Fixed Assets

Why are fixed assets important?

Fixed assets are important for several key reasons:

Revenue Generation

Fixed assets are instrumental in generating revenue for an entity. For instance, an entity uses a laptop for marketing activities, which in turn helps attract more business and increase profitability. These assets play an active role in the entity’s daily operations, contributing to its income generating activities.

Asset Liquidity

In times of financial distress or unexpected challenges, fixed assets can serve as a valuable source of liquidity. Suppose an entity faces a situation where a major client suddenly departs, leading to cash flow difficulties.

In such cases, the entity may choose to sell certain fixed assets, like a computer server, to raise funds and maintain the stability of its business operations. This ability to convert fixed assets into cash when needed provides a safety net for entities during uncertain times.

Collateral for Business Loans

Fixed assets can also play a crucial role in securing business loans. They can act as collateral or a form of guarantee for loan repayment. In essence, when an entity seeks financing from a lender, it can pledge its fixed assets as collateral.

If the entity fails to repay the loan, the lender has the right to seize and liquidate these fixed assets to recover the outstanding debt. This collateralization of fixed assets enhances the entity’s credibility and increases its chances of obtaining loans, as lenders have assurance in the form of tangible assets.

Financial Analysis

Information regarding an entity’s fixed assets plays a crucial role in ensuring accurate financial reporting, conducting comprehensive business valuations, and performing thorough financial analysis.

Investors and creditors rely on these reports to assess the financial well being of an entity and make informed decisions about investing in its shares or extending loans to support its operations.

Fixed assets hold particular significance for industries that require substantial investments in property, plant, and equipment (PP&E), such as manufacturing.

In cases where an entity consistently reports negative net cash flows related to the acquisition of fixed assets, it may indicate that the entity is in a growth or investment phase, emphasising its commitment to expanding and enhancing its operations. This information provides valuable insights into the entity’s strategic direction and financial priorities.

Depreciation of fixed assets

Tangible assets are subject to a process called depreciation. This means that a portion of the asset’s cost is gradually expensed each year, resulting in a decrease in its recorded value on the entity’s balance sheet. This approach allows the entity to align the asset’s cost with its long-term value and spread out the expense over its useful life.

According to AASB 116, depreciation is an accounting process where the cost allocated to an asset is gradually recognised as an expense over time. Typically, the depreciation expense is recognised in the profit or loss statement for each accounting period. However, there are exceptions when it can be included in the carrying amount of another asset.

For example, in the case of manufacturing equipment, the depreciation cost may be included as part of the cost of converting inventory, rather than expensed directly.

The way an entity chooses to depreciate an asset can sometimes lead to a disparity between the asset’s book value (the value that appears on the balance sheet) and its current market value (CMV), which is the amount it could potentially sell for in the current market.

Methods of Depreciation

As per AASB 116, There are several methods available for allocating the cost of an asset over its useful life in a systematic way. Three common depreciation methods are the straight-line method, the diminishing balance method, and the units of production method. Here’s how they work:

• The straight-line method spreads the depreciation cost evenly over the asset’s useful life. This means the depreciation charge remains constant each year, assuming the asset’s residual value (its value at the end of its useful life) remains unchanged.
• The diminishing balance method results in a decreasing depreciation charge over the asset’s useful life. It frontloads depreciation, meaning more is charged in the early years, and less in the later years.
• The units of production method bases depreciation on how much the asset is expected to be used or how much it’s expected to produce. The charge varies depending on the asset’s actual usage or output.

An entity selects the depreciation method that best matches how the asset’s future economic benefits will be consumed. Once chosen, this method is applied consistently from one accounting period to the next, unless there’s a significant change in how those future benefits will be consumed.

Non depreciable fixed assets

Certain fixed assets are classified as non depreciable, and one of the most evident examples in a business context is land. Land is considered non depreciable because it is expected to maintain or potentially even appreciate in intrinsic value over time.

In contrast, buildings can undergo depreciation, but this is applicable only when the entity owns them rather than leasing or renting.

Additionally, collectibles such as art and antiques also fall into the category of non depreciable assets. These assets are anticipated to either retain their value or possibly increase in value with time. However, it’s relatively uncommon for entities to possess these types of assets, as they are not typically part of standard business operations or investments.

Fixed assets on financial statements

Recording fixed assets on an entity’s financial statements involves specific processes and impacts the cash flow statement, as follows:

Cash Flow Statement

The acquisition or disposal of fixed assets is documented in the entity’s cash flow statement, specifically under the category of cash flow from investing activities.

When an entity purchases fixed assets, it results in a cash outflow, which is recorded as a negative figure in the cash flow statement.

Conversely, when the entity sells a fixed asset, it leads to a cash inflow, represented as a positive amount on the cash flow statement.

Impairment Write Down

If the value of a fixed asset drops below its net book value (the value recorded on the balance sheet), the asset is subject to an impairment write down.

This means that the recorded value of the asset on the balance sheet is adjusted downward to reflect its overvaluation compared to its market value. This adjustment reflects a more accurate assessment of the asset’s worth.

End of Useful Life

As per AASB 116, when a fixed asset reaches the end of its useful life, the usual practise is to dispose of it. Disposal can occur through selling the asset for a salvage value, which is an estimation of its value if broken down and sold in parts.

In some cases, an asset may become obsolete, resulting in disposal without any return payment.

In either scenario, the fixed asset is removed or written off from the balance sheet because it is no longer actively used by the entity.

These accounting procedures ensure that an entity’s financial statements accurately reflect the status of its fixed assets, their impact on cash flows, and any adjustments needed to account for changes in their value or their eventual disposal.