Learning one basic rule about business expenditures will vastly improve bookkeeping accuracy and avoid tax-reporting mistakes. This standard is simply the fact that some (but not all) purchases of items used in business are not expenses. These exceptions are assets.
Business assets appear on the balance sheet, which is a key component of your financial statements. By contrast, the income statement has the incomplete picture of only revenue and expenses. The balance sheet shows you what happened to profit that remained after paying expenses with revenue. Over time, the balance sheet may indicate that profit was used to increase funds in the bank account or repay loans. Another use of profit is acquisition of fixed assets, such as new equipment, machinery or building improvements.
Great care is necessary to identify expenditures that should be classified as fixed assets on the balance sheet. Most importantly, accounting help may be necessary when you borrow money to acquire a fixed asset. The entire asset cost and loan amount are recorded. Loan payments are therefore not expenses or asset additions. They are reductions in the loan balances on the balance sheet.
Fixed Asset Tax Classification
Improperly recording an asset purchase as an expense results in understated profit. This upsets tax planning. For income tax purposes, the costs of fixed assets are deducted as depreciation over time. Complicating this matter is the variety of periods over which different types of assets are depreciated. Your accountant therefore needs not only the cost for a fixed asset but also a description and the date when it was first used in business.
As a general rule, depreciable fixed assets are property with a useful life of more than one year. But small assets are an exception. A screwdriver, for example, may be an office expense on the income statement, although it will last for more than a year. But a programmable robotic assembly machine should be classified as a fixed asset on the balance sheet.
The threshold amount that identifies when a purchase qualifies for expensing tends to vary based on business size. For small businesses, the U.S. Internal Revenue Service generally permits an expense deduction for any single item with a cost of less than $2,500. Anything with a greater cost and a useful life exceeding one year should be classified as a fixed asset. Its cost is then depreciated over the allowable length of time permitted by the tax rules for the type of property.
Additions to Asset Value
An especially complicated purchase to classify is an improvement to an existing asset. Expenditures that improve property are categorized as new assets. Improvements to buildings are the most common area of confusion. But the issue also applies to machinery.
In general, a cost that merely makes something operate better is an expense. Conversely, you’ve acquired an asset when you spend money that adds to the life of a property, expands its size or is crucial to its functionality. For instance, fixing a hole in the ceiling may be a repair expense, but replacing the entire roof is likely considered an asset. The IRS has threshold amounts to distinguish repair expenses from improvement assets. These quantities vary based on multiple factors. So checking with your accountant about the numbers that apply to your business is the ideal route for avoiding errors.