Fixed assets are a common source of loan collateral. But how much do you really know about accounting for property, plant and equipment? FASB and IRS rules permit some leeway when deciding whether to capitalize or expense a purchase, as well as in choosing depreciation methods.
Capitalize or expense?
Deciding whether to capitalize or expense a purchase is subjective. Technically, if an asset is above a prescribed dollar amount (which varies from company to company) and is expected to have ongoing use to the business beyond the current period, it should be reported on the balance sheet and gradually depreciated over its expected useful life.
Alternatively, some purchases are expensed in the current period, typically as supplies or repairs and maintenance expense. Immediately expensing those purchases lowers the borrower’s profits compared to capitalizing purchases.
Beware: Repairs and maintenance are currently tax-audit “hot buttons.” Internal Revenue Code Section 263(a) classifies repairs and maintenance spending as a capitalizable improvement if it adds to an asset’s value, lengthens the duration that the client can use an asset or adapts an asset to a different use.
Book vs. market value?
When a borrower capitalizes a fixed asset, the amount shown on the balance sheet reflects the original purchase price minus any depreciation expense taken over the asset’s life. If the client uses accelerated tax depreciation methods for book purposes, the balance sheet may significantly understate a fixed asset’s ongoing value to the business.
Effect on balance sheet
The American Taxpayer Relief Act of 2012 (ATRA) allows companies to write off up to $500,000 of qualified fixed asset purchases in 2013, subject to a dollar-for-dollar phaseout above $2 million. For purchases above $2 million, borrowers can write off half the purchase price under ATRA’s bonus depreciation provision this year.
Federal stimulus programs have been permitting expanded tax depreciation allowances since 2008. So if a client uses tax depreciation methods for book purposes, the balance sheet may report zero value for items purchased over the last six years. But many of these fully depreciated items will continue to benefit the borrower for years to come.
In addition, profits may be unusually low in the year that Section 179 or bonus depreciation deductions are taken.
What can lenders do?
Lenders need to dig deeper to understand what’s really going on with a borrower’s fixed assets and depreciation methods. Formal fixed asset appraisals are a must-have if borrowers pledge them as loan collateral. If you accept fixed assets at face value, you’re likely to make imprudent decisions about the collateral values, profitability and overall creditworthiness.