What Are Fixed Assets?
If you're the owner of a small business, proper accounting records are a crucial component of your success. Not only do they help you figure out your taxes and keep you on the right foot with the Internal Revenue Service (IRS), but they also help you secure funding.
In this guide, we'll go over fixed assets (also referred to as plant, parts, and equipment, or PP&E) on a balance sheet. In your financial reporting, these assets play a vital role in the valuation of your business.
What Is a Fixed Asset?
Fixed assets, also known as capital assets, are physical or tangible assets a business owns and uses to bring in revenue. In other words, they're the long-term assets and equipment you'll use for business operations. There are also intangible assets (e.g., trademarks and intellectual property), but we won't focus on those in this article.
There are current and noncurrent assets. Current assets are considered short-term or liquid and can typically be turned into cash within a year. Inventory is a current asset. Fixed assets are considered noncurrent; a company's investment in a fixed asset is long term and will typically be used to generate income for more than a year. For example, a mechanic's tool set is a fixed asset.
Examples of Fixed Assets
There are a lot of things that your business uses that could be considered fixed assets. On a balance sheet, they show up as PP&E.
- Improvements and updates
- Parking lots or garages
- Computer equipment
- Office equipment
- High-priced software
Why Is It Important to Keep Track of Fixed Assets?
Fixed assets help you create revenue. For example, you use the machinery in your plant to create the items you distribute. They can also be sold if you need to improve cash flow, for example, to pay workers.
They can even help you secure funding. Lenders see fixed assets as collateral if you can't pay back their loans. Investors see businesses that have a lot of fixed assets, like factories, as having potential for profit.
Fixed Assets and Depreciation
Under the accrual method of accounting (the legal standard in the U.S.), fixed assets depreciate over time. This means that their expenses are recognized in multiple years. A business will decide how long it can use an asset (the useful life of the asset) and how much the asset can be sold for after that (the salvage value of an asset).
Four main types of depreciation
This is the simplest strategy. You divide the cost of the asset equally throughout its useful lifetime until it meets its salvage value. The formula is:
For example, your coffee shop purchases an espresso machine for $2,200. It has a useful life of 10 years and a salvage value of $200. Its straight-line depreciation rate is 10%. You would recognize $200 of the expense every year for 10 years until you reach $200.
Double-Declining Balance Depreciation
If you want to recognize more of your asset's cost immediately and less as time goes on, you can use this method. The first year you own an asset, you'll depreciate double the amount (percentage) you would with straight-line depreciation.
Each year after that, you'll deduct the same percentage to the book value (the original price minus depreciation) of that item, rather than the item's initial purchase price. The formula is:
|Double-Declining Balance Depreciation|
(Straight-Line Depreciation Rate x 2)
x First of Year Book Value
For our espresso machine, you would depreciate $440 (20% x $2,200) the first year. The next year, the book value would be $1,760 ($2,200 - $440), and you would depreciate $352 (20% x $1,760).
You would do this every year until you reach the salvage value.
Sum-of-the-Year's-Digits (SYD) Depreciation
Like double-declining balance depreciation, SYD depreciation lets you recognize more of an asset's cost now and less over time, but the depreciation amounts are more balanced throughout the years.
You'll first need to figure out SYD. It's simply all the digits counting up to the asset's life span. If the useful life span is 10 years, the SYD is 55 (1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55). The formula for finding SYD depreciation is:
(Assets Remaining Life Span / SYD)
x (Cost of Asset - Salvage Value)
You would depreciate your espresso machine by $363.64 the first year, $327.27 the second year, and so on until you reach the salvage value.
|(10 / 55) x ($2,200 - $200)||= $363.64|
|(9 / 55) * ($2,200 - 200)||= $327.27|
Units of Production Depreciation
You can depreciate an item based on how much you use it. A "unit of production" can be anything your asset creates. For our espresso machine, it's a coffee drink.
This method is usually only used for high-worth assets. The formula for figuring out units of production depreciation is:
|Units of production depreciation:|
Let's say you estimate that your espresso machine will make 8,000 drinks during its life span. The depreciation cost of one drink is $0.25.
|Depreciation cost of one drink|
In one year, you make 2,000 drinks. Your depreciation for that year is $500. You'll repeat this process year after year until you reach the salvage value.
To keep track of your depreciation, you should keep a depreciation schedule. This data table will help you visualize the amount each of your assets will depreciate over time. It should include information like:
- Purchase date
- Asset description
- Initial cost
- Useful life span
- Your depreciation method
- Salvage value
If your company has a lot of assets, depreciation can be pretty complicated. Skynova has software products that can help you keep great financial records.
When Are Fixed Assets Used in Small Business Accounting?
As a small business, you'll include fixed assets on several of your accounting documents and financial statements. In the next few sections, we'll go over a few ways they can show up.
In your balance sheet, fixed assets show up as PP&E. Under them, you'll make a line item for their accumulated depreciation cost for the year. You'll subtract the depreciation cost to come up with your cost less depreciation.
|Cost Less Depreciation||$2,000|
Including fixed assets on your balance sheet can help you get a loan. Using the above balance sheet, a lender will see that you have assets with a current value of $2,000, which they can use as collateral if you can't make your loan payments.
On an income statement, assets purchased over a financial period represent a decrease in revenue, while assets sold represent an increase in revenue. Seeing your business assets on an income statement gives possible investors a better view of your company's worth.
Your operating income is the amount of money you've made using your assets (net sales) minus any of the direct (i.e., the cost of goods sold, or COGS) or indirect (i.e., selling, general, and administrative, or SG&A) expenses of doing business. Here's a simplified cross-section of an income statement:
Cash Flow Statements
On a cash flow statement, fixed assets show up under investments. Items that your company purchases throughout the year represent a negative cash flow, while assets your company sells represent a positive cash flow. An item's depreciation is also a positive to cash flow.
For example, if your coffee shop purchases your espresso machine for $2,200 but sells an old espresso machine for $1,000, you have a negative cash flow from investing $1,200.
|Cash Flow From Investing|
|Equipment ($1,000 - $2,200)||($1,200)|
A negative cash flow for your asset account isn't necessarily a bad thing. Your cash flow statement lets investors know where your business is in terms of its development.
A negative investment cash flow tells investors that your company is in its early stages of acquiring assets. This can be attractive to investors looking to get in on the ground floor of your company.
Maintain Accurate Financial Accounting Records Using Skynova
Fixed assets are the things your business uses to make money. Understanding the role that they play in your accounting records is vital for staying in compliance, securing loans, and attracting investors.
Unless you're the proud owner of an accounting startup, you probably don't look forward to bookkeeping. Skynova has accounting software that can make processes like invoicing quicker and less confusing. We also have business templates and other software products to further your business processes.
Notice to the Reader
This article is a general introduction to fixed assets and may not be tailored to your specific business. Always speak to a professional accountant before making any big financial decisions for your business.