The primary objective of a business entity is to make profit and increase the wealth of its owners. The wealth grows many fold when the business starts to build capital assets. To find the true value behind the capital assets across time, understanding accounting for capital assets is important for any entrepreneur.
What are Capital Assets?
A capital asset is acquired or developed by a manufacturing company with an intent to use it in the production process to generate benefit in the future. The asset must generate the benefit for the manufacturing company for a time period longer than a year.
By definition, Capital Assets are a long lasting item of property that can be reasonably expected to contribute to the future profits of a business.
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Capital goods are assets such as factories, land, buildings, machinery, office equipment, furniture, vehicles and tools that an organization uses to produce goods or services. Construction in progress, trademarks, patents, copyrights, customer lists, intellectual property, and art can also count.
For example, a machine used in car manufacturing industry is a capital asset for the car manufacturer.
Difference Between Capital Assets & Other Inputs
- Capital assets are not consumed when the final product is made. They are not consumed in a single year of production.
- Inputs are consumed while making the final product and are treated as business expenses included in the cost of production.
Ice Creams Inc. has purchased a cooling device in their company to make ice creams from milk. Therefore, the cooling device is the capital asset for the business, which will be used over the years and the milk is the raw material which becomes the input cost of producing the ice cream.
Understanding Capital Assets
A capital asset is property that is expected to generate future revenue for a business. The distinction between capital assets and operational expenses depends largely on your business. Capital assets are the productive base of your business and this differs greatly from one industry to the next.
A utility company may categorize a fleet of cars as a capital asset but a car dealer might categorize cars as inventory. The rules surrounding classification of capital assets also vary by tax jurisdiction.
How to Account Capital Assets?
Manufacturing companies record tangible capital assets on their balance sheets as part of property, plant and equipment. Intangible assets, such as goodwill, trademarks and patents, are recorded as separate line items under the noncurrent assets section of the balance sheet.
Capital assets cannot be entirely deducted as business expenses in the year of their purchase. Instead, they are depreciated over the course of their useful lives. The business recognizes part of the cost each year through accounting techniques as depreciation, amortization and depletion.
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Capital assets are treated differently from operational expenses for tax purposes. In general, the costs of acquiring capital assets can’t by fully deducted at the time of purchase and must be amortized or depreciated over the life of the asset.
Capital assets are recorded on the balance sheet at their historical cost, less any accumulated depreciation (or amortization in the case of intangible assets). So if Ice Cream Inc. paid $100,000 for a piece of equipment in the factory, it would record it as a $100,000 asset on its balance sheet.
But as the asset ages and becomes worth less, Ice Cream Inc. would increase the amount of accumulated depreciation associated with the equipment, so that the equipment’s net book value reflects its reduced value.
Depreciation of Capital Asset
Depreciation is, simply put, the expense generated by the uses of an asset. It is the wear and tear of an asset or diminution in the historical value owing to usage. Further to this; it is the cost of the asset less any salvage value over its estimated useful life.
A fixed asset can be depreciated using the straight line method which is the most common form of depreciation. Tax depreciation is commonly calculated differently than depreciation for financial reporting.
Disposal of Capital Asset
When a manufacturing company sells capital assets, it records the capital gains or capital losses. If the remaining unamortized cost basis exceeds the proceeds received on the sale, the company records a capital gain. Also, the manufacturing company can retire a capital asset by writing it off the books. Recognizing it as a capital loss if there is an unamortized cost basis left for the asset.
Why It Is Important to Account Capital Assets?
The primary objective of a business entity is to make profit and increase the wealth of its entrepreneur and owners. In the attainment of this objective it is required that the management will exercise due care and diligence in applying the basic accounting concept of “Matching Concept”. Matching concept is simply matching the expenses of a period against the revenues of the same period.
The period of use of capital assets, for generation of revenue, is usually more than a year, i.e. long term. It is therefore obligatory that in order to accurately determine the Net Income or profit for a period, depreciation be applied on the total value of the asset and charged against the same revenue of the same period. This is essential in the prudent reporting of the net revenue for the entity in the period.
Net book value of an asset is basically the difference between the historical cost of that asset and its associated depreciation. From the foregoing, it is apparent that in order to report a true and fair of the financial jurisprudence of an entity it is relatable to record and report the value of fixed assets at its net book value.
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