Accounting for the purchase of major assets can be confusing to many business owners. The trouble arises when the purchase of assets – such as equipment, buildings and other property – is treated as if it were an ordinary expense. In fact, these major purchases should be addressed quite differently; unlike regular expenses, they have long life-spans, and this kind of a purchase should be accounted for by deducting the cost over the item’s useful life as a depreciation expense.
Buildings and land
The most obvious asset categories are buildings and land. Note that these are treated as separate categories because land is considered as distinct from the building that sits on it. The cost of land is never written off as an expense. By contrast, the cost of a building is deducted over time.
Since buildings and land are commonly purchased together, the owner must apportion a separate amount for the land and depreciate the building cost over several years. The acquirer’s cost includes financed amounts, and closing costs are counted as part of the purchase price. Newly constructed business buildings should include depreciable costs for architect fees and land clearing.
Upgrading a property
Adding or replacing some of the structural components of a building increases its life-span, so these costs will also be depreciated rather than expensed immediately. These changes may include upgrades to such important elements as the building’s roof, plumbing system, interior walls or exterior facade.
If you’re making additions or changes to the structure of a building that you’ve leased from someone else, these “leasehold improvements” are also considered assets.
Various types of equipment are purchased for use in business. Distinctive depreciation periods are assigned to machinery, vehicles, computers, software, and other asset types. Small items – such as staplers and disk drives – are expensed immediately rather than depreciated, due to their minimal cost.
The key ingredients involved in accurately calculating depreciation include historical cost, in-service date and property description. Costs for business assets are depreciated over defined periods that depend upon the type of asset. Changes in tax laws occasionally alter these depreciation periods, but the law in effect when an asset is placed in service applies for as long as that property is deployed in the business.
The in-service date is the date that the asset is first used for business purposes. For instance, the costs of a company’s new head office are not depreciated until the enterprise occupies the structure.
Asset value, as it is recorded on small business financial statements, is not adjusted for fluctuation in market value. Rather, the historical cost remains on the organization’s books along with accumulated depreciation.
This historical-cost method is primarily practiced in the U.S., where depreciation is a tax requirement in addition to being an accounting standard. Large companies outside the U.S. may use international financial reporting standards that account for changes in asset market values.
The historical-cost method has the advantage of averting market value assessments, which are typically impractical for small operations.