Selling off company assets is just another day-to-day hassle in the business world, you know.
But, a lot of folks out there don't really get the impact of selling those fixed assets and how accounting deals with it.
It's not as simple as the company selling an asset, pocketing the cash, and adjusting the sold asset off the books.
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Asset Sales: Motivations
Before we get into the nitty-gritty of selling fixed assets, let's understand why companies do it.
Well, reasons are pretty much like ours, you see. First off, maybe the company just doesn't need that asset anymore. Second, there might be a shinier, newer model out there, like a fancy machine replacing an old one. Third, maybe the asset is just busted.
Accounting Procedures for Fixed Asset Purchases
Now, let's dive into how companies record the purchase of fixed assets.
Wait, why are we talking about purchasing now?
Well, duh! So you get the whole picture of how fixed assets are presented by a company. Are they immediately an expense on the income statement or are they considered an asset?
That's what I'm getting into now.
So, when a company buys a fixed asset, let's say a machine for $10,000. Oh, and by the way, the purchase price isn't just the machine's sale price. It's the total accumulated cost of the machine, including shipping, assembly costs, and any other expenses related to getting that machine.
So, the company journals it by debiting the machine for $10,000 and crediting cash for $10,000. Why cash? Because it's a cash purchase. If it were on credit, it'd be crediting accounts payable instead of cash.
Okay, so now the acquisition cost is capitalized first on the balance sheet as an asset.
Confused yet?
Let me break it down. Quoting Investopedia, capitalization is recording a cost or expense on the balance sheet to delay recognizing the expense fully. [1]
So, from that definition, it means the cost of acquiring an asset isn't fully expensed at once on the company's income statement.
Deciphering Depreciation: Monthly Expenses
So, when a company buys a fixed asset, let's say a machine, for $10,000, and it has a useful life of 5 years with a salvage value of $2,000, and it's depreciated using the straight-line method.
Quoting CFI, the straight-line method is a method used to determine an asset’s rate of reduction in value over its useful lifespan. [2]
Therefore, the depreciation expense is:
| Financial Parameter | Value |
|---|---|
| Initial machine value | $10,000 |
| Salvage value | $2,000 |
| Useful life | 5 years |
| Annual depreciation expense | $1,600 |
| Monthly depreciation expense | $133.33 |
| Calculation of Annual Depreciation Expense | ($10,000 - $2,000) / 5 years = $1,600 |
| Meaning: Every month the company will allocate a depreciation expense of $133.33 on its income statement. | |
How do you record this monthly depreciation expense?
Through adjusting journal entries.
So, at the end of each month, the company makes an adjusting journal entry, debiting depreciation expense for $133.33 and crediting accumulated depreciation for $133.33.
Depreciation expense, as I mentioned earlier, goes into the income statement and reduces the company's income. While accumulated depreciation goes into the balance sheet as a contra asset account for that fixed asset.
Quoting Wall Street Prep, a contra account carries a balance that offsets the normal account, thereby reducing the paired account’s value. [3]
So, each fixed asset on the balance sheet always has its contra account paired with it. Hence, the acquisition cost won't change, accumulated depreciation keeps increasing each month, and the net asset value decreases over time.
Managing Asset Sales: Accounting Considerations
Now, after understanding that, you might wonder how accounting records the sale of fixed assets.
Well, it's easy!
First, determine if there's a gain from the sale. How do you figure that out? Subtract the selling price from the net book value.
Remember, it's the net book value! Not the purchase price! It's the fixed asset's value after deducting accumulated depreciation.
So, in the case of our company earlier, after a year of owning the asset, they want to sell it for $9,000 because they want a new one. The company needs to determine its net book value first.
Since it's been a year, the accumulated depreciation is $1,600 ($133.33 * 12 months). So now, the net book value of the machine is $8,400 ($10,000 purchase price - $1,600 accumulated depreciation).
So, the selling price is $600 higher than the net book value ($9,000 - $8,400), so the company needs to recognize it as a gain from the sale of fixed assets in its income statement.
The journal entry is:
What if the selling price is lower than the net book value? Well, that means there's a loss, which the company needs to recognize by debiting cash, accumulated depreciation, and loss on the sale of asset, and crediting the machine's carrying amount.
Cautionary Notes: Accounting Implications of Asset Sales
So, now you understand that recording the sale of company fixed assets isn't as simple as subtracting the sale price from the purchase price. There are a few more calculations involved than that.
What else should you pay attention to? That gains from selling fixed assets are recognized on the income statement and can affect the company's profit performance.
Sure, high profits are great, but since it's non-recurring and not part of the company's core operations, when calculating a company's net profit growth, you need to deduct gains from selling assets from the net profit.
Moreover, as I mentioned in my previous article, what truly matters are sales—not just any sales, such as selling fixed assets, but sales derived from the company's core operations or recurring sales.
Indeed, what about common stock sales? Do they also affect a company's profit?
No, they do not. Unlike asset sales, gains from ordinary stock sales—when the selling price exceeds the par value of the stock—are recognized as equity increases. The company acknowledges this by crediting the additional paid-in capital account with the difference between the selling price and the par value.
Conclusion: Accounting Realities of Asset Sales
Be cautious with gains from selling company fixed assets. Sometimes, they can be substantial (imagine if they're selling a business unit or a factory) and can inflate profits multiple times compared to the previous year.
Stay wary and consider whether the sale is due to the company having a cash shortage from poor business operations or just to mask its poor profit performance.
In conclusion, stay negative. Accounting and finance are built on a foundation of pessimism!
ARTICLE SOURCES
- Investopedia. Adam Hayes. Capitalize: What It Is and What It Means When a Cost Is Capitalized. https://www.investopedia.com/terms/c/capitalize.asp. (accessed April 7, 2024)
- CFI. Straight Line Basis. https://corporatefinanceinstitute.com/resources/accounting/straight-line-basis/. (accessed April 7, 2024)
- Wall Street Prep. Contra Account. https://www.wallstreetprep.com/knowledge/contra-account/. (accessed April 7, 2024)
