Assets such as buildings, machinery, trucks, and land are called fixed assets. They are often designated on the balance sheet by the title, "Property, plant, and equipment."
Fixed assets are expected to be of use to the business for several years. When a fixed asset is acquired, it is recorded at cost in accordance with the fundamental accounting concept known as the cost concept.
Accountant
The "cost" of a fixed asset includes all costs of acquiring and installing it to make it ready to use.
Bed Linens Company pays 0,000 for a piece of real property. It also pays ,000 for brokerage, ,000 for legal fees, and ,000 to tear down the existing structures in order to make the land ready for its intended use. The real estate should be recorded in its books at 1,000.
In the case of machinery, transportation and installation costs are usually included. Bed Linens Company purchased a weaving machine paying ,000. The company paid ,000 in freight charges to transport it and,000 in installation charges. This machine should be entered in the accounts at ,000.
If a business constructs a machine or building with its own personnel, all costs incurred in construction are included.
Bed Linens Company builds a new building for itself, using its own personnel. It spends 0,000 in materials, 0,000 in salaries and wages to persons engaged in the building's construction and 0,000 in other cost. This building should be entered in the accounts at 0,000.
When a new fixed asset is acquired and an old asset (i.e., a trade-in) is used as part payment, the fair market value of the trade-in is part of the cost of the new asset. Thus, if Bed Linens Company buys a new delivery truck for ,000 cash plus an old delivery truck the fair market value of which is ,000, the new truck should be recorded at ,000.
If the allowance given for the trade-in differs from the actual value of the trade-in, then the actual market value of the new asset should be used as the cost of the new asset.
Suppose that Bed Linens Company pays ,000 cash for a new delivery truck and receives an allowance of ,700, the new truck can be purchased for ,500 cash. Its cost should be recorded as ,500.
Except in rare cases, land retains its value indefinitely. If Bed Linens Company purchases a piece of land on December 31, l995, at a cost of 0,000, it will be recorded at 0,000 on December 31, l995 and at 0,000 on December 31, 2010.
Assets other than land become useless at some point in time. They have a limited life. Accounting practice treats this process as occurring gradually, that is, a portion of the asset is considered used up in its year of its life, until finally it is completely used up.
Since accounting assumes that some portion of an asset is used up during each year of its life, a portion of the cost of the asset is treated as an expense during each year of its life.
For example, suppose a machine tool is purchased at a cost of ,000 and its useful life is five years. It should be reasonable to charge 1/5 or ,000 as expense in each of the five years.
At the time the machine is acquired, we do not know how long it will prove to be useful. Therefore, one must estimate its useful life.
The process of recognizing a portion of the cost of an asset as an expense during each year of its estimated useful life is called depreciation. For example, the ,000 we take as an expense during each year of the five years of useful life of a machine tool that cost ,000 is termed the depreciation expense for one year.
An asset can become useless for either or both of two reasons:
(1) it may wear out physically; or
(2) it may become obsolete.
A loss of usefulness because of the development of improved equipment, changes in style, or other causes not related to the physical condition of the asset is an example of (2).
Depreciation of an asset relates both to physical wear and to obsolescence. Thus depreciation includes obsolescence. Since depreciation includes obsolescence, it is not quite correct to speak of depreciation and obsolescence as though they are two different phenomena.
To sum up, depreciation is the process of converting the cost of an asset into expense over the life of the asset. This process is employed because an asset gradually loses its usefulness. An asset can lose its usefulness for two reasons:
(a) it wears out;
(b) it becomes obsolete.
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