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The assets owned by the business are used in producing the goods and services to be sold by the enterprise. Choosing which assets to purchase is a fundamental management decision that affects the profitability of the business.
A wise selection of assets may increase the productivity and efficiency of the business and give it an edge over its competitors. The assets must be carefully recorded in the accounting records and regularly reviewed to ensure that the records are correct. For security reasons, a business must keep and regularly update a register of fixed assets.
Accounting standards specify particular methods for disclosure of fixed assets and for inclusion of a charge for depreciation in the income account. Accounting scandals involving assets shown in the accounts that were subsequently shown not to exist have increased the urgency of correct recording of assets.
Investors also need to be given a clear picture of the assets employed by a business. Various accounting ratios are used to help investors assess the performance of management and to assess the liquidity of an enterprise. The articles listed below provide the answers to common questions about assets.
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Acquiring and Accounting for Fixed Assets
A business normally needs fixed assets to enable it to earn profits. A manufacturing business requires buildings and heavy machinery, while a service supplier is likely to need office space, furniture and computers. Most businesses also use intangible assets such as goodwill, patents or trademarks. The choice of which fixed assets to buy is a very important business decision.
The assets of a business are categorized in the accounts as fixed assets or current assets. The fixed assets are the land, buildings, plant and equipment used in the conduct of the business. These fixed assets may be tangible assets such as machinery or intangible assets such as patents or trademarks. The valuation of intangible assets may be particularly difficult.
Intangible assets may take many forms. When an intangible asset is built up within a business over time, it often does not appear on the balance sheet at all because no expenditure was incurred for its acquisition. One example is goodwill when it is developed within the business rather than being bought through acquisition of another business. Other intangible assets such as patents may be developed through research and development and the costs of their development can be capitalized and shown on the balance sheet.
Current assets are the circulating capital such as cash, debtors and inventory that keep the business going in its day-to-day operations. Inventory is sold and the customer becomes a debtor to the business. When the debt is collected, the business holds cash with which to pay liabilities as they fall due. The ability to pay debts as they arise is important for continuing the business as a going concern. The business must monitor the level of current assets compared to current liabilities.
The difference between fixed and current assets has sometimes been a subject of dispute in company law. Fixed assets are the assets that are used to earn the profits of the business and are not normally readily convertible into cash. Current assets could be described as those assets that may be converted into cash within a relatively short period such as one year.
There are specific accounting rules in relation to what should be capitalized as a fixed asset and what is regarded as an expense that should be charged to the income account. The categorization of expenditure as fixed asset expenditure is determined by accounting standards and by the law of a particular country.
Assets are generally recorded in the accounts at their historic cost; in other words, the cost at the time when they were acquired. In most places, however, inflation of the currency occurs to a greater or lesser extent. Therefore, accounting standards provide for the possibility of revaluing assets on the balance sheet to reflect their worth at the time a particular set of financial statements is prepared rather than their cost on acquisition.
The criteria used by enterprises to capitalize items as assets on their balance sheet are considered significant enough to be documented and disclosed as part of Sarbanes Oxley compliance. The precise criteria for capitalizing assets as opposed to treating items as expenses are important for taxation purposes.
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Tracking Fixed Assets
The business needs to keep a good record of the fixed assets it owns both for its own management purposes and to provide evidence for the auditors. Some assets are very vulnerable to being stolen or becoming obsolete, and the management must have an up to date record of the assets owned by the business. Auditors are very thorough with respect to verifying fixed assets following scandals surrounding non-existent assets that have appeared on some balance sheets.
One sophisticated method of asset tracking is the use of GPS. This technology could be used by larger organizations with assets widely dispersed throughout the world. This is especially useful for organizations in the logistics, transport and shipping industries who have valuable assets that are constantly on the move. Fleet navigation systems enable the positions of vehicles in a fleet to be displayed on a map at any time.
There are many ways to keep a register of fixed assets. For a small business, an Excel file may be sufficient if the appropriate information is included and the register is regularly updated. This article describes one possible asset register. The Excel asset tracking template is available from the Bright Hub media gallery.
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Asset ratios may be used to asses the performance of the business. The enterprise will expect to receive a reasonable return on its assets and this will also be of interest to investors and lenders. This type of ratio therefore provides one way of measuring management performance.
A sales to fixed asset ratio may be used to measure the extent to which the business is utilizing its fixed assets effectively. This is another way of looking at how efficiently the assets are earning returns for the business and could be used to assess the performance of the company's management.
It is also possible to use ratios involving current assets to assess the liquidity of a business. The working capital to total assets ratio is an example of a ratio that measures liquidity. The ratio shows to what extent the capital of the business is tied up in fixed assets that cannot readily be turned into cash.
The net tangible assets ratio aims to arrive at the amount of net assets backing each share of the company. This is one way of looking at precisely what an investor is buying in terms of assets when a share purchase is made. This ratio gives an indication of the value that would be received for each share if the company's assets were sold and the proceeds distributed to shareholders.
The fixed assets to net worth ratio measures the proportion of funds of the business that are tied up in the fixed assets and the proportion that is in a more liquid form. This is therefore a liquidity ratio that indicates the ability of the business to continue to operate and pay its liabilities as they arise.
How to Calculate the Quick Ratio
The quick ratio or liquidity ratio measures the ability of an enterprise to pay its bills in the short-term by comparing the amount of current assets (excluding inventory) to the current liabilities. Where the quick ratio is less than 1.0 there is a danger that the enterprise will be unable to pay its bills as they fall due and ways should be found to raise more liquid funds.
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Accounting standards require fixed assets to be depreciated. As depreciation does not involve any cash outlay, it is not immediately obvious that a charge is required in the profit and loss account. To arrive at a correct profit figure, however, it is necessary to include all costs to the business that have been incurred in earning those profits and this includes the depreciation of assets used in the business.
For correct treatment of fixed assets in the accounts, it is necessary to include a charge for depreciation. This ensures that the consumption of the fixed assets is matched to the earnings from those assets in the appropriate accounting period. The charge for depreciation of fixed assets therefore aims to calculate the pattern of consumption of the asset over the life of the asset.
Various depreciation methods are used. All these methods aim to find a relatively simple way of estimating the consumption of the asset over its useful life. Some methods allow for the likelihood that the consumption will be greater when the asset is new. The general objective is to find a reasonable estimate of depreciation in each accounting period without incurring huge time costs in arriving at the correct amounts.
Depreciation is also applied to intangible assets such as goodwill but in this case, it is referred to as amortization. Intangible assets are also used to earn profits for the business and it is therefore reasonable to provide a charge in the accounts for their consumption in each accounting period.
When a decision has been made on the depreciation method to be used for each asset, a depreciation schedule may be created in Excel to manage the depreciation charge.
Assets used in certain specific business activities may be more limited in the range of depreciation methods that may be used. This could be a result of unusual patterns of depreciation of fixed assets or through limitations imposed by regulatory or tax authorities. An example of this type of asset is rental properties.
In addition to the charge in the profit and loss account, the accumulated depreciation must be shown as part of the disclosure of the net book value of fixed assets on the balance sheet. The balance sheet figure shows the aggregate depreciation of each category of fixed assets at the balance sheet date.
If a business wants to change the depreciation method used for a certain asset or category of assets, this may give rise to problems. In particular, the change in method could be challenged by the tax authorities.