A capital asset is property that a company possesses either for a useful part of business or an investment. Most often, these assets are tangible property that cannot easily convert to cash and will remain possessions of the business for a long time. Examples of a capital asset would be a piece of equipment or a piece of land with – or without - buildings.
Capital Asset Identification
Tangible property is visually recognizable with weight, substance and value. Capital assets include cash on hand or in the bank, documents of cash transfers (checks or money orders) and real property. Such property includes land with the air above it and the earth below it, containing some identifiable configurations or structures and subject to legislation in the United States.
Capital assets do NOT involve inventory, unpaid invoices (receivables), intellectual property (copyrights, patents and trademarks), certain pieces of equipment or vehicles. These assets do not easily convert to cash and their ownership continues as long as the asset generates a profit for the business.
Business Balance Sheet
Since capital assets are not easily convertible to cash, only a desperate situation would lead to liquidation of these items. Companies with an order of restructure due to bankruptcy may sell capital assets to comply with a court order.
The type of business determines the kind of items that qualify as capital assets and these appear on a business balance sheet with current value after application of the amount of depreciation. Some businesses will list simple office furniture, electronics and computer hardware as their capital assets.
However, grabbing a peek at an equipment-heavy enterprise reveals large, cumbersome and mechanical capital assets. These are the assets of a company that works in construction or alternative energy exploration.
Depreciation and the Tax Code
Any large business or corporation without an in-house accountant is treading on shaky ground. Some companies may need more than one financial professional if the business is subject to a number of unique services or operations where different sets of tax rules and treatments apply. The question that generally comes to light requiring professional input is the issue of depreciation.
One goal of accounting is to accurately represent annual gross income, expenses and resulting net income over the period of one year. Certain small businesses are able to reduce annual gross income by immediately depreciating the full amount of a capital asset purchase – even though the asset has the expectation of life longer than a year.
For companies or corporations, immediate depreciation of a capital asset could result in understatement of annual earnings for the first year of asset ownership. Worse, it could cause an income overstatement in the next several years while the item is still operational. Following IRS guidelines for depreciation of these assets is prudent and the choices are straight-line or declining balance methods.
A Matter of Choice
The several years following a capital asset purchase represent the useful life of an asset. At the end of that time, any remaining depreciation represents salvage value of the asset. A business owner could retrieve salvage value with a sale or by scrap.
A capital asset depreciates according to one of two formulas. The method chosen for the first year applies to the remaining useful life of the asset. Occasions might arise when a chosen method of depreciation is not the correct one. If you accidentally use it and realize the mistake later, you will need permission from the IRS to make a change and then file an amended tax return.
The Bottom Line
Capital assets get special tax law treatment and it is best to depreciate this asset over a period that is longer than one year. It makes sense to follow the IRS guidelines for capital assets to avoid penalties resulting from a tax audit. You do not get to choose which options make sense for depreciation as the IRS has already standardized the process.
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