 40%, but the metric has declined to an abysmal 5% after the manager of
the facility added a number of automated machining stations that added a large
amount of capital investment to the facility without much of an offsetting reduc-
tion in labor costs.
298
The CFO brings in consultants to investigate the situation. They recommend that
the facility eliminate most of the automated machining stations and replace them
with smaller, more flexible work stations that are both manually operated and
more easily configurable. The current return on operating assets (ROA) and the
projected calculation after these changes are made is noted in the following ta-
ble:
Initial ROA Projected ROA

Net profit $500,000 $700,000
Total assets $10,000,000 $7,000,000
Proposed robot elimination $(3,500,000)

Proposed work station additions $500,000
Net change in depreciation $(200,000)
Return on operating assets 5% 10%
The proposed changes should double the return on operating assets. In addition,
they may introduce sufficient flexibility into the production process to generate
enough additional profits to bring the facility back to the returns it generated in
its glory days.
Bottleneck Utilization
In most production operations, there is a particular work station
that is perpetually overworked, and which keeps the rest of the fa-
cility from maximizing its production potential – this is the bottle-
neck operation. A key focus of the manufacturing manager is to
ensure that this work station is fully supported and utilized at all
times, which makes the bottleneck utilization metric one of the
more important performance measures that a company can track.
To calculate bottleneck utilization, divide the actual hours of
usage of the operation by the total hours available. Depending on
how closely management watches this metric, you may want to re-
calculate it every day. The formula is:
Actual hours of bottleneck usage

Total hours in the measurement period
299
While important, the bottleneck utilization metric does not

track the profitability of the work being run through the bottleneck
operation. Thus, it could be utilized nearly 100% of the time, but
with only low-profit items being manufactured, the company’s
profitability would still be low. Thus, this metric should be used in
combination with an analysis of the profitability of products being
scheduled for production.
EXAMPLE
Mole Industries runs a small production line that creates motorized tunneling
devices for cable laying operations. The bottleneck in the production line is the
paint booth. The paint booth runs for three shifts, seven days a week, while the
rest of the production line runs for a standard eight-hour day, five days a week.
Management is concerned that the paint booth will limit the production line’s
ability to expand, and wants to know what bottleneck utilization it has. The cal-
culation is:
152 Actual hours of operation

168 Hours in a week
= 90% Bottleneck utilization
The calculation shows that there are only 16 additional hours of bottleneck time
available, and it is likely that the paint booth staff will have a difficult time mak-
ing those few additional hours available, given ongoing maintenance require-
ments. Thus, the management team needs to discuss whether it should invest in
an additional paint booth or outsource some painting to a supplier. It may make
more sense to build a new paint booth if there is an expectation of a large and
permanent increase in sales (which would pay for the investment in a new paint
booth), whereas outsourcing may be the better option if sales are not expected to
increase much beyond the current level.
Unscheduled Machine Downtime

A properly managed production facility has a maintenance sched-
ule for all of the equipment under its control, to which it closely
adheres in order to ensure that all equipment is operational during
planned production hours. When a machine requires unscheduled
downtime for maintenance, this can be a warning flag that the ma-
300
chine in question is beginning to approach the end of its life span,

and should be replaced. Otherwise, management will find that an
increasing amount of down time is needed for additional un-
planned maintenance, which in turn can interrupt the production
schedule and jeopardize the timing of deliveries to customers.
The calculation of unscheduled machine downtime is the total
minutes of unscheduled machine downtime, divided by the total
minutes of machine time during the measurement period. It is best
to run this calculation for each individual machine, so that you can
more easily spot which ones may be in need of replacement. The
formula is:
Total minutes of unscheduled machine downtime

Total minutes of machine time
It can be difficult to accumulate the information required for this

metric. Machine operators tend to forget to record the information,
and automated systems that track this information are quite expen-
sive.
EXAMPLE
The controller of Mole Industries is compiling the budget for the upcoming year,
and wants to know if any production equipment may require replacement. He
compiles the information in the following table about a group of lathes for the
preceding month:
Lathe 1 Lathe 2 Lathe 3

Unscheduled downtime (hours) 7 21 112
Total machine time (hours) 720 720 720
Unscheduled downtime per- 1% 3% 16%
centage
Age of machine 4 years 6 years 11 years
The table provides two pieces of evidence in favor of replacing Lathe 3: its un-
scheduled maintenance percentage is eight times higher than the average down-
time of the other two lathes, and it is by far the oldest machine in the group. The
301
controller elects to make further inquiries targeted at the possible replace of this
lathe.
Summary
The determination of the adequacy of an investment in fixed assets
is a difficult one to make just from ratio analysis. You really need
to examine the capacity level of each machine, its age and mainte-
nance record, and how it relates to the production flow to see if
new equipment is needed. Still, if you are conducting a high-level
examination of the fixed assets of a company, ratio analysis is a
good way to obtain a general impression of the situation.
You should exercise some caution when using any of the met-
rics related to the utilization of assets. If an asset is not being fully
utilized, this is not necessarily bad – it should only be used to the
extent that it is providing products that can be sold in the near fu-
ture. If you use a utilization metric to argue in favor of increasing a
machine’s rate of production, you may only be forcing the com-
pany to create more inventory than it needs.
There is certainly no need to track all of the metrics described
in this chapter, but you should select a few that most closely match
your informational needs, and focus on tracking them over the long
term.
302
Review Questions
1. The sales to fixed assets ratio can be misleading when:

a. There is a small installed fixed asset base
b. There is a large proportion of sales returns to sales
c. An investment has been made for which sales are still
ramping up
d. The company uses straight-line depreciation
2. The accumulated depreciation to fixed assets ratio is less useful

when:
a. A company leases its assets under capital leases
b. A company uses straight-line depreciation
c. A company uses accelerated depreciation
d. A company promptly derecognizes assets when it dis-
poses of them
3. The denominator of the return on assets employed ratio does

not include:
a. Accounts receivable
b. Accounts payable
c. Inventory
d. Fixed assets
4. Bottleneck utilization is useful for:

a. Maximizing the production potential of a constrained
resource
b. Maximizing the usage of all work centers
c. Maximizing the efficiency of administrative areas
d. Minimizing operating expenses
303
Review Answers
1. The sales to fixed assets ratio can be misleading when:

a. Incorrect. When there is a small installed asset base, the
ratio will be high, but may still represent an important
relationship.
b. Incorrect. The proportion of sales returns to sales
should have no impact on the ratio, as long as the pro-
portion is steady over time.
c. Correct. When you have made a substantial investment
for which sales are still ramping up, the ratio will be
distorted during the ramp-up period.
d. Incorrect. Under straight-line depreciation, there is no
acceleration of depreciation that would have distorted
the ratio.
2. The accumulated depreciation to fixed assets ratio is less useful

when:
a. Incorrect. If a company leases its assets under capital
leases, there is no effect on the accounting for them, so
the ratio is not impacted.
b. Incorrect. The even recognition of depreciation expense
over time that results from the straight-line method does
not detract from the usefulness of the ratio.
c. Correct. A company uses accelerated depreciation,
since it results in a large proportion of accumulated de-
preciation even when assets are relatively new.
d. Incorrect. When a company promptly derecognizes as-
sets that it has disposed of, this improves the reliability
of the information related to the remaining assets, and
so makes the ratio more useful.
304
3. The denominator of the return on assets employed ratio does

not include:
a. Incorrect. Accounts receivable are included in the de-
nominator of the return on assets employed ratio.
b. Correct. Accounts payable are not included in the de-
nominator of the return on assets employed ratio.
c. Incorrect. Inventory is included in the denominator of
the return on assets employed ratio.
d. Incorrect. Fixed assets are included in the denominator
of the return on assets employed ratio.
4. Bottleneck utilization is useful for:

a. Correct. Maximizing a constrained resource is the pri-
mary reason for using the bottleneck utilization meas-
urement.
b. Incorrect. The ratio is targeted only at a bottleneck op-
eration, not at all operations.
c. Incorrect. Administrative areas are not considered a
bottleneck, and so are not the target of the bottleneck
utilization ratio.
d. Incorrect. Bottleneck utilization has no direct impact on
operating expenses.
305
Chapter 17
Introduction
If you are responsible for the accounting records of a company that
pertain to fixed assets, you may be curious about how these records
and related accounting systems are investigated by auditors as part
of an annual audit. The following sections note the objectives that
an auditor will likely pursue as part of a fixed asset audit, as well
as the procedures he is most likely to follow, and the information
that he will request from you.
Fixed Asset Audit Objectives

Before an auditor begins his audit procedures, he first decides upon
the objectives that he wants to pursue through those procedures.
The primary objectives related to fixed assets are:
• Authorization. Have the fixed assets been purchased under
the correct company-specific authorizations? Fixed assets
may be extremely expensive, so a purchase not made
within the proper limits of authority may indicate a serious
control problem.
• Existence. Are the fixed assets actually there? Even if all of
the supporting paperwork is in order that appears to con-
firm the existence of a fixed asset, it is possible that the as-
sets have been removed, so the auditor needs to visually
confirm their existence.
• Presentation. Have all fixed assets been properly recorded
in the balance sheet, and have all asset classes, asset retire-
ment obligations, capitalized interest, depreciation, im-
pairments, leased assets, and liens been properly disclosed?
• Recordation. Have all fixed assets been recorded as fixed
assets? If the cost of some fixed assets were charged to ex-
pense as incurred, or if some costs under the capitalization
limit were recorded as expenses, this can profoundly alter
the profitability and asset levels of a company.
• Valuation. Have fixed assets been valued correctly? Valua-

tion includes not only the initial cost applied to a fixed as-
set, but also any subsequent changes to that cost, impair-
ments, and (if the IFRS framework is being used) revalua-
tions.
The auditor then uses these objectives to design a set of audit pro-
cedures. These procedures are described in the next section.
Fixed Asset Audit Procedures

The exact audit procedures used will vary somewhat by audit firm,
but you can expect to see some variation on the following proce-
dures in a typical audit:
• Discuss purchasing controls. The auditors will discuss any
changes since the last audit in your internal controls over
the purchasing of fixed assets. They may ask about changes
in the capitalization limit, as well as changes in the expen-
diture levels and types of expenditures at which fixed asset
purchases are authorized. There may also be a discussion of
the capital budgeting process, to the extent that it modifies
authorization levels for fixed asset purchases.
• Discuss leasing controls. The auditors may discuss changes
since the last audit in your controls over the leasing of fixed
assets (irrespective of whether they are operating or capital
leases). This topic may not arise if you do not lease assets.
• Compare capital budget to purchases. If there is a robust
capital budgeting system in place, the auditors will com-
pare the assets authorized through it to actual purchases, to
see if there are any fixed asset purchases occurring without
the formal review process.
• Match supporting documents to register. The auditors will
likely trace supplier invoices to the costs listed in the fixed
asset register for assets acquired during the accounting pe-
riod being audited. They will also look for evidence that a
person with the proper authority approved these invoices
(which may include a review of the board of directors min-
307
utes), and that there is evidence of asset receipt. If the com-

pany obtained title to an asset, such as for land or a vehicle,
they may want to see the title document.
• Match register to assets. The auditors may trace assets
listed on the fixed assets register to the assets themselves
by conducting a physical count of selected fixed assets.
This count is likely to be targeted primarily at the highest-
cost assets, with a few additional lower-cost items selected
at random. The auditors may also review the condition of
the assets, and any evidence that they are no longer in use.
• Match assets to register. During a physical count of fixed
assets, the auditors may trace assets found back to the fixed
assets register. This procedure uncovers undocumented as-
sets.
• Trace transfer documentation. If fixed assets have been
transferred between departments or subsidiaries, the audi-
tors may examine the related transfer documentation to see
if the transfers were properly authorized.
• Review physical safeguards. The auditors may review any
safeguards the company has installed to prevent the unau-
thorized movement of fixed assets, or unauthorized access
to them. This procedure may be minimized for those assets
too heavy to be moved, but can be a major issue for highly
movable assets, such as laptop computers.
• Examine asset class assignments. If you have standardized
asset useful lives and depreciation methods based on the
asset classes to which you have assigned fixed assets, ex-
pect the auditors to review the contents of each class to see
if the fixed asset assignments are appropriate.
• Verify depreciation. The auditors will review your depre-
ciation calculations to see if assets have been assigned the
correct useful lives and depreciation methods (in compari-
son to the asset classes of which they are a part), and will
want to see documentation of any salvage values that you
have incorporated into the depreciation calculations. They
may also manually re-compute some of the depreciation
308
calculations, especially if the depreciation expense does not

appear reasonable in comparison to the amount charged to
expense in prior years.
Tip:
You should always use the same useful life and depreciation
method for a fixed asset that is standard for all assets within its as-
set class. Otherwise, you will present the auditors with a broad ar-
ray of depreciation calculations that are difficult for you to justify
and for the auditors to verify.
If you have had large asset dispositions during the year, the
auditors may also review your depreciation calculations for
those assets through the disposal date.
• Verify revaluations. If you are using the IFRS framework,
you have the option to periodically revalue selected classes
of fixed assets. If so, the auditors will review your revalua-
tion documentation.
Tip:
If you engage in revaluations, always use a written valuation report
from a third-party appraiser as the basis for your revaluations.
Auditors consider this to be strong objective evidence of a revalua-
tion.
• Investigate impairments. The auditors will review any

documentation you have prepared regarding the impairment
of fixed assets, and may also investigate declines in the
market price of assets, any significant adverse changes in
the extent of asset use, operating losses associated with as-
sets, and physical damage to assets. If you are constructing
assets, they may investigate whether there are significant
cost overruns. They may bypass this procedure if the
amount of fixed assets is quite small, on the grounds that
any possible impairment would be immaterial.
309
• Investigate asset retirement obligations. The auditors will

determine whether there is a legal obligation to incur mate-
rial expenses to retire an asset, and whether the company
has appropriately accounted for such asset retirement obli-
gations.
• Investigate held for sale assets. If any assets have been
classified as held for sale, the auditors will investigate the
documentation supporting this classification, as well as any
revaluations of these assets, and whether they should con-
tinue to be classified as held for sale.
• Investigate liens. The auditors may investigate whether
there are any encumbrances or liens on fixed assets that re-
quire disclosure.
• Investigate lease agreements. The auditors may examine
any outstanding lease agreements to see if the underlying
assets have been appropriately classified as operating or
capital leases.
Tip:
If the auditors want you to reclassify an operating lease as a capital
lease, you may be able to protest that the extra accounting work
associated with this changeover is not worth the effort, if there is
no material impact on the financial statements.
• Investigate repairs and maintenance. The auditors will re-

view the contents of the repairs and maintenance general
ledger account to see if there are any items that had been
charged to expense that should instead have been capital-
ized as additions to fixed assets.
• Investigate groups of assets. The auditors may choose to
review situations where you have clustered together and
capitalized groups of assets that would otherwise individu-
ally be below the corporate capitalization limit, and
whether this treatment matches the company’s capitaliza-
tion policy for such situations.
310
• Verify disposals. The auditors will review the documented

authorization for any asset disposals, as well as the proper
recognition of any resulting proceeds from a sale. They will
also investigate the derecognition of these assets from the
accounting records, to see if any gain or loss on disposition
was properly calculated and recognized. They may also as-
certain if any assets disposed of had been used as collateral
on existing loans.
• Investigate gain and loss accounts. The auditors may re-
view the contents of the revenue, gain, and loss accounts in
the general ledger to see if there were any transactions that
indicate the sale of fixed assets, but for which the related
assets and accumulated depreciation were not removed
from the fixed asset records.
• Calculate analytics. The auditors will engage in analytical
procedures to identify any fluctuations over time in the re-
lationships between the various fixed asset and other ac-
counts, and that appear to be inconsistent with other infor-
mation. For example, they might calculate depreciation ex-
pense as a proportion of fixed assets on a trend line, to see
if the proportion has changed significantly. They will in-
quire further if they spot any anomalies.
• Review financial statement presentation. The auditors will
verify that all fixed assets been properly recorded in the
balance sheet, and that all asset classes, asset retirement ob-
ligations, capitalized interest, depreciation, impairments,
leased assets, and liens have been properly disclosed in the
accompanying footnotes to the financial statements.
Auditor Requests
The auditors will likely ask for several documents related to fixed
assets, which are:
• Fixed assets register. This is a complete listing of every
fixed asset owned by the company, including the cost of
each item, its asset class, useful life, depreciation method,
and salvage value (if any). If the assets are widely distrib-
311
uted through multiple locations, it is also extremely useful

to include an asset location in the register, which the audi-
tors can reference if they elect to physically review a selec-
tion of fixed assets. You should be certain that the cost to-
tals in the fixed asset register tie to the related account bal-
ances in the general ledger, or provide a detailed reconcilia-
tion that reveals (and justifies) any differences between the
two.
Tip:
Matching the totals in the fixed asset register to the associated gen-
eral ledger account balances should be a standard practice as part
of closing the books every month. If you do not do so until the end
of the year, you may be facing a mess that requires more investiga-
tory time than you have available.
• Purchases detail. This is a binder in which you store copies

of all supplier invoices for purchased fixed assets, which
the auditors then trace back through the accounting records
to verify that the amounts at which fixed assets were pur-
chased are the amounts recorded in the accounting records.
If you have constructed assets, then you should have an ex-
cellent organizational structure for the underlying purchase
and labor receipts, with a summary page for each project
that lists all costs incurred, and from which the auditors can
trace a total project cost back to the accounting records.
Tip:
The auditors may spend a significant amount of time reviewing the
fixed asset purchases binder, so help them be more efficient by us-
ing a highlighter to point out the amounts on supplier invoices that
you capitalized. Also, if some explanation of capitalized amounts
is needed, append a memo to the relevant documents, so the audi-
tors can reconstruct your record keeping.
312
• Fixed asset roll forward. This is a summary table that be-

gins with the totals for each fixed asset account at the be-
ginning of the audit period, adds to it any changes during
the period that related to asset additions and deletions, and
then concludes with the ending balances for all of these ac-
counts. The auditors will trace the beginning balances in
this table to their audited financial statements from the pre-
ceding year, as well as the ending balances listed in their
trial balance for this year, and all of the changes listed for
the current period. This is a significant document for the
auditors, so you should ensure that the information in it is
correct and ties to all general ledger balances before giving
it to them. An example of a fixed asset roll forward is:
Example of a Fixed Asset Roll Forward Report

Beginning Ending
Account Balance Additions/ Balance
Number Description 12/31/20x1 Deletions 12/31/x2
Asset Categories
1510 Computer equipment $4,200,000 $380,000 $4,580,000
1520 Furniture and fixtures 350,000 (20,000) 330,000
1535 Land improvements 150,000 -- 150,000
1545 Machinery 3,100,000 600,000 3,700,000
1550 Office equipment 200,000 40,000 240,000
Asset totals $8,000,000 $1,000,000 $9,000,000
Accumulated Depreciation Categories

1610 Computer equipment $(1,050,000) $(500,000) $(1,550,000)
1620 Furniture and fixtures (160,000) (50,000) (210,000)
1635 Land improvements (10,000) (10,000) (20,000)
1645 Machinery (900,000) (320,000) (1,220,000)
1650 Office equipment (30,000) (20,000) (50,000)
Accumulated depreciation totals $(2,150,000) $(900,000) $(3,050,000)
Grand total fixed assets $5,850,000 $100,000 $5,950,000
If there are a large number of additions to and deletions

from the schedule, you might consider using a separate col-
umn to document each type of transaction, just to make the
report easier to read and audit.
313
Tip:
If there are many fixed asset transactions, it can be difficult to up-
date the fixed asset roll forward report for a full year. This is espe-
cially problematic when the audit is scheduled to begin shortly af-
ter the year closes. You can mitigate this issue by fully updating
the report in the preceding month, so that it is accurate for 11
months of the year, and then conduct a minor additional roll for-
ward for the final month of the year, thereby bringing it up to date
for the auditors.
What is a trial balance?

A trial balance is a report listing the ending debit and credit bal-
ances in all accounts at the end of a reporting period.
Summary
This chapter has outlined the basic steps that an auditor can be ex-
pected to follow in an audit that relates to fixed assets. However,
the amount of effort expended may vary considerably, depending
upon how much money the company has invested in its fixed as-
sets. If there are few fixed assets, as is commonly the case in many
services businesses, an auditor may conclude that the entire
amount of fixed assets listed on a company’s balance sheet is so
minimal as to only require the briefest auditor attention. Con-
versely, in an asset-intensive business, the auditors may find it
necessary to comb through the accounting records in great detail,
given the impact on the financial statements of having incorrect
account balances in this area. Thus, the information in this chapter
does give an overview of the procedures that auditors follow, but
does not give an indication of whether they elect to follow those
procedures, or the intensity with which they choose to do so.
314
Review Questions
1. The auditor’s presentation objective is intended to address

whether:
a. All fixed assets have been valued correctly
b. All fixed asset purchases were properly authorized
c. All fixed assets have been recorded
d. All fixed assets have been appropriately disclosed
2. The auditor’s verification of depreciation does not include:

a. Manually recomputing selected items
b. Comparing to prior years for reasonableness
c. Examining useful lives
d. Verifying the existence of assets
3. The following is not an audit procedure for held for sale assets:
a. Investigate whether there are any liens on such assets
b. Investigate the documentation supporting this classifi-
cation
c. Investigate any revaluation of assets classified as held
for sale
d. Determine whether such assets should continue to be
classified as held for sale
4. The fixed asset roll forward report is designed to:

a. Show the changes in the various fixed asset accounts
from the beginning to the end of the period being au-
dited
b. Contain the purchasing records for all fixed assets
c. List every fixed asset owned by the company
d. List the ending debit and credit balance for all accounts
at the end of a reporting period
315
Review Answers
1. The auditor’s presentation objective is intended to address

whether:
a. Incorrect. Proper valuation is the intent of the valuation
objective.
b. Incorrect. Proper authorization is the intent of the au-
thorization objective.
c. Incorrect. Proper recording of assets is the intent of the
recordation objective.
d. Correct. Appropriate disclosure is the intent of the
presentation objective.
2. The auditor’s verification of depreciation does not include:

a. Incorrect. The manual recomputation of depreciation is
a standard audit procedure.
b. Incorrect. Comparing the depreciation expense to the
expense in prior years is a standard audit procedure.
c. Incorrect. The examination of the useful lives of assets
is a standard audit procedure.
d. Correct. Verifying the existence of fixed assets is an
audit procedure, but it is not related to the auditing of
depreciation.
3. The following is not an audit procedure for held for sale assets:
a. Correct. Investigating liens is not an audit procedure
for held for sale assets.
b. Incorrect. Investigating supporting documentation is an
audit procedure for held for sale assets.
c. Incorrect. Investigating asset revaluations is an audit
procedure for held for sale assets.
d. Incorrect. Determining the continuance of an asset in
the held for sale classification is a proper audit proce-
dure.
316
4. The fixed asset roll forward report is designed to:

a. Correct. The fixed asset report is designed to show the
changes in the various fixed asset accounts from the
beginning to the end of the period being audited.
b. Incorrect. The purchases detail binder contains the pur-
chasing records for all fixed assets.
c. Incorrect. The fixed assets register lists every fixed as-
set owned by the company.
d. Incorrect. The trial balance lists the ending debit and
credit balance for all accounts at the end of a reporting
period.
317
Appendix
Journal Entries
The following journal entries show the format you can use for
most accounting transactions related to fixed assets. They are
sorted in alphabetical order by type of activity.
Amortization. To record the amortization of intangible assets for a

reporting period.
Debit Credit
Amortization expense xxx
Accumulated amortization xxx
Asset exchange. To record the exchange of dissimilar assets. This

entry also eliminates the accumulated depreciation on the asset
being relinquished. There are line items in the entry for the
recognition of either a gain or a loss on the exchange. You may
need to add either a debit or a credit to this entry if cash is be-
ing paid or accepted.
Debit Credit
Asset acquired [state the account] xxx
Accumulated depreciation xxx
Loss on asset exchange [if any] xxx
Gain on asset exchange [ if any] xxx
Asset relinquished [state the account] xxx
Asset held for sale #1 (initial reclassification). To record the re-

classification of an asset to the held for sale asset class.
Debit Credit
Assets held for sale xxx
Asset [state the account] xxx
Asset held for sale #2 (fair value decline). To record the decline in
fair value of an asset classified as held for sale.
Appendix – Journal Entries
Debit Credit
Loss on decline of fair value of assets xxx
held-for-sale
Asset held for sale #3 (fair value recovery). To record the recovery
in fair value of an asset classified as held for sale.
Debit Credit
Recovery of fair value of assets xxx
held-for-sale
Asset held for sale #4 (sale of asset). To record the sale of an asset
classified as held for sale. The entry includes line items for a
gain or loss on the sale transaction.
Debit Credit
Cash xxx
Loss on asset sale [if any] xxx
Gain on asset sale [ if any] xxx
Asset impairment. To record the reduction in an asset’s book value

to its fair value when the fair value is less than its book value.
Debit Credit
Impairment loss xxx
Accumulated impairment xxx
Asset retirement obligation #1 (initial recognition). To record the

initial liability for an asset retirement obligation.
Debit Credit
Asset retirement obligation liability xxx
319
Asset retirement obligation #2 (accretion expense). To record the

periodic accretion expense associated with an asset retirement
obligation liability.
Debit Credit
Accretion expense xxx
Asset retirement obligation liability xxx
Asset retirement obligation #3 (depreciation expense). To record the

periodic depreciation expense for the asset of which the asset re-
tirement obligation is a part.
Debit Credit
Depreciation expense xxx
Asset retirement obligation #4 (settlement). To record the settle-

ment and derecognition of the asset retirement obligation.
There are additional line items for the recognition of a gain or
loss on the settlement, depending upon the amount of expendi-
tures actually incurred.
Debit Credit
Remediation expense [if any] xxx

Loss on ARO settlement [if any] xxx
Gain on ARO settlement [if any] xxx
Asset revaluation #1 (accumulated depreciation elimination). To

record the elimination of accumulated depreciation associated
with a fixed asset prior to its being revalued under IFRS.
Debit Credit
320
Asset revaluation #2 (gain on revaluation). To record a revaluation

gain under IFRS. An additional line item is included for the re-
versal of a loss on revaluation in a prior period (if any).
Debit Credit
Asset [state the amount] xxx
Loss on revaluation [a reversal, if any] xxx
Other comprehensive income – gain xxx
on revaluation
Asset revaluation #3 (loss on revaluation). To record a revaluation

loss under IFRS. An additional line item is included for the re-
versal of a gain on revaluation in a prior period (if any).
Debit Credit
Loss on revaluation xxx
Other comprehensive income – gain on xxx
revaluation [a reversal, if any]
Capital lease. To record the initial acquisition of a leased asset that

is classified as a capital lease.
Debit Credit
Asset (capital lease) xxx
Capital lease obligations xxx
Component replacement. To record the replacement of a compo-

nent. This entry eliminates the original asset and any accumu-
lated depreciation, while a second entry records the replace-
ment component. There is a loss on asset derecognition stated
in the entry, on the assumption that the asset being replaced has
not yet been fully depreciated as of the replacement date.
Debit Credit
Loss on asset derecognition [ if any] xxx
Asset [being replaced, state the ac- xxx
count]
321
Debit Credit
Cash or Accounts payable xxx
Depreciation. To record the depreciation expense incurred for a

reporting period. Many line items are presented for the accu-
mulated depreciation for different types of asset classes. You
may also apportion the depreciation expense among depart-
ments or subsidiaries.
Debit Credit
Depreciation expense xxx
Accumulated depreciation – xxx
Buildings
Computers
Equipment
Furniture
Software
Vehicles
Derecognition (sale). To eliminate a fixed asset from the account-

ing records upon its disposal through a sale to a third party.
The entry provides for recognition of either a gain or loss on
the transact ion.
Debit Credit
Cash xxx
Loss on asset sale [if any] xxx
Gain on asset sale [ if any] xxx
322
Donated asset #1 (related to major activities). To record the re-

ceipt of a donated asset by a not-for-profit entity, where the
donated asset is related to the entity’s major activities.
Debit Credit
Revenue xxx
Donated asset #2 (related to peripheral activities). To record the

receipt of a donated asset by a not-for-profit entity, where the
donated asset is related to the entity’s peripheral activities.
Debit Credit
Gain on contributed assets xxx
Interest capitalization. To capitalize the interest cost associated

with the construction of a fixed asset.
Debit Credit
Interest expense xxx
323
Glossary
This glossary contains terms specific to or related to fixed assets or
the accounting for fixed assets.
Accretion expense. The expense arising from an increase in the
carrying amount of the liability associated with an asset retire-
ment obligation. It is not an interest expense. It is classified as
an operating expense in the income statement.
Accumulated amortization. The sum total of all amortization ex-
pense recognized to date on an amortizable intangible asset.
Accumulated depreciation. The sum total of all depreciation ex-
pense recognized to date on a depreciable fixed asset.
Accumulated impairment. The cumulative amount of impairment
charged to a fixed asset.
Active market. A market in which the items being traded are ho-
mogenous, there are willing buyers and sellers, and prices are
available to the public.
Amortization. The write-off of an intangible asset over its expected
period of use.
Assessed value. The valuation assigned to a property by a govern-
ment appraiser. This valuation is used as the basis on which
property taxes are calculated.
Asset class. Assets of a similar nature and use that are grouped to-
gether. Examples of asset classes are land, buildings, machin-
ery, furniture and fixtures, and office equipment.
Asset group. The unit of accounting for one or more fixed assets,
which is the lowest level at which you can identify cash flows
that are independent from the cash flows of other asset groups.
Asset number. A unique identification number that is typically
etched into a metal plate and affixed to a fixed asset. It may be
the primary form of identification in the fixed asset database.
Glossary
Asset retirement obligation. A liability associated with the retire-

ment of a fixed asset.
Balance sheet. A report that summarizes all of an entity’s assets,
liabilities, and equity as of a given point in time, which is usu-
ally the end of an accounting period.
Book value. An asset’s original cost, less any depreciation that has
Boot. The cash paid as part of an exchange of assets between two
parties.
Capital expenditure. A payment made to acquire or upgrade an
asset. You record a capital expenditure as an asset, rather than
charging it immediately to expense. Instead, you depreciate it
over the useful life of the asset.
Capitalization. When you record an expenditure as an asset, rather
than an expense. This usually occurs when the amount of an
expenditure exceeds a company’s capitalization limit, and it
has a useful life of greater than one year.
Capitalization limit. The amount paid for an asset, above which an
entity records it as a fixed asset. If an entity pays less than the
capitalization limit for an asset, it charges the asset to expense
in the period incurred.
Capitalization rate. The rate you use to calculate the amount of
interest to be capitalized.
Carrying amount. The recorded amount of an asset, net of any ac-
cumulated depreciation or accumulated impairment losses.
Cash-generating unit. The smallest identifiable group of assets that
generates cash inflows independently from the cash inflows of
other assets. Examples are product lines, businesses, individual
store locations, and operating regions.
Chart of accounts. A listing of all accounts used in the general
ledger, usually sorted in order by account number.
325
Glossary
Collateral. An asset that a borrower has pledged as security for a

loan. The lender has the legal right to seize and sell the asset if
the borrower is unable to pay back the loan by an agreed date.
Commercial substance. A condition that arises when an entity’s
future cash flows are expected to change significantly as a re-
sult of a transaction. A cash flow change is considered signifi-
cant if the risk, timing, or amount of future cash flows of the
asset received differ significantly from those of the asset given
up.
Conditional promise to give. A promise to contribute that is de-
pendent upon the future occurrence of a specific future event
whose occurrence is uncertain.
Cost to sell. The costs incurred in a sale transaction that would not
have been incurred if there had been no sale. Examples of costs
to sell are title transfer fees and brokerage commissions.
Custodian. The person who is responsible for a fixed asset. Also
known as the responsible party.
Depletion base. The natural resource that is to be depleted as an
asset. It is comprised of the acquisition, exploration, develop-
ment, and restoration costs associated with the asset.
Depreciation. The gradual charging to expense of an asset’s cost
over its expected useful life.
Derecognition. The process of removing a transaction from the ac-
counting records of an entity. For a fixed asset, this is the re-
moval of the asset and any accumulated depreciation from the
accounting records, as well as the recognition of any associated
gain or loss.
Discount rate. The interest rate used to discount a stream of future
cash flows to their present value. Depending upon the applica-
tion, typical rates used as the discount rate are a firm’s cost of
capital or the current market rate.
326
Glossary
Disposal group. A group of assets that you expect to dispose of in

a single transaction, along with any liabilities that might be
transferred to another entity along with the assets.
Easement. The legal requirement to allow access to a property by
third parties for a specific purpose.
Executory costs. The transactional and operational fees associated
with a lease, which includes such items as insurance, mainte-
nance, and taxes.
Expenditure. A payment or the incurrence of a liability by an en-
tity.
Fixed asset. An expenditure that generates economic benefits over
a long period of time. Also known as property, plant, and
equipment.
General ledger. The master set of accounts that summarize all
transactions occurring within an entity.
Gross carrying amount. The total cost of a fixed asset prior to any
reductions for depreciation or impairment.
Held for sale. A designation given to assets that an entity intends
to sell to a third party within one year. You do not depreciate a
fixed asset that is designated as held for sale.
Impairment. When the carrying amount of a fixed asset exceeds its
fair value. The amount of the impairment is the difference be-
tween the two values.
Income statement. A financial report that summarizes an entity’s
revenue and expenses, as well as its net income or loss. The in-
come statement shows an entity’s financial results over a spe-
cific time period, usually a month, quarter, or year.
In service date. The date on which an asset is brought to the condi-
tion and location for which it was intended. This is the point at
which cost accumulation and interest capitalization ends, and
when depreciation begins.
327
Glossary
Intangible asset. An identifiable, non-monetary asset that has no

physical substance.
Intangible asset class. A group of intangible assets having similar
characteristics and usage. Examples are brand names, licenses,
and copyrights.
Interest. The cost of funds loaned to an entity by a lender, usually
expressed as a percentage of the principal on an annual basis.
Lessee. The party in a leasing transaction that contracts to make
rental payments to a lessor in exchange for the use of an asset.
Location code. An abbreviation of the address and room within
which a fixed asset is located.
Other comprehensive income. A separate section of the income
statement that follows the profit or loss section. It contains
various items of revenue, expense, gains, and losses that do not
appear within profit or loss.
Periodic depreciation. The amount of depreciation recorded in the
current accounting period.
Profit or loss. That portion of the income statement prior to other
comprehensive income. It contains the results of operations,
plus finance and tax expenses, and the effect of discontinued
operations.
Property, plant, and equipment. An expenditure that generates
economic benefits over a long period of time. Also known as a
fixed asset.
Purchase cost. The installed cost of an asset.
Recoverable amount. The higher of an asset’s fair value less any
costs to sell, and its value in use. Value in use is the present
value of any future cash flows you expect to derive from an as-
set.
Reporting unit. An operating segment or one level below an oper-
ating segment. An operating segment is a component of a pub-
328
Glossary
lic entity that engages in business activities and whose results

are reviewed by the chief operating decision maker, and for
which discrete financial information is available.
Residual value. The estimated amount that you would currently
obtain upon the disposal of a fixed asset at the end of its esti-
mated useful life. Also known as salvage value.
Responsible party. The person who is responsible for a fixed asset.
Also known as the custodian.
Salvage value. The estimated amount that you would currently ob-
tain upon the disposal of a fixed asset at the end of its esti-
mated useful life. Also known as residual value.
Serial number. A unique number assigned to a fixed asset by its
manufacturer. The serial number may be used in place of a
company-assigned asset number.
Supplier. The entity from which a company purchases a fixed as-
set. Can also be identified as the manufacturer or vendor.
Temporary difference. The difference between the carrying amount
of an asset or liability in the balance sheet and its tax base.
Throughput. Revenues minus totally variable costs. Totally vari-
able costs are usually just the cost of materials, since direct la-
bor does not typically vary directly with sales.
Unconditional promise to give. A commitment that only requires
the passage of time or a demand by the receiving entity for the
commitment to be realized.
Useful life. The estimated lifespan of a depreciable fixed asset, dur-
ing which it can be expected to contribute to company opera-
tions.
Value in use. The present value of any future cash flows you ex-
pect to derive from an asset or cash-generating unit.
Warranty period. The time period during which the manufacturer
will pay for repairs to equipment, or its replacement.
329
Glossary
Zoning classification. The type of use to which a property may be

put, as per the guidelines issued by the government having ju-
risdiction over the property. Examples of zoning classifications
are agricultural, commercial, industrial, open space, residential,
and retail.
330
Index
Bottleneck analysis, 19
Abandoned assets, 166 Bottleneck utilization, 299
Accelerated depreciation, 95 Building
Accretion expense, 84 Asset account, 4
Accumulated depreciation Record keeping, 213
Calculation of, 109 Business combinations, 45, 58
Definition of, 121
Accumulated depreciation to fixed Capital budgeting
assets ratio, 294 Definition of, 17
Acquisition cost, 44 Policies and procedures, 251
Active market, definition of, 145 Post-installation review, 32
Amortization, definition of, 92 Process, 17
Art, valuation of, 202 Proposal analysis, 24
Asset approval form, 236 Proposal form, 28
Asset class, definition of, 120 Capital expenditure, 30
Asset classes, 208 Capital lease
Asset condition monitoring, 285 GAAP accounting, 45
Asset replacement report, 228 IFRS accounting, 58
Asset retirement obligation Capitalization
Definition of, 81 Definition of, 66
Disclosure of, 174 Limit, 2, 39, 117
IFRS accounting for, 88 Rate, 71
Impact on impairment, 130 Capitalized interest, disclosure of,
Liability for, 81 181
Measurement of, 83 Carrying amount, definition of, 61
Policies and procedures, 267 Cash flow to fixed asset
Settlement of, 86 requirements ratio, 295
Asset tags, 280 Cash-generating unit
Audit of fixed assets Definition of, 183
Auditor requests, 311 Impairment of, 147
Internal, 241 Change in estimate
Objectives, 306 Disclosure of, 176, 182
Procedures, 307 Chart of accounts
Audit report, 225 Asset codes, 210
Definition of, 210
Balance sheet, 2 Class, definition of, 173
Bar code tracking, 282 Collateral, 34
Base unit, 41 Commercial substance, 48, 61
Book value, definition of, 99, 291 Component of an entity, 164
Boot Computer equipment asset account,
Accounting for, 49 4
Definition of, 49 Conditional promise to give, 199
331
Constraint analysis, 18 Sum-of-the-years' digits, 97
Construction Units of production, 103
Accounting procedure, 257 Derecognition, definition of, 55
Record keeping, 212 Disclosure
Construction in progress asset Asset retirement obligations,
account, 4 174
Contributed assets Capitalized interest, 181
Restrictions on, 199 Change in estimate, 176, 182
Valuation of, 200 General fixed asset, 179
Contributed services General fixed asset topics, 173
Valuation of, 201 Held-for-sale assets, 185
Controls Impairment, 187
Asset acquisition, 236 Intangible assets, 178, 189
Asset construction, 239 Interest capitalization, 176
Depreciation, 244 Recoverable amount, 183
Disposal, 245 Revaluation, 191
Laptop computers, 246 Discontinued operations, 164
Not-for-profit entity, 203 Discount rate, definition of, 20
Theft, 240 Disposal
Valuation, 242 GAAP accounting for, 166
Cost model, 120 IFRS accounting for, 168
Cost to sell, 160 Policies and procedures, 270
Disposal group, definition of, 157
Depletion Document retention, 221
Base, 101 Donated assets. See Contributed
Method, 100 assets
Policy, 263 Double declining balance
Procedure, 265 depreciation, 98
Depreciation
Accelerated, 95 Equipment
Accumulated, 109 Asset account, 5
Concepts, 93 Record keeping, 215
Controls, 244 Exchange
Definition of, 2, 92 IFRS non-monetary, 60
Double declining balance, 98 Non-monetary, 47
IFRS, 110 Policies and procedures, 261
Journal entries, 108 Executory costs, 46
MACRS, 104
Of not-for-profit assets, 202 Fair value less costs to sell, 144
Policies and procedures, 262 Finance lease, 58
Purpose of, 93 Fixed asset
Report, 222 Accounts, 208
Straight-line, 97
332
Capitalization of later Reversal of, 133, 148
expenditures, 116 Timing of test, 131
Definition of, 1 Income statement, 2
Derecognition, 156 Inspections, capitalization of, 54
Disclosures under GAAP, 173 Intangible asset
Disclosures under IFRS, 179 Class, 189
Disposal of, 166 Definition of, 5
IFRS business combinations, 58 Disclosure of, 178, 189
IFRS initial cost of, 55 Impairment disclosure, 177
IFRS recognition of, 53 Policies and procedures, 268
Impairment, 129 Revaluation of, 124
Manual, 274 Interest, 66
Register, 311 Interest capitalization
Roll forward report, 313 Calculation of, 73
Furniture and fixtures asset Derecognition of, 75
account, 5 Disclosure of, 176
IFRS accounting for, 75
General ledger, definition of, 208 Period, 69
Generally Accepted Accounting Rate, 71
Principles, 7 Reason for, 66
Usage of, 68
Held-for-sale International Financial Reporting
Accounting for, 156 Standards, 7
Definition of, 131
Disclosure of, 185 Journal entries, compilation of, 318
Disposal group, 157
Measurement of disposal losses Land
on, 130 Definition of, 5
Reclassification from, 161 Depreciation of, 107
Historical treasures, valuation of, Record keeping, 218
202 Land improvements
Definition of, 5
Idle assets, 166 Depreciation of, 107
Impairment Lease
Accounting for, 132 Capital, 45
Corporate asset testing, 138 Record keeping, 219
Disclosure of, 187 Lease or buy decision, 33
IFRS accounting, 134 Leasehold improvements, 5
Indicators of, 138 Lessee, definition of, 46
Intangible asset disclosure of,
177 MACRS depreciation, 104
Measurement of, 129 Maintenance report, 230
Policies and procedures, 266 Matching principle, 1
333
Mid-month convention, 95 Property, plant, and equipment,
definition of, 3
Net present value analysis, 17, 20
Non-monetary exchange Record keeping
GAAP Accounting, 47 Building, 213
IFRS accounting, 60 Construction, 212
Not-for-profit Equipment, 215
Asset controls, 204 Land, 218
Asset depreciation, 202 Lease, 219
Asset recognition, 197 Policies, 271
Asset recordation, 203 Procedure, 258
Entity, 197 Recoverable amount, definition of,
134
Office equipment, 5 Repair and maintenance costs, 53
Other comprehensive income, 122 Repairs and maintenance expense
to fixed assets ratio, 292
Payback method, 23 Replacement parts, 53
Policies Reporting unit, definition of, 131
Asset exchange, 261 Reports
Asset retirement obligation, 267 Asset replacement, 228
Asset tracking, 272 Auditor, 225
Asset transfer, 270 Depreciation, 222
Capital budgeting, 251 Fixed asset roll forward, 313
Depreciation, 262 Fixed assets register, 311
Disposal, 270 Maintenance, 230
Impairment, 266 Responsibility, 227
Intangible asset, 268 Responsibility report, 227
Record keeping, 271 Return on assets employed, 296
Revaluation, 259 Return on operating assets, 298
Procedures Revaluation
Asset exchange, 261 Disclosures, 191
Asset recognition, 256 Model, 120
Asset retirement obligation, 267 Of intangible assets, 124
Asset tracking, 273 Of tangible assets, 120
Auditor, 307 Policies, 259
Capital budgeting, 252 Procedure, 260
Depreciation, 264 RFID tracking, 283
Disposal, 270
Impairment, 266 Sales to fixed assets ratio, 290
Intangible asset, 268 Salvage value, 94
Revaluation, 260 Software, 5
Profit or Loss, 122 Straight-line depreciation, 97
334
Sum-of-the-years' digits Unscheduled machine downtime,
depreciation, 97 300
Useful life, 4, 93
Temporary difference, 106
Throughput, definition of, 19 Value in use
Trial balance, 314 Calculation of, 141
Definition of, 139
Unconditional promise to give, 199 Vehicles, 5
Unit depletion rate, 101
Units of production method, 103 Wireless monitoring, 285
335

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AccountingTools Series

Steven M. Bragg, CPA

The Comprehensive Guide

Published by Steven M. Bragg, Centennial, Colorado.

No part of this publication may be reproduced, stored in a retrieval system, or

Limit of Liability/Disclaimer of Warranty: While the publisher and author have

Printed in the United States of America

Chapter 2 - Capital Budgeting Analysis 17

Chapter 3 - Initial Fixed Asset Recognition 39

Chapter 4 - Interest Capitalization 66

Chapter 5 - Asset Retirement Obligations 81

Chapter 6 - Depreciation and Amortization 92

Chapter 7 - Subsequent Fixed Asset Measurement 116

Chapter 8 - Fixed Asset Impairment 129

Chapter 9 - Fixed Asset Disposal 156

Chapter 10 - Fixed Asset Disclosures 173

Chapter 11 - Not-for-Profit Fixed Asset Accounting 197

Chapter 12 - Fixed Asset Record Keeping 208

Chapter 13 - Fixed Asset Controls 236

Chapter 14 - Fixed Asset Policies and Procedures 251

Chapter 15 - Fixed Asset Tracking 280

Chapter 16 - Fixed Asset Measurements 290

Chapter 17 - Fixed Asset Auditing 306

Appendix - Journal Entries 318

• Part I – Accounting for Fixed Assets. Chapters 1 through 9

Accounting and Finance for Your Small Business

Free On-Line Resources

What are Fixed Assets?

By designating an expenditure as a fixed asset, we are shifting the

What is the Income Statement?

What is the Balance Sheet?

The process of identifying fixed assets, recording them as assets,

An alternative treatment of the $5,000 mold in the preceding ex-

The “Fixed Asset” Designation

• The PP&E name is simply too long.

Thus, we are using the more all-encompassing “fixed assets” term

Fixed Asset Classifications

What is a Useful Life?

You also usually create general ledger accounts by classification,

it. Besides the materials and labor required for construction,

A capital lease is not usually identified as a separate asset, since a

Henderson Industrial decides to construct a new production facility. It purchases

Expenditure Item Classification Useful Life Depreciation

Applicable Accounting Frameworks

Accounting for Fixed Assets

• Initial recognition. There are a number of factors to con-

The Fixed Asset Impairment chapter delves into this ac-

The accounting transactions noted above can involve a consider-

Accounting for Intangible Assets

Accounting for Not-for-Profit Fixed Assets

Fixed Asset Disclosures

GAAP and IFRS have different disclosure requirements, so we

Fixed Asset Controls

ures. These sensors, as well as location tracking sensors, are de-

Fixed Asset Policies and Procedures

Fixed Asset Record Keeping

• Asset replacement report. Includes information about each

Fixed Asset Auditing

Fixed Asset Measurements