In the world of accounting, there are two types of expenses on the reports widely misunderstood. They are depreciation and amortization. I will try to help the novice gain an understanding of depreciation in this article. So if you can, clear your mind and let us begin:
In business we purchase all types of goods to get the job done. Most of what we buy goes into the product that we sell. This is known as inventory or once sold, costs of the product/service delivered. Then we have some overhead expenses such as rent, utilities, office supplies, insurance etc. But often we have to buy a machine or some sort of asset that is used to help us produce or deliver the product/service. These types of financial outlays are big-ticket items. The most common in business is a vehicle. Others include:
- Machines that produce the product
- Equipment that help in delivering service
- Office equipment from computers to printers
- Storage systems
- Monitoring equipment
Notice that the company does not sell these assets to the customer; it needs these assets to produce or deliver the final product. Quite often these assets cost large sums of money and the owner has to seek out some form of financing or capital to purchase this equipment.
Now imagine for a moment that if you pay out a large sum of money for this asset and then expensed it to your income statement (profit and loss) you would show a large loss on that report. Not good! In accounting we want the financial reports to reflect the correct picture of what is happening. When you buy a large piece of equipment such as a vehicle, you want to expense that vehicle over time as you use the vehicle in operations. This is referred to as ‘matching’ the cost of the item to its use.
Therefore, accountants improvise with an alternative system. This is called depreciation. The best system out there is one that matches the exact production life of the asset to the utilization rate. Let us go back to the vehicle. Assume its life expectancy is exactly 100,000 miles; other vehicles of the same caliber and quality just die at 100,000 (imagine this is one of those cartoons where at exactly 100,000 miles the vehicle shuts off, a puff of smoke comes out, the doors fall off, transmission drops out, the bumpers hang by a thread, and the glass shatters). If this is true, then we can measure the utilization rate accurately. If the vehicle costs $20,000 then for every mile it is driven we expense to the income statement 20 cents. In those months that we drive it 3,000 miles, we expense $600 as ‘vehicle access’ expense.
At the point of purchase, we post this asset as a fixed asset on the balance sheet for $20,000. As we use the vehicle, we expense at the mileage consumption rate and use an offset account called ‘vehicle access’ on the balance sheet to illustrate how much of the $20,000 has been used or consumed to date. If our vehicle is due to shut down at 100,000 miles, we can calculate the number of miles left that are available. This makes it easy.
Guess what, it isn’t that easy after all. This is because almost all assets have a life expectancy that we can’t calculate. Think about this for a moment, if you bought a bronze statue; what is its life expectancy? 300 years? 400 years? I guess it would depend on how many pigeons are around. Well this exists with most pieces of equipment. We just don’t really know. The manufacturer can estimate, but the reality is they do not know EXACTLY how long it will last. Most often assets run their course due to time, others due to usage, and most are a function of both. Some can last for decades if properly maintained; think about railroad tracks.
Well, it seems there is some sort of pickle here. How do we match the fair amount of the original cost to its usage. The answer is we do the best that we can. We use time as the best model. Depreciation is calculated based on time. In the vehicle example above, the most common time period is five years. Makes sense, after five years the vehicle will be major need of restoration work to keep it running further. It will have close to 100,000 miles on it, the transmission will be ready to drop out as I illustrated above. Paint job, new brake systems, etc. Thus, depreciation breaks down the original $20,000 cost by 60 months (5 yrs) and we expense $333.33 to the income statement and offset the fixed asset on the books with the same amount. After the first month, the vehicle is now worth $19,667. This continues over 60 months until we reach zero in value left on the books.
The key here is that the owner decides how he wants to depreciate the fixed assets. He should communicate with his accountant and agree to a fair and reasonable life expectancy for the particular asset. It doesn’t take long; the owner should understand the equipment better than anyone else and he should use his experience and make a reasonable time selection for the asset’s depreciation cycle.
Now there is more to it, but that is for future articles where I’ll discuss different depreciation cycles and of course tax cycles too. I’ll further explain which is the best system based on your industry. I’ll even illustrate why it is important to get accurate with the information so as to maximize the value of your business. As you learn more and use this information and your business acumen increases, your wealth will increase too. Act on Knowledge.