Accounting for Fixed Assets
I previously discussed how double-entry accounting works—including how to create the balance sheet—in my article A Basic Introduction to Accounting. Now let's explore some more basic accounting concepts: revenue, expenses, and depreciation. Fixed assets provide a great way to explore these concepts, so let's not waste anytime and get right into it!
Revenue Recognition
Sales Revenue
Imagine we run an airline company. Lucky us. Somebody just bought a plane ticket to escape Seattle's dreary winter weather and soak up the sun in Palm Springs, so let's book the journal entry.
Cash $100
Unearned Revenue $100How come the revenue is unearned?
In US GAAP accounting, revenue recognition principles dictate when revenue is allowed to be recognized.
For physical goods, this is normally at the point of delivery.
In our case, we're providing a service, so we can't book revenue until the customer has taken their plane flight.
This means that while we have received cash, we have to book the revenue in a liability account titled Unearned Revenue.
Once our customer takes their flight to Palm Springs, the revenue has been earned, so we can now recognize it on our books with the following entry.
Unearned Revenue $100
Sales Revenue $100The Fixed Asset Lifecycle
Acquiring a Fixed Asset
Great, now our company has some cash! Now imagine we need to buy a new plane for our fleet. A certain large airplane manufacturer in Washington is in dire straits and is having a major sale on airplanes. We can buy a new airplane for only $100! Let's book our new purchase.
Airplane $100
Cash $100Straight-line Depreciation
Now we have a fixed asset (our new airplane) on the books. Fixed assets are subject to depreciation. Straight-line depreciation is the most commonly used method for depreciating an asset, which we'll use here. Under straight-line deprecation, the annual depreciation expense is calculated by subtracting the residual value of the asset from its cost and dividing the result by the asset's useful life (normally measured in years). Let's say our airplane will have no residual value left over when it's fully depreciated and has a useful life of 2 years. To calculate our annual deprecation expense we take the cost of $100 and remove the residual value. Since our residual value is 0, our dividend in the equation is 100. Our divisor is the 2 years. The result is our depreciation expense, which is the quotient of $100 / 2, or $50.
(100 - 0) / 2 = 50Now it's time to book our depreciation expense for the year. Depreciation expense is offset by a contra asset account called accumulated depreciation, which carries a negative balance to offset the fixed asset.
Depreciation Expense $50
Accumulated Depreciation $50We can now calculate our book value. The equation is the cost of the fixed asset less accumulated depreciation. At the end of the first year, our book value is $50, which is the result of $100 - 50.
cost - accumulated depreciation = book value
100 - 50 = 50The Income Statement
Year 1
Now that the year is over, let's make the income statement. The income statement is a financial statement that captures a company's revenues and expenses over a period of time. Compare that to the balance sheet that we previously discussed, which reflects the current balances of the general ledger at a specific moment in time.
Year 1
--------------------------------
Income Statement
--------------------------------
Revenues
--------------------------------
Sales Revenue $100
--------------------------------
Gross Revenues $100
--------------------------------
Expenses
--------------------------------
Depreciation Expense $50
--------------------------------
Total Expenses $50
--------------------------------
Net Income $50
================================The income statment ultimately represents revenues less expenses to arrive at either a net income or net loss. As you can see, the depreciation expense reduces our net income for the year. This is because we have to account for the expense related to the asset's book value decreasing as it is used1. Because our revenues exceed our expenses, we have net income (aka net profit) for the year.
Year 2
In the next year, we book a similar entry to before.
Depreciation Expense $50
Accumulated Depreciation $50Our accumulated depreciation for the airplane is now $100, which means our book value is now $0. When the book value reaches the residual value of the asset ($0 in our case), the asset has reached the end of its useful life and can be scrapped. To scrap the asset, we must remove the cost of the asset from our books by crediting its original cost. The offsetting entry is to also reduce the accumulated depreciation balance.
Accumulated Deprecation $100
Airplane $100Now the airplane has been removed from our books. Suppose we reach the end of year 2 and somehow didn't manage to sell any flights. We may be facing a going concern, but we still have to prepare our income statement for year 2.
Year 2
--------------------------------
Income Statement
--------------------------------
Revenues
--------------------------------
Gross Revenues $0
--------------------------------
Expenses
--------------------------------
Depreciation Expense $50
--------------------------------
Total Expenses $50
--------------------------------
Net Loss $(50)
================================Well, not a great year for us. We lost $50 because our expenses exceeded our revenue, resulting in a net loss. But at least we learned how to keep track of them and can now do better planning in the future!
Disposing a fixed asset early
We're almost done, but what would happen if we got rid of our airplane before it was fully depreciated? There are multiple ways this could happen. One is if the asset becomes lost or damaged and has to be written off, and another scenario is if we sell the asset early.
Imagine we have recorded a single year of depreciation expense for the airplane. Recall that it has two years of useful life, so it's halfway through. Let's show the depreciation entry again.
Depreciation Expense $50
Accumulated Depreciation $50The airplane currently has a book value of $50.
Writing off a lost or damaged fixed asset
Let's see what writing off a damaged fixed asset early looks like first. Suppose our airplane is damaged to the point of unusability before the end of its life. We would book the following journal entry.
Loss on asset disposal $50
Accumulated Depreciation $50
Airplane $100As you can see above, we have to book a loss on the asset disposal of $50 to balance the entry in order to sum to the total value of the original cost of the $100 airplane. Loss on asset disposal is an expense. Let's see how this change affects our income statement.
Year 1
--------------------------------
Income Statement
--------------------------------
Revenues
--------------------------------
Sales Revenue $100
--------------------------------
Gross Revenues $100
--------------------------------
Expenses
--------------------------------
Depreciation Expense $50
Loss on asset disposal $50
--------------------------------
Total Expenses $100
--------------------------------
Net Income $0
================================Due to the natural balancing characteristic of double-entry accounting, our numbers remain the same since we added a new expense account, and the expenses still sum to $100.
Selling a fixed asset early for a gain
Now let's consider the second scenario from above where we sell the asset early. Imagine we're ready to get rid our airplane and have found a potential buyer that wants to pay $75, which is more than the plane's current book value of $50. We happily decide to sell the airplane and book our entry as soon as the cash clears.
Cash $75
Accumulated Depreciation $50
Gain on asset disposal $25
Airplane $100As you can see, we still reduce the balance of the airplane and its accumulated depreciation account from our books. We also book the cash we received. This leads to a $25 difference, which is the amount in excess of our airplane's book value. The excess is booked as a gain on asset disposal, which we can see reflected in our alternate version of the income statement below.
Year 1
--------------------------------
Income Statement
--------------------------------
Revenues
--------------------------------
Sales Revenue $100
Gain on asset disposal $25
--------------------------------
Gross Revenues $125
--------------------------------
Expenses
--------------------------------
Depreciation Expense $50
--------------------------------
Total Expenses $50
--------------------------------
Net Income $75
================================Thanks to our savvy decision to sell the airplane for a profit, we now have positive net income! Unlike our previous scenario, this transaction added an entry for a revenue account rather than an expense account.
Selling a fixed asset early for a loss
Let's consider one final scenario. Suppose we don't like our airplane very much. Its bathrooms are always out of order, the tray tables don't stay latched, and occasionally the door plug blows out mid-flight2. We want to sell this plane and move on from it. However, we're forced to sell it for less than its book value given its undesirable condition. Our buyer offers us $253, which is less than our $50 book value. Tough break for us, but we have to book the journal entry regardless.
Take a moment to stop and think about what the journal entry should look like before reading below.
Cash $25
Accumulated Depreciation $50
Loss on asset disposal $25
Airplane $100Unfortunately, we have to book a loss on our asset disposal, which is debited as an expense and naturally balances each side. Let's take a look at our alternate income statement after this scenario.
Year 1
--------------------------------
Income Statement
--------------------------------
Revenues
--------------------------------
Sales Revenue $100
--------------------------------
Gross Revenues $100
--------------------------------
Expenses
--------------------------------
Depreciation Expense $50
Loss on asset disposal $25
--------------------------------
Total Expenses $75
--------------------------------
Net Income $25
================================Our journal entry above, as well as our income statement, both look similar to the first scenario where we wrote off the airplane entirely. The key difference is that we sold the airplane for $25 in cash. This means we didn't book the remaining $50 of book value as a complete loss. Accordingly, we actually end the period with a net income of $25.
Closing Thoughts
In the real world there would be more ramifications to these types of scenarios. For example, selling the plane for a $25 loss might appear better on the surface than letting the airplane depreciate over its full useful life of two years. What I didn't capture above is the revenue that could have been earned from using the airplane, which might have continued in the airplane's second year.
This lesson was conducted in a vacuum because the amount of journal entries can add up quickly, and I wanted to focus on the core concepts around fixed assets. Now that you've read up to this point, you've learned the basics of accounting for fixed assets. It can get incredibly more complex, so you should probably save that for a CPA to handle!