Capital Assets

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Should my company capitalize and amortize the costs of sets and costumes?

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Capital assets generally include items of significant value that are owned for longer than a year, and used in operations. Spending on production can vary widely from show to show and company to company. If you are spending significant sums in these areas, it’s worth exploring this issue.

Let’s take the example of an opera company that has adopted an accounting policy of capitalizing its sets and costumes and amortizing them over 7 years, based on the fact that it draws from a “canon” of works, and therefore remounts shows from time to time.

One way to look at capital assets is as a deferred expense. You pay all the bills in Year 1, but (through amortization) you recognize the expense over the estimated useful life of the asset (in this example 7 years), so that each year of use bears its proportional estimated share of the cost (in this example 1/7 per year).

The argument in favour of capitalizing and amortizing sets and costumes would be that you expected to use them actively over the estimated 7 years, either in your own shows or as rental properties. 

Let’s work through the accounting effect, step by step. In the first year of adopting this policy, you would record your sets and costumes as assets, not expenses. This would have the effect of improving your bottom line. You would of course need to record one year of amortization expense – that is, 1/7th of the purchase price. The remaining 6/7ths of the expense would be postponed to future years. 

Onward to Year 2, and a new year of programming with (potentially) a new group of directors and designers. Will those artists be content to reuse Year 1’s sets and costumes? It seems likely that, in most cases, while they may reuse some “stock” items, they would prefer to create something new and different. In that instance, the company would incur new expenses for set and costume purchases. Once you set up an amortization policy, you need to follow it -- so you would amortize Year 2’s production items in the same way. Financially, the result would still feel pretty sweet, because in this year you recognize the cost of 1/7 of Year 1 purchases plus 1/7 of Year 2 purchases... but you can see where this is heading.

By the time you hit Year 7, the bottom-line advantage has disappeared because you've got seven active amortization cycles. You're also saddled with a certain amount of extra bookkeeping – and, more importantly, production expense becomes difficult to interpret. Imagine looking at the Year 7 income statement. You know for a certainty what your box office revenue was, but because related expenses and revenues are no longer matched within a fiscal period, it becomes trickier to interpret the financial result. The set and costume expense in Year 7 does not capture the cost of Year 7 shows, but rather 1/7 of the costs for each of the previous seven years.

The real "bottom line" to this story is that you can't out-run expense. You need to recognize it sooner or later. Our opera company might have been tempted to adopt the amortization policy as a gambit to improve the bottom line at a point when things weren't going well – but over the longer haul this approach doesn't put you any further ahead.

Now – let’s look at the other side of the coin. If you expense sets and costumes during the year of the show for which they were created, expense recognition is clear. That's very helpful for the purpose of evaluating financial results. But, it's also true that companies, especially larger companies in the opera and ballet worlds, DO remount productions and rent productions to other companies. If you don't amortize the cost, those future uses have no cost attached to them – and the financial statements for those years could be seen as misstated by the amount of expense that perhaps should have been attributed to them.

Expensing items in the year of the production means that companies may own a lot of stock – sets, costumes, props, etc. – that's not acknowledged on the balance sheet as an asset. However, that is how the set and costume expense is typically handled, in the experience of Young Associates staff. 

The question for management is which treatment best reflects the company’s financial results? And, which treatment best applies generally accepted accounting principles (GAAP) such as cost-benefit and materiality? Managers need to evaluate whether the advantage of matching revenue and expense recognition outweighs the possible misstatement of future bottom lines. 

This would be an excellent topic to discuss with your accountant.

Click here for more q and a's on capital assets. 

When it comes to my financial statements, what is “real”?

This question came from the Executive Director of a small organization – and she asked it repeatedly, with a great deal of very genuine concern! The issue, it seems – and this is a common concern for non-financial folks – was understanding the nature of accrual accounting.

“Real,” in her terms, meant that money had changed hands. Even in the days of electronic transfers, cash in the bank still feels indisputably legit and tangible! However, non-cash transactions can be just as “real” as those involving money. For example, they may record agreements or management estimates that provide the basis for measuring financial results.

Accounts receivable and grants receivable are amounts owed to you by clients/customers and funders. A state of obligation exists when you have delivered work, and the promised payment is due. This state of obligation felt real to the Executive Director, because she was well aware of the costs her organization had incurred, and the urgency of collecting the receivable amounts.

By the same token, accounts payable were not questioned: the state of obligation between the organization and its suppliers was evident, because the organization had received goods or services for which it hadn’t yet paid, and the invoices were sitting in the “bills to be paid” file.

Prepaid expenses and deferred revenues posed a challenge. In both of these cases, money actually has changed hands – but those transactions are not recorded on the income statement as expenses and revenues; rather, they are recorded on the balance sheet as assets and liabilities (respectively). Eventually, when the obligations are satisfied, these items will be recognized as expenses and revenues. Read on…

A prepaid expense item is an asset – something you own. It arises when you have paid for goods or services ahead of time. A classic example would be a rent deposit. Often, when a lease is signed, the lessee must pay “first and last.” Obviously, you receive the first month of your tenancy right away. However, you have paid up-front for the last month on your lease, and you won’t receive that service for a period of years. You own the right to receive it, because you have prepaid it… and the landlord is effectively in your debt for that month of occupancy.

When the last month rolls around, the landlord provides the month of occupancy. At that point, the organization no longer has an asset, because it has collected on the obligation. In the accounting records, the asset must be removed – and the rent expense can be officially recognized. Note that the last month’s rent eventually does appear as an expense, but not until it’s being used. In that last month, it’s a non-cash expense item; the cash changed hands back when the lease was signed.

A deferred revenue item is a liability – something you owe. It arises when someone else has prepaid you for goods or services that you have not yet delivered. A classic example from the performing arts is a subscription. Many organizations run intensive campaigns during the spring and summer to sell subscription packages for the next fall/winter series of shows. At the point when the subscriber pays, they have a promise from the organization, but they won’t enjoy the concerts or plays for months down the road. The organization owes the subscriber those shows.

When the organization delivers its performances, it discharges its liability. In the accounting records, the liability must be removed – and the ticket sales revenue can be officially recognized. Thus, eventually those subscription packages do turn into revenue, but as a non-cash revenue item; the cash changed hands back when the subscriber made the purchase.

The depreciation of capital assets can also cause confusion. A capital asset is an item of significant value that an organization will own for a period longer than a year, and use in carrying out its operations. Depreciation (or amortization) is the process by which the cost of that asset is spread over the years of ownership. Please look to these further questions and answers that present the process in detail:

For our purposes here, the important thing to understand is that the asset (usually) must be paid for when it is bought. Each year’s depreciation is a non-cash expense item, representing that year’s estimated share of the cost.

One of the purposes of accounting is to measure the expenses and revenues associated with each year of operations, regardless of when money changes hands. As you can see, items may be paid for either before delivery or afterwards. The exchange of cash does not create the revenue or expense: rather, the usage of the goods or services in the course of operations. Balance sheet accounts are used to “park” or accrue items so that they can be properly recognized in the correct operating year. Non-cash revenues and expenses can be just as real as those paid “cash on the barrel head.”

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I received a grant to help with my capital asset purchases. My bookkeeper says this is a liability. How does this make sense?

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Your bookkeeper is correct. But, before you try to come to grips with the treatment of the capital grant, it will help if you review the depreciation of capital assets, explained in this FAQ.

Donations to a capital campaign (e.g. from individuals and businesses) are treated in the same way as grants (e.g. from foundations and governments).

Your funders and donors have provided money that is intended to benefit your organization over the life of the capital purchases. In the same way that the cost of a capital asset is spread over the years of ownership, the benefits of a capital grant must be spread over the same years, using the same technique.

A typical name for this item is “Deferred Contributions for Capital Assets,” and it appears with other deferred revenues in the liability section of the balance sheet.

You should discuss your organization’s capital policies with your accountant, to make sure they are appropriate to your particular situation.

I discarded my capital asset before it was fully depreciated. Now what?

When you purchase a capital asset, you need to estimate what its useful life will be. The key word, here, is estimate. You don’t know at the outset what will happen… what will turn out to be a lemon, what will break, or what will (amazingly) last years longer than you anticipated. You also don’t know what advances will come along, that may make it more economical to replace something early than to use it ‘till it wears out.

If you discard something earlier than expected, then the year of disposal must take all remaining undepreciated cost.

This makes sense: the mechanism of depreciation is intended to spread the cost of an asset fairly over the years of ownership. If you dispose of an item early, then your accounting records must show that the asset is gone. The only way to do this is to take the expense.

Managing the journal entries around discarding capital assets is a good topic of discussion with your accountant. You need to follow your organization’s accounting policies, and make sure you’re recognizing the expense correctly.

I’m still using a capital asset that has been fully depreciated. Is this ok?

That’s good news!

Capitalizing and depreciating (or amortizing) major purchases allows you to spread out expense over estimated useful life. When you buy a new asset, you have no way of knowing how it will perform. You might find yourself discarding some purchases early – and you might own others for longer than you had expected.

If you wind up using your asset after it has been fully depreciated, then those extra years of useful life get a “free ride,” from the viewpoint of expense.

Remember, the function of depreciation is to spread the purchase price over an estimated time span. Once the original cost has been fully expensed, that’s it!

It’s important to make sure that you are depreciating your capital assets over a reasonable time frame. Be sure to discuss capitalization and depreciation policies with your accountant, to confirm that you’re following methods that work for your organization and its belongings.

I know that my capital assets are worth more (or less) than my financial statements show. What’s with that?

Accounting does not attempt to reflect the market value of your assets. Your accounting statements reflect the cost of purchase.

The process of capitalizing and depreciating (or amortizing) major purchases allows the cost to be shared over the years of useful life. You can see other FAQs on aspects of this process:

It’s also true that the capital assets on your balance sheet indicate the investment your organization has made into significant purchases that support and enable your operations. It’s important to declare that you’ve purchased sufficient equipment to allow staff to carry out their work, and that you own a building, or have invested in renovations to improve the property that you lease.

Indeed, in the commercial world (not so much in the not-for-profit) companies calculate “return on assets” as a measurement of their productivity and success.

However, consider how hard it would be to show market (or resale) value.

You may just have bought a nice, state of the art computer for $1500 – but the moment you take it out of the box, it’s used equipment. You may not even have plugged it in – but you couldn’t expect to get $1500 if you tried to resell it. After you’ve used it for a year, how much would it be worth as a second-hand machine? And yet, as far as your organization is concerned, it’s still a useful and functional item in the office.

If that’s the case with equipment, which wears out and becomes obsolete, you can imagine that dealing with real estate – where market values can float up and down over time – would be much more complex.

To create meaningful financial statements, it’s essential to have a constant unit of measurement. Generally Accepted Accounting Principles (GAAP) recognize this through the Stable Dollar Concept, which assumes that the purchasing power of a dollar remains unchanged over time. This allows us to make reasonable comparisons between fiscal years.

That said, there are circumstances where it is permissible to “write up” or “write down” an asset to reflect a permanent change in its value. Your accountant can advise whether this pertains to your organization.