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Capitalizing vs Expensing Assets

Capitalizing vs Expensing AssetsWould love to get an insight on fixed asset policy you have seen out there in your companies or with your clients.  More specifically, what determins whether you expense or capitalize an asset? I'm re-writing our policy right now, and trying to decide what it should be going forward. 

By way of background, we're growing internet business and by my rough estimate right now we have spent $300k in fixed asset purchases last year. Most of our fixed assets are computers, servers, office furtuniture and equpment we buy for our employees working at HQ or remotely.  We use MACRS depreciation both for tax and book. 

Answers

Topic Expert
Wayne Spivak
Title: President & CFO
Company: SBAConsulting.com
LinkedIn Profile
(President & CFO, SBAConsulting.com) |

There are 3 answers; What does the IRS say?; What does your Auditor say: and what is the value of the single line-item purchases?

What is the estimated life of the products, what does the IRS regs say? Are the items "installed" like cabling or a switch/router or are they iPad tablets....

Based on the given background you will definitely need to capitalized servers and office furniture (most are high dollar items). Computers/equipment may or may not fall into the grey area.

Caveat, if you are leasing they need to be capitalized.

Timothy Ogden
Title: President/CFO
Company: Joseph Elon, LLC
(President/CFO, Joseph Elon, LLC) |

If you are leasing something, it is generally not capitalized unless you end up purchasing it (or in certain situations with a Capitalized Cost Reduction against a lease--like many pre-paid leases). Equipment leases are usually off-balance sheet (operating) leases and are expensed on the income statement.

Sarah Jackson
Title: Associate Editor
Company: Proformative
(Associate Editor, Proformative) |

Proformative offers 400+ business courses with free CPE, many on Accounting.

Chris Shumate
Title: Accounting Manager
Company: Dominion Development Group, LLC
LinkedIn Profile
(Accounting Manager, Dominion Development Group, LLC) |

Going along with what Wayne said, keep in mind the IRS is changing the rules for de minimus deductions. Is your company audited, reviewed, or has some type of applicable financial statement? I attended a webinar on it recently, but I do not have my notes on me right now to go too in depth. Here is a link if you are interested: http://www.bkd.com/webinars/2012/what-contractors-need-to-know-regarding-tangible-property-regulations.htm

One thing I learned from the webinar is that if you have 10 computers that individually are below your threshold, but in aggregate does not fit the tax year's less than or equal to the greater of 0.1% of the taxpayer's gross receipts for the taxable year as determined for Federal income tax purposes; or 2% of the taxpayer's total depreciation and amortization expense for the taxable year as determined in its AFS, then you may still have to capitalize a portion of the computers for tax purposes.

As part of full disclosure: I am not an expert in this area, what I stated immediately above is my interpretation of a webinar I attended. I am not a CPA, I do not work in public accounting. I have always worked in corporate accounting. I may be correct, but I would advise watching the webinar and discussing what you learned with your tax CPA.

Timothy Ogden
Title: President/CFO
Company: Joseph Elon, LLC
(President/CFO, Joseph Elon, LLC) |

I'd steer clear of most 'webinars' (a term that actually is a gibberish word amalgamation) and instead, get out there and learn from your surroundings. Most web-based seminars are crap and very few actually are useful (some are).

I started college a very long time ago (and finished a long time ago as well), but I still have the same Principles of Accounting book by Needles, Anderson and Caldwell sitting on my book shelf above my desk. Yes, I reference it when I've already turned off my computer--and the principles STILL hold true.

It sounds like you're eager to pick up information to better yourself in your career and that is very admirable. Please check out my response below--there are a few things in there I think you may find useful. These are things I learned the long and hard way, but I never forgot them and they have never steered me wrong--even in the face of multiple IRS audit meetings that I have attended with various clients.

Anonymous
(VP of Finance) |

Thanks for your answers, Wayne and Chris. We're not audited by an accounting firm or the IRS, but I want to keep our books as clean as we can in case we will be soon.

Yes, reading more on this it does appear the rules are about to change, so will keep my eye on that.

Timothy Ogden
Title: President/CFO
Company: Joseph Elon, LLC
(President/CFO, Joseph Elon, LLC) |

Please see my response below and don't hesitate to drill down into any detail with me...always happy to help someone in the trenches.

Anonymous
(VP of Finance) |

We were doing the same thing you're doing now - book the same as tax. But after a while our asset listings got out of control and I had to rely on an accounting firm to track that for us and tell me our depreciation expense.

Our policy now is that everything under $500 gets expensed right away. Items over $500 get capitalized and depreciated on straight line for book, and MACRS for tax. Because we're private, we just made the change prospectively.

Timothy Ogden
Title: President/CFO
Company: Joseph Elon, LLC
(President/CFO, Joseph Elon, LLC) |

Check out my response below--the first part of it was geared more toward the first two respondents. The middle part may be of help to you. It sounds like you'd benefit from FAS. You speak the truth about asset listing getting out of control! I hope the response helps.

Timothy Ogden
Title: President/CFO
Company: Joseph Elon, LLC
(President/CFO, Joseph Elon, LLC) |

You can reasonably justify capitalizing assets under $600 each or with a useful life of less than 2 years (think laptops). (600 divides easily by 2 and accrues in one year at a rate of $50/month, which is generally the fiduciary point where we begin to give items stern recognition--see the mathematical relationships here?)

I'm reading through some of the responses and it never fails: some folks who obviously have little experience (me--nearly 20 years as an accountant) feel the need to pipe up and they throw more questions back at you for the simple need of speaking...but I digress.

The IRS may be changing many rules for deductions in the future, but they HAVE YET TO DO IT.

If you would like a simple deduction schedule, I will be happy to provide you with one. Personally, I use the Sage program FAS (Fixed Assets, Sage), which integrates beautifully with my version of Sage 50 Quantum 2014 that came complete with Crystal Reports (and is fully GAAP compliant). If you're using QB, they have some capability for this, but it's not very robust and it does have accuracy issues (yes, QB has accuracy issues, has for years and is NOT fully GAAP compliant). There's a reason I became a member of the Sage Accountants Network--access to all of these goodies!

When I enter items into FAS, it has an entire battery of detailed fields that can be populated. At the time you make the purchases, these fields capture your detail (down to the warranty of the item), track it however you want it to do so, and then FAS PROPERLY BOOKS THE ENTRIES ALONG THE WAY directly into your favorite accounting software. Once that asset has met its useful life span on your books, it remains on your property register, but not as a depreciable fixed asset. When you dispose of the asset prematurely for a loss, you'll want to have the benefit of re-recognizing that asset and capitalizing the loss. Conversely, if you dispose of the asset for more than its book value (which may be zero), you'll be required to capitalize the gain. <--Capital Gains and Losses--amazing how the math all ties back when you take the time to do it right up front and manage it all prudently along the way.

These things do take a small investment of time to set them up correctly ONCE. It just so happens that they help you write your policies and best practices along the way. Not only that, they are easy to modify as the IRS rules change. <-Note, rarely ever are IRS rules enacted to act in a retrograde manner. They almost always allow for a period of realization to account for the existence of legacy items.

Also, think about when the time comes for you to file your property tax renditions with the local taxing authority(ies)...every year...as long as you're in business.

Jim Schwartz
Title: Corporate financial advisor
Company: Wabash Financial Strategies
(Corporate financial advisor, Wabash Financial Strategies) |

Re Timothy Ogden's assertion that lease payments are generally treated as rents and expensed, I must disagree. In 1975 the IRS addressed this question in a Revenue Procedure that offered safe harbor guidance about what constitutes a "true" lease (i. e., an operating one where rents could be expensed). The accounting profession followed in 1978. The accounting folks have tightened requirements periodically and continue to struggle with the issue today as part of the convergence with international accounting standards. The consistent theme has been for more and more leases to be capitalized, not expensed. If the lease term is, at the inception of the lease, for most (say, > 80%) of the expected useful life of an asset or if the end of term fair market value is projected to be minimal (say, < 20%), the lease should likely be capitalized. Another telltale indicator is the purchase option. If it is a fixed price and/or nominal relative to projected end of lease term value, capitalization is likely appropriate.

The logic is that these features characterize an asset ownership scenario and this "substance" should drive tax and accounting treatment. Further, there is no "look back" at the end of the lease to reclassify the lease vs ownership question unless the facts that were known at lease inception show that the wrong treatment was chosen at the outset.

Obviously, cases where the lease term is short relative to expected asset life or projected future value can more likely still qualify for operating lease treatment. In practice, companies seem to expense lease payments in many cases where such treatment does not appear justified. A key consideration for leasing is that it can offer benefits in cash flow, financing and asset management/replacement, among other things that may be more significant than tax or balance sheet treatment.

Anonymous
(Managing Director) |

In a related matter need some help and possiblly an auditor for my enterprise integrated smart process application platform co. As I understand currently, software co’s are required by SFAS 86 to capitalize certain development costs of software to be sold, rented/leased or otherwise marketed. And that capitalization occurs once technological feasibility has been reached and costs are determined to be recoverable.Capitalization ends and amortization begins when the product is available for general release or ship date to customers.

However, since above is a guideline only, determining “technological feasibility” and amortization parameters is a puzzle. The “flexibility” leads to all sorts of questions; when can you tell when you cross over from “R” to “D”? And that is trickier distinction with iterative or agile development vs traditional software waterfall design approaches.

My interpretation is that “D” costs can be capitalized in agile since most of your D is done DURING iterations PRIOR to reaching technological feasibility whereas in waterfall approaches, all the D is done AFTER technological feasibility is reached.

Our platform evolution is now up to v 5.0 and thus we're pretty far down the road in terms of technological feasibility; and we’re still iterating quarterly or every six months for our clients and therefore thought we could capitalize all this iterative “D”. In our agile environment, assume that most of the “R” was completed pre 2008….” We reinvested $2.1 million in our software from our energy services revenue. The software has seen two major evolutionary releases since 2008”.

And I am assuming that we are “creating new assets” e.g. v.5.0,5.1, 6.0, 7.0 etc to depreciate alongside the original assets v 3.5, 4.0 etc i.e. when new asset is placed in service, where its useful life will be equal to the remaining useful life of the original asset)..or are we stuck calling these costs to “rebuild” –i.e. evolutionary releases or is it to repair a design flaw? If the latter, then it hits the P&L cash flow not balance sheet.

So does v 5.0 qualify as enhancements not resulting in significant additional capability beyond that for which the software was “originally intended”….as it was supposed to work right the first time? My thinking was that we built out the software , then customers realized it wasn’t “complete” and we spent more money from energy services to iterate and make complete….therefore it should be capitalized.

Thus if you replace the prior builds with a new build at higher cost, the old “wasted money” should be written off. One can probably argue the point with auditors if the old platform versions are still being used, and the new work is a new module in which case one can argue that you have developed a new asset that is separate from the old one.

The two functions of the quoted rule (ASC 350-35-1) are to force the write-off of something that doesn’t exist or is not functional, or; to prevent gaming of the accounting rules. Since we are building software that is incremental to what we had, and what we had still has value, I believe we’re not violating the spirit of these rules if we account for it as new separate asset. But need to confirm this with an auditor.

A big part of reason for trying to capitalize our software investment is 1) try and keep IT COGS expenses low and stretched out over a period of years by deferring the handling of those expenses to the out years through depreciation which reduces current year IT budget and 2) it enhances the intangible asset base on our balance sheet, so to investors –even though operational impact is more or less same either way- “optically” it looks like they are investing in a company that has software assets. It’s probably too much of a stretch.

Lastly, the norm is for most software development or products co’s to expense development anyway as evidenced by Salesforce and the 146 out of 207 software co’s surveyed that expense. Notwithstanding, Salesforce still allocates 15% IT COGS as R&D expense collection on balance sheet. And in most industries there are available tax credits for R&D expenses. And I think the R&D tax credit rules are changing for 2014 under some new federal legislation this where it may benefit us to expense vs depreciate. Again, a lot of this accounting stuff not in my wheelhouse.

Sorry alot of preamble here but wanted to give some background and hope someone can help. Looking to hire an auditor who can help us with these matters.

Thanks for your patience, new to group.

Ken Stumder
Title: Finance Director / Controller
Company: Ken Stumder, CPA
(Finance Director / Controller, Ken Stumder, CPA) |

Anon MD - you say this is not your wheelhouse but you summed it all up quite nicely.

I think the survey results are telling - complex accounting rules have simply inclined companies to expense D costs up front. There is too much diversity/subjectivity in practice and no company wants to take an impairment charge down the road if their best-faith cap policy is questioned by a third party.

Best I can tell, it hardly makes a difference if company A capitalizes and company B expenses because analysts are smart enough to look at the financials of both companies and determine how the accounting treatment effects earnings, operating cash flows, etc.

If you track development spend, you can show investors how much has been invested in the product over time, and upkeep costs are demonstrable by levels of IT staffing, consulting costs, etc.

I am certainly interested in other views on this topic!

Kevin Roones
Title: Senior Accounting Professional
Company: In-between
(Senior Accounting Professional, In-between) |

As is the case with a lot of accounting issues, the important thing is that you have an established written policy that is consistently applied. It will help you if you have a good time tracking system for your developers. At the company that I worked for, capitalized software development, which significantly enhanced the marketability or significantly extended the life of the products was capitalized and amortized over 3 years, beginning when the products were offered for sale or when the enhancements were integrated into the product. The new enhancements or functionality had a new 3 year life, not an incremental one to the original development.

You are correct that bug fixes (and training) should be expensed as incurred, and that when a specific product release is discontinued an impairment is recognized and the remaining unamortized cost is written off.

Sheila Saffold
Title: Manager of Accounting
Company: Hospital
(Manager of Accounting, Hospital) |

Our policy is to capitalize items where the unit cost is more than $2,000 and we expect it to last more than one year. There is one caveat: for large construction projects, say remodeling an entire floor, we capitalize everything that goes into the construction, whether it is over $2k or not.

Mark Sutherland
Title: CFO
Company: Profit By Design CFO & Controller Servic..
(CFO, Profit By Design CFO & Controller Services) |

To answer your question: "More specifically, what determins whether you expense or capitalize an asset?", I believe GAAP states that if an item has a useful life greater than 1 year, it's cost must be allocated over such useful life, and not expensed all in year 1. Exception: I generally expense a subject item whose value is under $1,000. My recollection is that the IRS will accept this policy, so long as you apply it consistently from period to period to all subject assets. I have found that having a GAAP book handy has served me well on these kinds of subjects. I believe Steven Bragg is a co-author of the GAAP book if you want to do a search for it.

Delena VerHey
Title: Controller
Company: KellyMitchell Group, Inc
LinkedIn Profile
(Controller, KellyMitchell Group, Inc) |

If you are keeping your books on a tax basis (rather than GAAP), then you would apply the current IRS guidelines regarding capitalization. Starting Jan 1, 2016 the de minimis safe harbor rule is that you are required to capitalize any single item (as shown on an invoice) that is over $2,500. Definitely talk to a tax accountant or at least do your own research on the IRS website. Here's the link to the safe harbor regulation that I'm referring to...

https://www.irs.gov/pub/irs-drop/n-15-82.pdf

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