When companies buy big ticket items like buildings, machinery, or vehicles, accountants are not necessarily required to keep those assets on the books in a specific way. There are rules, of course, but management and the board of directors have some leeway to determine the best way to account for these assets.
To document how the company will address these situations, management creates a fixed asset capitalization policy to guide the accountants, auditors, and regulators on the treatment of these high value assets.
What are fixed assets and how are they accounted for?
A fixed asset is a long lasting, tangible piece of property owned by a company. A company's building, land, equipment, vehicles, and machinery are all typical examples of fixed assets.
Because these assets provide value to the company over a long period of time, several years or more, accountants treat them differently than other expenses incurred in the operation of the company.
For example, a marketing expense is included on a company's income statement in the year that the money was spent. This is because the benefit from that marketing expense was most likely fully realized in the same period. That expense, therefore, is matched up with the income that it produced this year.
The value of a new production facility is not as straightforward. The new production capacity is useful not just this year, but also next year and many years into the future. Accountants must find a way to expense an appropriate amount of the buildings initial cost and ongoing maintenance in each year that the building provides value.
To do that, they capitalize these fixed assets, and expense only a portion of the fixed asset's costs each year.
How capitalization works
Fixed assets are recorded on the company's balance sheet as an asset. Strictly speaking, putting any asset on the balance sheet is called "capitalizing" it.
Using specific, standardized formulas for each type of asset, accountants take into account the asset's cost, its ongoing maintenance expenses, and its anticipated useful life.
With those variables, the accountant expenses a certain portion of the asset's costs each year as a line item on the income statement called depreciation. The value of the asset is decreased on the balance sheet in line with its depreciation expense to balance the financial statements. In this way the accountant is able to match the cost of the asset with the value it provides over time.
How the company's fixed asset capitalization policy comes into play
Within the accounting rules for fixed assets, companies have some flexibility in how, when, and what they capitalize and expense. The company's fixed asset capitalization policy defines how the company will address these choices.
Generally, the policy will define a certain threshold dollar amount above which assets will be capitalized and below which items will be expensed. For example, a copy machine is technically a fixed asset that will last for a number of years. However, for most businesses the cost to purchase the copy machine is too low to bother with complex capitalization accounting. Because the cost is insignificant, the company is allowed to expense the full cost of the copier at one time. A multi-million dollar production facility, on the other hand, should be capitalized.
Another choice involves multiple assets that function in similar or interrelated ways. The rules allow for some of these assets to be capitalized together as a group, while others should have separate accounting. A group of machines all on the same assembly line could be grouped, for example, as opposed to equipment at different locations which may be better treated individually. The same decision applies to how the company will address the repairs and maintenance expenses for the various machines. In all of these cases, the fixed asset capitalization policy defines when and how the company will make these choices.
The policy will also include any conventions that apply to the given industry within which the company operates. The company can choose to follow these standard practices or not, but the decision should be consistent and documented in its policies.
The fixed asset capitalization policy ensures consistency and accuracy
The accounting of fixed assets can be a complex and confusing process. Defining exactly how the company will address these issues in a comprehensive fixed asset capitalization policy is an important responsibility for the management team.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus. Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at email@example.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.