Which Costs Are Depreciated
When a company purchases a fixed asset, such as a computer or machine, the cost of the asset is spread over its useful life, which may be years after the purchase. Therefore, depreciation is a period cost: As time passes, the fixed asset is used to generate revenue. The cost of the fixed asset is converted into an expense.
Your next question may be: Which costs associated with purchasing a fixed asset do you add together when figuring up the entire cost? Just the purchase price? Purchase price plus tax and shipping? Other costs?
Except for the allocation of cost between land and buildings, figuring depreciated cost is straightforward. Per GAAP, the business has to record all fixed asset purchases on its balance sheet at their original cost plus all the ordinary and necessary costs to get the fixed asset ready to use. The total cost of the fixed asset is referred to as its depreciable base.
For example, a company makes pencils and buys a new machine to automatically separate and shrink-wrap ten pencils into salable units. Various costs of the machine may include the purchase price, sales tax, freight-in, and assembly of the shrink-wrapping machine on the factory floor. (Freight-in is the buyer’s cost to get the machine from the seller to the buyer.)
Handling real property depreciation
Now, what about real property — land and buildings? Both are clearly fixed assets, but the cost of the land a building sits on isn’t depreciated and has to be separated from the cost of the building. Your financial statements will list land and building as two separate line items on the balance sheet. Why? The answer is that GAAP mandates that separation — no ifs, ands, or buts about it.
The cost of land is never depreciated either under GAAP or on the company’s tax return. That’s because the land a building stands on is assumed to retain its value. In other words, it won’t be used up or run down through use over time.
So, if a company pays $250,000 to purchase a building to manufacture its pencils and the purchase price is allocated 90 percent to building and 10 percent to land, how much of the purchase price is spread out over the useful life of the building? Your answer is: $250,000 x 0.90 = $225,000.
Allocating costs between land and buildings
Frequently, a company pays one price for both a building and the land that the building sits on. Figuring out the allocation of costs between land and building is a common challenge. The best approach is to have an appraisal done during the purchasing process.
An appraisal occurs when a licensed professional determines the value of real property. If you’ve ever purchased a home and applied for a mortgage, you’re probably familiar with property appraisals. Basically, the appraisal provides assurance to the mortgage company that you’re not borrowing more than the property is worth.
Even if a business doesn’t have to secure a mortgage to purchase a real property asset, it still gets an appraisal to make sure it’s not overpaying for the property. Alternatively, county property tax records may show an allocation of costs to land. However, that allocation is just for property tax purposes; it may not be materially correct for depreciation purposes.
Just remember to subtract land cost from the total before calculating real property depreciation (depreciation on just the building).
Land improvements, such as fences, roads, and gates, are depreciable. Land improvements should be shown as a separate line item on the balance sheet.
If a business purchases a piece of raw land and constructs its own building, the accounting issue is more straightforward, because you have a sales price for the land and construction costs for the building.
Expensing repairs and maintenance
Preventative repair and maintenance costs are expensed in the period in which they’re incurred. For example, on June 14, a florist business has the oil changed and purchases new tires for the flower delivery van. The cost of the oil change and tires goes on the income statement as an operating expense for the month of June.
The next month, the delivery van’s transmission goes completely out, stranding the driver and flowers at the side of the road. Rebuilding the transmission significantly increases the useful life of the delivery van, so you have to add the cost of the new transmission to the net book value of the van on the balance sheet.
Net book value (or book value for short) is the difference between the cost of the fixed asset and its accumulated depreciation at any given time.