Fixed Assets and Depreciation: How Equipment Reaches the Books

Fixed asset

A fixed asset is something a business buys to use for more than a year rather than to sell, such as a vehicle, a machine, a computer, or a building. Because the business gets use from it over several years, its cost is not treated as an expense in the month it is bought; the cost is recorded as an asset and then moved to expense a little at a time through depreciation.

The mistake this page prevents is the most common one in small-business books: a 30,000 machine posted to an expense account, so one month shows a large loss and every later month shows a profit that is too high because the machine cost nothing. Under GAAP (Generally Accepted Accounting Principles) the cost has to be matched against the years the machine earns revenue. The chart of accounts is what makes that possible, and it takes four accounts, not one.

Structure

A fixed asset needs its own account, and that account needs three companions. The asset account holds what was paid. Accumulated depreciation holds how much of that cost has been used up so far; it is a contra asset, which means it sits on the asset side of the balance sheet with a credit balance and reduces the asset above it. Depreciation expense holds this period's share of the cost. Gain or loss on disposal holds the difference between what the asset was worth on the books and what it sold for.

Two chart decisions are hidden in that table. The first is granularity: one Equipment account is enough for a business with a few machines, but a business that wants to know what its vehicles cost separately from its machines needs Equipment and Vehicles as separate accounts, each with its own accumulated depreciation line. The second is the capitalization threshold. Every business should write down a dollar amount below which a purchase is expensed even if it lasts years, because tracking depreciation on a 90 dollar office chair costs more than it tells you. A common threshold is 2,500, which is the IRS de minimis safe harbor for businesses without audited statements, but it is a policy choice, and the important thing is applying it the same way every time. The Repairs and Maintenance account exists so that the routine spending on an asset has somewhere to go that is not the asset itself.

Recording

Say the business buys a machine for 30,000 and pays 1,200 to have it delivered and installed. The cost of the asset is everything it took to get the machine ready to use, so the asset is recorded at 31,200, not 30,000. Figures are illustrative.

The business expects to use the machine for five years and sell it for about 1,200 at the end. The amount to spread over those five years is the cost less that expected salvage value: 31,200 minus 1,200, which is 30,000. On the straight-line method, the most common choice for small-business books, that is 6,000 a year, or 500 a month. Each month the same entry runs.

Straight-line is not the only method. Units of production charges depreciation by use, such as per mile or per unit made, and double-declining balance charges more in the early years and less later. The chart does not care which method the business chooses; the accounts are the same four. What the method changes is the size of entry 2 each month. For the timing principle behind spreading the cost at all, see accrual vs. cash basis.

When the machine is eventually sold, the last entry removes both the cost and the accumulated depreciation from the books and records the difference. If the machine has a book value of 1,200 after five years and sells for 1,800, the business records cash of 1,800, clears the 31,200 asset and the 30,000 accumulated depreciation, and books a 600 gain. If it sells for 900, the 300 difference is a loss. Either way the number goes to account 7100, not to revenue, because selling equipment is not what the business is in business to do.

Reporting

Here is where the two entries land after the first month. The highlighted rows exist only because the chart has the accounts that produce them.

The balance sheet shows three numbers where a single-account chart would show one: what was paid, how much has been used, and what is left. The 30,700 net figure is the book value. It is not what the machine would sell for; it is the cost that has not yet been charged to expense. After five years the two lines will read 31,200 and (30,000), and the net will be the 1,200 salvage value until the machine is sold.

The income statement shows 500 of machine cost this month, and it will show the same 500 for the next fifty-nine months. Had the purchase been posted to an expense account, this month would show a 17,200 loss and every following month would carry no machine cost at all. Depreciation is also the reason net income and cash differ: the 500 expense moved no cash, so on the statement of cash flows it is added back to net income under operating activities, while the actual payment for the machine, when it happens, appears under investing. How each account reaches each statement is covered in how accounts become statements.

Insight

Three questions a business asks about its equipment, and why a chart with one blended account cannot answer them.

Every industry that owns equipment applies this page differently: construction depreciates heavy machinery per job, restaurants depreciate kitchen build-outs over the lease term, and manufacturers route depreciation on factory equipment into cost of goods sold rather than operating expense. Read the industry guides built on this foundation for your own sector, or see how your current chart handles fixed assets today.

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