Monday, April 13, 2009

Accounting for Fixed Assets

Fixed assets are those items that you can't immediately count as an expense when purchased. Fixed assets include such things as vehicles, furniture, equipment, and so forth. Fixed assets are tricky for two reasons: Typically, you must depreciate fixed assets (more on that in a bit), and you need to record the disposal of the fixed asset at some point in the future—for either a gain or a loss.

Purchasing a Fixed Asset

Accounting for the purchase of a fixed asset is pretty straightforward. Table 1 shows how a fixed asset purchase typically looks:

Account
Debit Credit
Delivery truck 12,000
Cash
12,000

Table 1 - Journal Entry 10: Recording Fixed Asset Purchase

If you purchase a $12,000 delivery truck with cash, for example, the journal entry that you use to record this purchase debits delivery truck for $12,000 and credits cash for $12,000.

Within QuickBooks, this journal entry actually gets made when you write the check to pay for the purchase. The one thing that you absolutely must do is set up a fixed asset account for the specific asset. In other words, you don't want to debit a general catch-all fixed asset account. If you buy a delivery truck, you set up a fixed asset account for that specific delivery truck. If you buy a computer system, you set up a fixed asset account for that particular computer system. In fact, the general rule is that any fixed asset that you buy individually or dispose of later individually needs its own asset account. The reason for this is that if you don't have individual fixed asset accounts, later on the job of calculating gains and losses on the disposal of the fixed asset turns into a Herculean task.

Dealing with Depreciation

Depreciation is an accounting gimmick to recognize the expense of using a fixed asset over a period of time. Although you may not be all that familiar with the mechanics of depreciation, you probably do understand the logic. For the sake of illustration, suppose that you bought a $12,000 delivery truck. Suppose also that because you know how to do your own repair work and take excellent care of your vehicles, you will be able to use this truck for ten years. Further suppose that at the end of the ten years, the truck will probably have a $2,000 salvage value (your best guess). Depreciation says that if you buy something for $12,000 and that you can later sell it for $2,000, that decrease in value can be apportioned to expense. In this case, the $10,000 decrease in value is counted as expense over ten years. That expense is called depreciation.

Accountants and tax accounting laws use a variety of methods to apportion the cost of using an asset over the years in which it's used. A common method is called straight-line depreciation. Straight-line depreciation divides the decrease in value by the number of years that an asset is used. An asset that decreases $10,000 over ten years, for example, produces $1,000 a year of depreciation expense.

To record depreciation, you use a journal entry like the one shown in Table 2.

Account
Debit Credit
Depreciation expense 1,000
Acc.dep.—delivery truck
1,000

Table 2 - Journal Entry 11: Recording Fixed Asset Depreciation

Journal Entry 11 debits an expense account called "depreciation expense" for $1,000. Journal Entry 11 also credits a contra-asset account called "accumulated depreciation—delivery truck" for $1,000. (By convention, because the phrase "accumulated depreciation" is so long, accountants and bookkeepers usually abbreviate it as "acc. dep.") Note also that you need specific individual accumulated depreciation contra-asset accounts for each specific individual fixed asset account. You don't want to lump all your accumulated depreciation together into a single catch-all account. That way lies madness and ruin.

Disposing of a Fixed Asset

The final wrinkle of fixed asset accounting concerns disposal of a fixed asset for a gain or for a loss. When you ultimately sell a fixed asset or trade it in or discard it because it's now junk, you record any gain or loss on the disposal of the asset. You also remove the fixed asset from your accounting records.


To show you how this works, consider again the example of the $12,000 delivery truck. Suppose that you've owned and operated this truck for two years. Over that time, you've depreciated $2,000 of the truck's original purchase price. Further suppose that you're going to sell the truck for $11,000 in cash. Table 3 shows the journal entry that you would make in order to record this disposal.

Account
Debit Credit
Delivery truck
12,000
Cash 11,000
Acc. dep.—delivery truck 2,000
Gain on sale
1,000

Table 3 - Journal Entry 12: Recording Fixed Asset Sale for Gain

The first component of Journal Entry 12 shows the $12,000 credit of the delivery truck asset. This makes sense, right? You remove the delivery truck from your fixed asset amounts by crediting the account for the same amount that you originally debited the account when you purchased the asset.

The next component of the journal entry shows the $11,000 debit to cash. This component, again, is pretty straightforward. It shows the cash that you receive by selling the asset.

The third component of the journal entry backs out the accumulated depreciation. If you depreciated the truck $1,000 a year for two years, the accumulated depreciation contra-asset account for the truck should equal $2,000. To remove this accumulated depreciation from your balance sheet, you debit the accumulated depreciation account for $2,000.

The final piece of the disposal journal entry is a plug, a calculated amount. You know the amount and whether that amount is a debit or credit by looking at the other accounts affected. For example, in the case of Journal Entry 12, you know that a $1,000 credit is necessary to balance the journal entry. Debits must equal credits.


Remember

A credit is a gain. A credit is essentially revenue.

If the plug was a debit amount, the disposal produces a loss. This makes sense; a loss is like an expense, and expenses are debits.

If you're confused about the gain component of Journal Entry 12, let me make this observation. Over the two years of use, the business depreciated the truck by $2,000. In other words, the business, through the depreciation expense, said that the truck lost $2,000 of value. If, however, the $12,000 delivery truck is sold two years later for $11,000, the loss in value doesn't equal $2,000. The loss in value equals $1,000. The $1,000 gain, essentially, recaptures the unnecessary, extra depreciation that was incorrectly charged.

1 comment:

Michael said...

how do i set up a Gain on Sale account? what type of account is it? income?

please email me back: pham.michael.s@gmail.com

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