Long-Term Assets: Fixed Assets & Depreciation
The Big Picture: Your Business’s Helpful Robots
Imagine you own a lemonade stand. You buy a shiny new blender to make frozen lemonade. That blender will help you make money for years—not just today!
Things that help your business for a long time are called Fixed Assets. But here’s the twist: they get tired and worn out over time. That’s where depreciation comes in—it’s how we track that “tiredness” in our accounting books.
Let’s explore this adventure together!
Property, Plant & Equipment (PP&E)
What Is It?
PP&E = The big, helpful things your business owns that last more than one year.
Think of them as your business’s robot helpers:
- 🏢 Property = Land and buildings (your robot’s home)
- 🏭 Plant = Factories and big machines (your robot’s workshop)
- 🔧 Equipment = Tools, computers, vehicles (your robot’s arms and legs)
Simple Example
Maya’s Bakery buys:
- A building for $100,000 (property)
- An industrial oven for $15,000 (equipment)
- A delivery van for $25,000 (equipment)
All of these are PP&E because they’ll help Maya bake and sell cakes for many years!
The Key Rule
PP&E must be:
- Physical (you can touch it)
- Used in operations (helps make money)
- Long-lasting (more than 1 year)
Asset Acquisition Costs
The Real Price Tag
When you buy something big, the price tag isn’t the full story!
Acquisition cost = Purchase price + ALL costs to get it ready to use
Think of it like buying a puppy:
- Puppy price: $500
- Vet checkup: $100
- Food bowls & bed: $50
- Total cost of your “puppy asset”: $650
What Gets Added to the Cost?
| Asset Type | Extra Costs to Include |
|---|---|
| Building | Legal fees, renovation, architect fees |
| Equipment | Shipping, installation, testing |
| Land | Survey fees, clearing, legal fees |
| Vehicle | Registration, delivery, modifications |
Example: The Pizza Oven
Sal buys a pizza oven for his restaurant:
- Oven price: $8,000
- Shipping: $500
- Installation: $1,200
- Test run (ingredients): $100
Total acquisition cost: $9,800
This $9,800 goes on the books—not just $8,000!
Lump-Sum Purchases
Buying the Bundle
Sometimes you buy multiple things together for ONE price. It’s like buying a toy set instead of individual toys!
The Problem: How do you split the cost fairly?
The Solution: Fair Market Value Allocation
Use this formula:
Each Asset's Cost = (Asset's Fair Value ÷ Total Fair Value) × Total Price Paid
Example: The Package Deal
Sam buys a building AND the land under it for $200,000 total.
Step 1: Find fair market values
- Land alone: $60,000
- Building alone: $140,000
- Total fair value: $200,000
Step 2: Calculate percentages
- Land: $60,000 ÷ $200,000 = 30%
- Building: $140,000 ÷ $200,000 = 70%
Step 3: Allocate the purchase price
- Land cost: $200,000 × 30% = $60,000
- Building cost: $200,000 × 70% = $140,000
Why does this matter? Land doesn’t depreciate, but buildings do!
Capital vs. Revenue Expenses
The Big Decision
Every time you spend money, ask yourself:
“Will this help my business for MORE than one year?”
graph TD A["Money Spent"] --> B{Helps for > 1 year?} B -->|YES| C["CAPITAL Expense"] B -->|NO| D["REVENUE Expense"] C --> E["Add to Asset Value"] D --> F["Expense Immediately"]
Capital Expenses (The Big Upgrades)
Makes the asset BETTER or LONGER-LASTING
Examples:
- Adding a new engine to a truck (extends life)
- Building an extra room (adds capacity)
- Major computer upgrade (improves performance)
Rule: Add to asset’s value on balance sheet!
Revenue Expenses (The Everyday Fixes)
Just keeps things running normally
Examples:
- Oil change for the truck
- Fixing a broken window
- Replacing printer ink
Rule: Expense it NOW on income statement!
The Easy Test
| Question | Capital | Revenue |
|---|---|---|
| Extends useful life? | ✅ | ❌ |
| Increases capacity? | ✅ | ❌ |
| Improves efficiency? | ✅ | ❌ |
| Just maintains it? | ❌ | ✅ |
Example: The Delivery Van
- New tires for safety: Revenue (regular maintenance)
- New GPS navigation system: Capital (improves capability)
- Oil change: Revenue (routine upkeep)
- New refrigeration unit: Capital (adds new function)
Depreciation Concepts
Why Do We Depreciate?
Remember our robot helpers? They get tired over time!
Depreciation = Spreading the cost of an asset over its useful life
It’s like this: If a $10,000 machine helps you for 10 years, it’s not fair to say you “spent” $10,000 in year one. You should spread that cost: $1,000 per year.
The Matching Principle
Match the cost of the asset to the time it helps you earn money!
Key Terms to Know
| Term | Meaning | Example |
|---|---|---|
| Cost | What you paid | $10,000 |
| Useful Life | How long it helps | 5 years |
| Salvage Value | What it’s worth at the end | $2,000 |
| Depreciable Base | Cost - Salvage Value | $8,000 |
What Depreciates vs. What Doesn’t
graph TD A["Fixed Asset"] --> B{What type?} B --> C["Land"] B --> D["Everything Else"] C --> E["NO Depreciation!"] D --> F["YES - Depreciate It"]
Land NEVER depreciates—it doesn’t wear out!
Depreciation Methods
1. Straight-Line Method (The Fair Splitter)
The simplest and most popular!
Formula:
Annual Depreciation = (Cost - Salvage Value) ÷ Useful Life
Example: Machine costs $12,000, salvage $2,000, life = 5 years
Depreciation = ($12,000 - $2,000) ÷ 5 = $2,000 per year
Every year gets the SAME amount. Simple and fair!
| Year | Depreciation | Total So Far |
|---|---|---|
| 1 | $2,000 | $2,000 |
| 2 | $2,000 | $4,000 |
| 3 | $2,000 | $6,000 |
| 4 | $2,000 | $8,000 |
| 5 | $2,000 | $10,000 |
2. Double-Declining Balance (The Fast Starter)
More depreciation early, less later!
Perfect for assets that lose value quickly (like computers).
Formula:
Rate = (1 ÷ Useful Life) × 2
Annual Depreciation = Book Value × Rate
Example: $10,000 equipment, 5-year life, no salvage
Rate = (1 ÷ 5) × 2 = 40%
| Year | Book Value | × 40% | Depreciation |
|---|---|---|---|
| 1 | $10,000 | × 40% | $4,000 |
| 2 | $6,000 | × 40% | $2,400 |
| 3 | $3,600 | × 40% | $1,440 |
| 4 | $2,160 | × 40% | $864 |
| 5 | $1,296 | × 40% | $1,296* |
*Year 5 takes whatever is left!
3. Units-of-Production (The Activity Counter)
Depreciation based on HOW MUCH you use it!
Perfect for machines, vehicles, equipment with measurable output.
Formula:
Rate per Unit = (Cost - Salvage) ÷ Total Expected Units
Depreciation = Units Used × Rate per Unit
Example: Printer costs $5,000, salvage $500, expected to print 100,000 pages
Rate = ($5,000 - $500) ÷ 100,000 = $0.045 per page
| Year | Pages Printed | Depreciation |
|---|---|---|
| 1 | 30,000 | $1,350 |
| 2 | 25,000 | $1,125 |
| 3 | 20,000 | $900 |
The more you use it, the more it depreciates!
Quick Comparison
graph TD A["Choose Method"] --> B{What's the asset like?} B -->|Steady use over time| C["Straight-Line"] B -->|Loses value fast early| D["Double-Declining"] B -->|Usage varies a lot| E["Units-of-Production"]
Partial Year Depreciation
Starting Mid-Year
What if you buy an asset in March instead of January?
You only depreciate for the months you actually OWNED it!
Example: The June Purchase
Buy a $12,000 machine on June 1st
- Useful life: 5 years
- Salvage: $2,000
- Annual depreciation: $2,000
Year 1: Only owned 7 months (June-December)
- Depreciation = $2,000 × (7 ÷ 12) = $1,167
Year 2-5: Full years = $2,000 each
Year 6: Remaining 5 months
- Depreciation = $2,000 × (5 ÷ 12) = $833
The Half-Year Convention
Some companies use a simpler rule:
“No matter when you buy it, take HALF a year’s depreciation in year one!”
| Method | Year 1 Depreciation |
|---|---|
| Actual months | Based on purchase date |
| Half-year convention | Always 50% |
Revision of Depreciation
When Things Change
Sometimes your original estimates were wrong!
What might change?
- Useful life (lasts longer or shorter than expected)
- Salvage value (worth more or less at the end)
The Rule: Look Forward, Not Back
Don’t fix the past—just adjust the future!
Steps:
- Find the current book value (cost - accumulated depreciation)
- Find the new salvage value
- Find the new remaining life
- Calculate new depreciation
Example: The Surprised Accountant
Machine originally:
- Cost: $20,000
- Salvage: $2,000
- Life: 5 years
- Annual depreciation: $3,600
After 2 years: Book value = $20,000 - $7,200 = $12,800
Surprise! The machine will last 5 MORE years (not 3) and salvage is now $800.
New calculation:
New Depreciation = ($12,800 - $800) ÷ 5 = $2,400 per year
We don’t go back and fix years 1-2. We just use $2,400 going forward!
Putting It All Together
graph TD A["Buy Asset"] --> B["Calculate Total Cost"] B --> C{Multiple assets in one purchase?} C -->|Yes| D["Allocate by Fair Value"] C -->|No| E["Use full cost"] D --> F["Start Depreciation"] E --> F F --> G{Which method?} G --> H["Straight-Line"] G --> I["Double-Declining"] G --> J["Units-of-Production"] H --> K["Calculate Annual Amount"] I --> K J --> K K --> L{Bought mid-year?} L -->|Yes| M["Prorate for Partial Year"] L -->|No| N["Full Year Depreciation"] M --> O["Review Annually"] N --> O O --> P{Estimates changed?} P -->|Yes| Q["Revise Going Forward"] P -->|No| R["Continue as Planned"]
Key Takeaways
-
PP&E = Long-term physical assets that help your business
-
Acquisition Cost = Purchase price + all costs to get ready to use
-
Lump-Sum Purchases = Allocate based on fair market values
-
Capital vs Revenue = Does it help for more than one year?
-
Depreciation = Spreading cost over useful life
-
Methods: Straight-line (even), Double-declining (fast start), Units-of-production (usage-based)
-
Partial Year = Only depreciate for months owned
-
Revisions = Adjust future depreciation, don’t change the past
You’ve Got This!
Fixed assets and depreciation might seem complex, but remember:
It’s just like tracking how your toys get worn out over time—and being fair about when to count that cost!
Every big business uses these concepts. Now you understand them too! Go forth and balance those books with confidence! 🎉