Fixed assets represent long-term assets used by companies and businesses in the generation of revenues and profits. There are several types of fixed assets that companies use, including property, plant, and equipment.
Since most of these assets require high-value investments, accounting standards require companies not to charge the cost of these assets in a single accounting period.
There are several reasons why companies don’t charge assets in a single period. Most importantly, it is because the matching principle of accounting requires companies to charge expenses in the period that they help generate revenues. It is why companies use depreciation to contribute to the value of fixed assets over a period of time.
However, there is still an asset that companies do not depreciate, land. The reason is behind it is that land has an infinite useful life. Other assets, in comparison, have a useful life after which they stop generating revenues for a company.
The only case where land is depreciable is when there are natural resources that companies can extract from it.
When companies purchase land, it may come with a building on it. Therefore, they need to allocate the cost between the land and building.
It is so they can depreciate only the building element and not the land itself. Sometimes, however, companies may also perform some land improvements, which can be depreciable.
What is the land improvement?
Land improvement refers to enhancements made to a plot of land to make it more usable. Usually, these improvements have a useful life and, therefore, are depreciable.
However, if a land improvement does not have a useful life or companies cannot estimate it, then the company cannot depreciate the improvement. Similarly, there are some costs that qualify as land improvements and some which do not.
For companies to consider expenditure on land as improvement, they must meet several requirements. Most importantly, the expenditure should be of capital nature and not revenue nature.
It means that any expense borne on land should enhance its quality, increases its useful life or increasing its value. Any regular maintenance work done to it does not qualify as capital expenditure.
That is the reason why expenditure such as demolishing an existing building and clearing and levelling the land do not qualify as capital expenditure.
Companies perform these actions as a part of regular maintenance and do not affect the value of the land. Demolishing a building also has an impact on the value of the building and not the land.
Other improvements to land, for example, adding elements to it can qualify as improvements. For instance, if a company installs drainage and irrigation systems, landscaping, parking lots, driveways, walkways, outdoor lighting, or fencing, it can recognize it as a land improvement.
Almost all these items have limited lives and, therefore, the company must depreciate them.
The accounting treatment of land improvements comes under the accounting standard for property, plant and equipment. Companies need to calculate all the costs that go into these improvements. However, they must ensure these expenditures are of capital nature.
The initial measurement of the cost of these improvements includes all costs involved in bringing the improvements into working condition.
Once companies measure the initial cost of the improvement, they can use the following journal entry to record the land improvement in their accounts.
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The land improvements represent a fixed asset for a company, which will appear in its Balance Sheet. On the other hand, any payment made against the installation of these improvements reduces the cash or bank balance of the company.
If the company obtains these improvements on credit or any other terms, it can modify the credit side of the double-entry.
Like any other depreciable asset, the accounting treatment for land improvements depreciation is straightforward. Companies need to start by establishing the cost of improvements.
In case they cannot calculate its value, they cannot capitalize it either. After determining the cost, companies need to estimate the useful life of the improvement.
The useful life of an asset can depend on several factors. However, it generally requires judgement. After establishing the useful life, the company needs to decide on the depreciation method to use for depreciating the land improvements.
Usually, companies have two options when it comes to depreciation techniques. These include the straight-line method and double-declining balance techniques.
The journal entry to record depreciation, after calculating it, is as follows.
The above journal entry is similar to a depreciation recording entry for any other fixed asset.
The land is a non-depreciable fixed asset for companies due to its infinite useful life. However, land improvements with useful life are depreciable. Land improvements are any enhancement to land that increases its value. These improvements need to be of capital nature and not revenue nature.