Mastering Asset Accounting: Capitalization of Costs

To capitalize it or not?! That’s the question!

The U.S. GAAP requires the capitalization of costs when incurred a future economic benefit. While, in some cases, the decision of whether to capitalize or not is unclear, an equipment purchase is a straightforward case to capitalize the costs.

Want to learn more about Asset Accounting and capitalization of costs? Read this helpful guide for more information on the capitalization of costs in different areas, such as repairs and maintenance, contract costs, startup costs, advertising costs, internally-developed intangible assets, patent defense costs, website development costs, etc.

What Is an Asset?

Under the Statement of Financial Accounting Concepts 6, Elements of Financial Statements, an asset is defined as “future economic benefits obtained or controlled by an entity as a result of a past transaction or events”.

Historically, an asset is defined by three fundamental characteristics: (a) it represents a probable future benefit that can contribute directly or indirectly to future net cash inflows, either on its own or in conjunction with other assets, (b) it is obtainable by a specific entity and that entity can regulate others’ access to it, and (c) the transaction or event that confers the entity’s right to the benefit or control over it has already occurred.

What Are Fixed Assets?

Fixed assets are long-term tangible assets that are used in the operations of a business, such as land, buildings, machinery, and equipment.

ASC 360, Property, Plant and Equipment (PPE) is the Accounting Standards Codification section that provides guidelines for the accounting and reporting of property, plant, and equipment (PP&E), which are fixed assets that have a physical substance and are expected to be used for more than one year. ASC 360 specifies the criteria for recognizing and measuring fixed assets, the methods for depreciation and impairment testing, and the disclosures required in financial statements. Proper adherence to ASC 360 is essential for companies to ensure accurate reporting of their fixed assets and to comply with accounting regulations.

What Costs Should Be Capitalized Under ASC 360 for Fixed Assets?

ASC 360 provides guidance on the capitalization of costs for fixed assets. The general rule is that costs incurred in acquiring or improving property, plant, and equipment (PP&E) should be capitalized if they meet the following criteria:

The cost should be directly related to the acquisition or improvement of the asset.
The cost should increase the asset’s capacity, efficiency, or useful life.
The cost should be significant, which means that it should be material in amount relative to the total cost of the asset.

Below presents a few examples of costs that can be capitalized include:

Purchase price of the asset
Shipping and handling costs
Installation and assembly costs
Legal and professional fees related to the acquisition of the asset
Costs of testing and trial runs
Costs of refurbishing or improving the asset
ASC 360 also provides guidance on the treatment of repairs and maintenance costs for fixed assets. These costs are generally expensed as incurred, unless they meet certain criteria for capitalization as betterments or extraordinary repairs. Proper adherence to ASC 360 is crucial for accurate reporting of fixed asset costs and compliance with accounting regulations.

Allocating Costs over an Asset’s Life through Depreciation

Depreciation is an important accounting concept that allows businesses to allocate the cost of an asset over its estimated useful life. This process is necessary to match the costs of an asset with the revenue it generates, and to reflect the asset’s diminishing value over time. However, depreciation can be a complex and nuanced process that requires careful consideration of several factors.

The first consideration is the estimated useful life of the asset. This is the length of time the asset is expected to provide value to the business. For financial reporting purposes, this estimate is based on the asset’s service life, which may differ from its physical life. The service life is an estimate made by management based on factors such as the type of asset, its condition when purchased, past experience, expected usage, and expected obsolescence. This estimate may be based on industry standards or specific to the business’s operations.

The estimated useful life for financial reporting purposes may be different than the depreciable life for tax reporting purposes. Tax methods and lives often encourage investments in productive assets by permitting a faster write-off, whereas depreciation for financial reporting purposes is intended to match costs with revenue.

If an asset will have a residual value at the end of its service life that can be realized through sale or trade-in, depreciation should be calculated on cost less the estimated salvage value. The depreciable life is the term that the asset is used by the owner, but if the asset is not worthless at the end of that life, estimated salvage value should be considered. For instance, most businesses use five years as the useful life for automobiles. In practice, a particular business may have a policy of purchasing and trading in automobiles every three years. In this case, three years, not five, should be the estimated useful life for depreciation, but the trade-in value must be estimated and used in the calculation of depreciation. As with all accounting rules, materiality should be considered in determining whether the recognition of residual values is needed.

The method of depreciation used also needs to be considered. The straight-line method is the most used, but other methods such as units of production, sum of the year’s digits, and declining balance exist. Straight-line depreciation allocates the same amount of depreciation expense to each year of an asset’s life. Units of production depreciation allocates the depreciation expense based on the asset’s usage, whereas sum of the year’s digits and declining balance methods allocate more depreciation expense in the earlier years of an asset’s life.

As estimates, useful lives should be evaluated during an asset’s life, and changes should be made when appropriate. Changes in estimates are accounted for prospectively, meaning that the depreciation expense is adjusted for the remaining life of the asset, rather than retrospectively adjusting prior years’ depreciation.

In conclusion, depreciation is a complex process that requires careful consideration of several factors, including the estimated useful life of the asset, the depreciable life for tax purposes, and the method of depreciation used. By accurately calculating depreciation, businesses can match the costs of an asset with the revenue it generates and provide more accurate financial statements.

What Are Intangible Assets?

Intangible assets are non-physical assets that are used in the operations of a business, such as patents, trademarks, copyrights, and goodwill. ASC 350, Goodwill and Intangible Assets is the Accounting Standards Codification section that provides guidance on the accounting and reporting of intangible assets. The section specifies the criteria for recognizing and measuring intangible assets, the methods for amortization and impairment testing, and the disclosures required in financial statements. Proper adherence to ASC 350 is crucial for companies to ensure accurate reporting of their intangible assets and compliance with accounting regulations.

What Costs Should Be Capitalized Under ASC 350 For Intangible Assets?

ASC 350 provides guidance on the costs that should be capitalized for intangible assets, not fixed assets. However, there are some similarities between the capitalization requirements for fixed and intangible assets.

Under ASC 350, costs that should be capitalized for intangible assets include:

Acquisition costs: The costs directly attributable to the acquisition of an intangible asset, such as the purchase price, legal fees, and due diligence costs.
Development costs: The costs incurred during the development of an intangible asset, such as research and development costs, design costs, and testing costs.
Direct costs of producing an internally developed intangible asset: The costs directly related to the production or creation of an internally developed intangible asset, such as salaries and wages, overhead, and materials.

Noticed that not all costs related to intangible assets should be capitalized. For example, general and administrative expenses, advertising and marketing expenses, and ongoing maintenance costs are typically expensed as incurred. Proper adherence to ASC 350 is crucial for companies to ensure accurate reporting of their intangible asset costs and compliance with accounting regulations.

ASC 350 for the Capitalization of Software Costs

ASC 350 provides specific guidance on how to account for the costs of computer software purchased for internal use. In accordance with this guidance, capitalized costs include fees paid to third parties for purchasing and/or developing software, as well as fees for hardware installation and testing, including the parallel processing phase. Additionally, costs incurred to develop or purchase software that allows for the conversion of old data are also capitalized. However, costs associated with data conversion are expensed as incurred.

While training and maintenance costs can make up a significant portion of total expenditures, they are expensed as period costs. On the other hand, upgrade and enhancement costs should be expensed, unless it is probable that they will result in additional functionality.

In cases where software is purchased from a third party, the purchase price may include multiple elements, such as training costs, fees for routine maintenance, data conversion costs, reengineering costs, and costs for the rights to future upgrades and enhancements. To determine how to allocate these costs, an organization should use objective evidence of fair value for each element of the contract, rather than relying solely on the separate prices listed in the contract. Once allocated, costs should be capitalized and expensed accordingly.

Asset Accounting Guidance With CPCON

Asset accounting can get tricky when you need to review and establish a capitalization policy, which reflects on more regulatory pressure on your business accounting practices. However, ASC 360 and 350 standards outline a guidance for determining what and when to capitalize costs of intangible assets and fixed assets.

Our Asset Advisory team has deep experience in reviewing and establishing asset capitalization policies for financial reporting, tax, insurance, and regulatory compliance. We can guide you through the accounting process. This can help you maximize value for your organization while remaining compliant with the latest regulations.