The Fixed Asset Policy (#329)
/The Nature of a Fixed Asset Policy
This episode covers the main contents for a fixed asset policy. First, what is a fixed asset policy, and why do we need it? It describes how you’re supposed to account for fixed assets. This isn’t minor, because without it, there’s a good chance that you’ll set up a different useful life, depreciation type, and salvage value for every asset you acquire, which can be quite a mess.
Fixed Asset Classifications
The first step in setting up a fixed asset policy is deciding upon how many classifications of fixed assets you’re going to use. For example, you could set up classifications for buildings, furniture and fixtures, vehicles, computer hardware, and production equipment. It all depends on the nature of the business.
The reason for doing this is to assign a standard useful life and depreciation method to each classification, which is then applied to each fixed asset within that classification. So for example, you might assign a seven-year useful life to the furniture and fixtures category, with straight-line depreciation, and no salvage values allowed. That last part is useful for some categories, because there’s rarely any salvage value associated with furniture.
Now, don’t go too deep with the classifications concept. Unless your business has thousands of assets, it doesn’t make a lot of sense to have dozens of classifications. Keep it relatively simple. Ten classifications or less might be fine, and if you go past twenty classifications, you should start to question what the extra level of detail is really achieving.
Then assign useful lives and depreciation methods to each of the classifications. The useful life figure can be calculated from an average of the company’s experience with its own assets. Again, don’t be too anal about it. If your research indicates that the useful life of computer hardware is 3.8 years, then round it up to four years. That’s good enough.
Depreciation Methods
As for depreciation methods, I personally prefer the straight-line method in all cases, because accelerated depreciation tends to skew a bunch of performance ratios, like return on assets. But that’s your call. Whatever method you decide to use, try to apply it consistently across all of the fixed asset classifications. You don’t have to, but consistency of application will make life easier, and you’ll make fewer mistakes when calculating depreciation.
Fixed Asset Salvage Values
As for salvage values, that will vary by individual asset. But I would suggest that you apply a flag to each of the classifications that either allows the application of salvage values, or it does not. By doing so, you don’t have to mess with trying to derive what are probably minor salvage values for most fixed assets. For example, building assets and equipment assets probably have significant salvage values, while furniture, computer hardware, and computer software probably don’t.
The Capitalization Threshold
That covers asset classifications. Next up, include a capitalization threshold in the policy. This is the dollar value for an asset purchase that represents the dividing line between charging the purchase directly to expense, or recording it as a fixed asset. This threshold is used to keep from wasting time recording minor items as fixed assets. For example, a wireless mouse for your computer will be used over several years, and so it could be classified as a fixed asset – but why bother when it only costs a few dollars?
The usual approach is to make a common-sense judgment about what types of purchases you want to keep track of over the long term. Also, if you do an historical analysis of how much various purchases cost, there’s usually a natural dividing line for what appears to constitute a fixed asset. The exact amount will vary by company. A really small firm might set the capitalization level as low as $1,000, while others might use $2,500 or $5,000. A really large firm might decide that $10,000 works for them.
A key point here is that the accounting standards do not state that you can use a capitalization limit. It’s simply allowed through common usage. Auditors will allow it, because charging something off to expense in the current period is always more conservative than capitalizing it and then charging it off through depreciation over a number of years. And auditors like conservative accounting.
Multiple Fixed Asset Purchases
A final item is what to do with lots of assets purchased on a single invoice. For example, you could buy a bunch of chairs that individually fall below the capitalization limit, but which exceed the limit when charged to the company as a group, on a single invoice. My view is that these items can be capitalized – but you can go either way with it. Just include it in the policy, and apply your decision consistently.
Fraudulent Financial Reporting
That covers the basics. Another issue to be aware of is that the fixed asset policy is prime territory for fraudulent financial reporting. That’s because someone could lengthen the useful life for an asset classification in order to delay recognizing depreciation expense. Or, altering the depreciation method from an accelerated method to the straight-line method would do the same thing.
They can make these changes look like standard procedure by altering the fixed asset policy. To keep this from happening, institute a rule that the audit committee has to approve any changes to the fixed asset policy. This rule might not work, since the people making these changes are company managers, and they may just “forget” to inform the committee. Still, you can at least have the rule in place.
The Need for an Exhaustive Fixed Asset Policy
A final thought is in regard to the original listener question, which was about how to develop an “exhaustive” fixed asset policy. It’s that word “exhaustive.” Accountants have a reputation for being too bureaucratic, maybe because we want to have rules in place for everything. That’s not actually necessary. You should only create a rule if an issue keeps coming up. If it only happens once, then there’s no need for a rule. To apply this concept to the fixed asset policy, keep it relatively short and to the point. Only expand the policy if there’s an actual ongoing need for a rule.