Businesses and non-profit entities capitalize machines, furniture, buildings, and other property, plant, and equipment (PPE) assets on their balance sheets. Here is a refresher on some common questions about how to properly report these long-lived assets under U.S. Generally Accepted Accounting Principles (GAAP).
What is included in book value?
PPE is reported on the balance sheet at historical cost. This includes the amount of cash or cash equivalents paid for an asset. Historical cost also may include costs to relocate the asset and bring it to working condition. Examples of capitalized costs include the initial purchase price, sales tax, shipping, and installation costs.
Costs incurred during an asset’s construction or acquisition that can be directly traced to preparing the asset for service also should be capitalized. In addition, costs incurred to replace PPE or enhance its productivity must be capitalized. However, repairs and maintenance costs may be expensed as incurred.
GAAP does not prescribe a dollar threshold for when to capitalize an asset. But, for simplicity, management may set a capitalization threshold as long as it does not materially affect the financial statements. PPE below that threshold may be written off as incurred.
How long is the useful life?
Useful life is the period over which the asset is expected to contribute directly or indirectly to future cash flow. When estimating the useful life of an asset, management should consider all relevant facts and circumstances, such as:
- The asset’s expected use
- Any legal or contractual time constraints
- The entity’s historical experience with similar assets
- Obsolescence or other economic factors
What is the right depreciation method?
Depreciation is meant to allocate the cost of an asset (less any salvage value) over the period it is in use. GAAP provides the following four depreciation methods:
For simplicity, many small businesses deviate from GAAP by using the same depreciation method for tax and financial statement purposes. The IRS prescribes specific recovery periods for different categories of PPE and provides accelerated depreciation methods.
Under current tax law, instead of using the standard Modified Accelerated Cost Recovery System depreciation method, certain entities currently may choose to immediately deduct a qualified PPE purchase under Section 179 or the bonus depreciation program, thus reducing taxable income in the years the asset is placed in service. The use of these accelerated depreciation methods may create a large spread between the value of PPE on the balance sheets and the assets’ fair market values.
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Reporting PPE is a gray area in financial reporting that relies on subjective estimates and judgment calls by management. We can help you report these assets in a reliable, cost-effective manner.