If you own a business and have a plant as well as equipment, you have to follow different accounting rules for fixed assets compared to current assets like cash or receivables. Understanding this difference is important, especially when it comes to valuation.
An asset in the business world can be cash or accounts receivable (money owed to your company by customers). An asset can also be the raw materials you have in inventory that have not been made into a product yet, as well as finished goods sitting in inventory and awaiting purchase. But those assets are called 'current assets' in accounting financial statements like the balance sheet.
Fixed assets are assets the company has that will not fluctuate in value based upon a sale or month-to-month. Fixed assets include things like the land your company business owns and the plant and equipment on that land that are used to produce your products sold. Fixed assets are also known as tangible assets.
Fixed Assets and the Balance Sheet
When preparing financial accounting statements, fixed assets are reported differently than current assets. For example, on the Balance Sheet, current assets (cash, accounts receivable, raw materials and finished goods) are listed and calculated in a separate section from fixed assets. Fixed assets are listed under the title 'plant and equipment.' But both types of assets fall under the Balance Sheet heading of "Assets."
Fixed Assets and Accounting Rules
With current assets, you will see a fluctuation on a month-to-month basis on the balance sheet. One month your business might have $1,000 in cash, a current asset--the next it might be $5,000. Likewise, inventory amounts will fluctuate based on sales made and orders shipped during the period. Therefore, the accounting rules for current assets are governed by this information and activity, as it occurs.
Fixed assets, however, are governed by another accounting rule: depreciation. Assets like land generally appreciate in value, while assets like plants and equipment depreciate. These appreciations and depreciations must be reflected on the financial statements. They are done so under the accounting term of depreciation.
Fixed Assets and Depreciation
Businesses need a numerical way of estimating the depreciation of their plant and equipment properties. But if left to their own devices, this calculation amount would differentiate considerably. Banks and investors would be unable to accurately know if the depreciation was being under emphasized during a business purchase or not, thus an immoral seller could say his plant was worth $10,000 when it was only worth $5,000, if left to create this accounting number percentage himself.
GAAP (generally accepted accounting principals) is the solution. This accounting rule process, which must be followed by all companies when preparing their financial statements, addresses this potential depreciation problem. GAAP sets accounting guidelines that dictate how much depreciation is calculated and reported on business financial documents, eliminating potential errors in value. It assigns the same formula across-the-board organization-wise, hence the different accounting rules for fixed assets.
Accounting Rule Variances
You can see that fixed asset accounting rules, then, must differentiate from current asset accounting rules, as the fixed assets have a longer life than other assets and do not lend themselves to such simplistic calculations as "How much cash did we take in this month or pay out?"