Depreciation Accounting Methods

The basic theory of depreciation accounting is unarguable: The amount of capital a business
invests in a fixed asset, less its estimated future residual value when it will be disposed
of, should be allocated in a rational and systematic manner over its estimated useful
life to the business.

A fixed asset’s cost should not be charged entirely to expense in the year the asset’s acquired.
Doing so would heavily penalize the year of acquisition and relieve future years from any
share of the cost. But the opposite approach is equally bad: The business shouldn’t wait
until a fixed asset is eventually disposed of to record the expense of using the asset. Doing so
would heavily penalize the final year and relieve earlier years from any share of the fixed
asset’s cost.

Essentially, cost less residual value should be apportioned to every year of the fixed asset’s
use. (Land has perpetual life, and therefore, its cost isn’t depreciated.) The theory of depreciation is relatively simple, but the devil is in the details. And, I mean details!

Frankly, there’s not much point in discussing the finer points of depreciation accounting. I
could refer you to many books written by accounting scholars on depreciation. But as a practical
matter the federal income tax law dictates the depreciation methods and practices used
by most businesses.

Let me step on the soapbox for a moment. The depreciation provisions in the income tax law
are driven mainly by political and economic incentives, to encourage businesses to upgrade
and modernize their investments in long-term operating assets. By and large, businesses
follow income tax regulations on depreciation. As the result, useful lives for depreciating
fixed assets are too short, salvage value is generally ignored, and depreciation is stacked
higher in the early years. In other words: fixed assets generally last longer than their income
tax depreciation lives; when disposed of fixed assets often have some salvage value; and, a
strong case can be made for allocating an equal amount of depreciation to each year over the
useful life of many fixed assets. In short, actual depreciation practices deviate from depreciation
theory. Okay, I’m off my soapbox now.

No depreciation expense for the year has been recorded yet, but obviously, some amount of
depreciation must be recorded. The business purchased all its fixed assets during the first
week of the year, and the assets were placed in service immediately, so the business is entitled
to record a full year’s depreciation on its fixed assets. (Special partial-year rules apply
when assets are placed in service at other times during the year.)

The company’s plant, property, and equipment account consists of the following components:

Land $150,000
Building $468,000
Machines $532,000
Total $1,150,000

The cost of land is not depreciated. Land stays on the books at original cost as long as the
business owns the land. Ownership of land is a right in perpetuity, which does not come to
an end. Land does not wear out in the physical sense, and generally holds its economic value
over time. Buildings, machines and other fixed assets, on the other hand, wear out with use
over time and generally reach a point where they have no economic value.

Assume the business decides to maximize the amount of depreciation recorded in the year,
according to the provisions of the income tax law.

How to take care of some housekeeping details

I want to point out a few things about income statements that accountants
assume everyone knows but, in fact, are not obvious to many people.
(Accountants do this a lot: They assume that the people using financial statements
know a good deal about the customs and conventions of financial
reporting, so they don’t make things as clear as they could.) For an accountant,
the following facts are second-nature:

Minus signs are missing. Expenses are deductions from sales revenue,
but hardly ever do you see minus signs in front of expense amounts to
indicate that they are deductions. Forget about minus signs in income
statements, and in other financial statements as well. Sometimes parentheses
are put around a deduction to signal that it’s a negative number,
but that’s the most you can expect to see.

Your eye is drawn to the bottom line. Putting a double underline under
the final (bottom-line) profit number for emphasis is common practice
but not universal. Instead, net income may be shown in bold type. You
generally don’t see anything as garish as a fat arrow pointing to the
profit number or a big smiley encircling the profit number — but again,
tastes vary.

Profit isn’t usually called profit.The bottom-line
profit is called net income. Businesses use other terms as well, such as
net earnings or just earnings. (Can’t accountants agree on anything?) In
this book, I use the terms net income and profit interchangeably.

You don’t get details about sales revenue. The sales revenue amount in
an income statement is the combined total of all sales during the year;
you can’t tell how many different sales were made, how many different
customers the company sold products to, or how the sales were distributed
over the 12 months of the year. (Public companies are required to
release quarterly income statements during the year, and they include a
special summary of quarter-by-quarter results in their annual financial
reports; private businesses may or may not release quarterly sales
data.) Sales revenue does not include sales and excise taxes that the
business collects from its customers and remits to the government.
Note: In addition to sales revenue from selling products and/or services,
a business may have income from other sources. For instance, a business
may have earnings from investments in marketable securities. In its
income statement, investment income goes on a separate line and is not
commingled with sales revenue.

Gross margin matters. The cost of goods sold expense is the cost of
products sold to customers, the sales revenue of which is reported
on the sales revenue line. The idea is to match up the sales revenue
of goods sold with the cost of goods sold and show the gross margin
(also called gross profit), which is the profit before other expenses are
deducted. The other expenses could in total be more than gross margin,
in which case the business would have a loss for the period.