A basic principle of “financial accounting“ is that the cost of the long-term operating resources used by a business should be allocated over the years these “fixed assets“ are used. It is definitely against generally accepted accounting principles (GAAP) to charge the entire cost of a fixed asset to expense in the year of its purchase or construction. The allocation of cost over a fixed asset’s useful life is called “depreciation“. The book value of fixed assets equals their original cost less the “accumulated depreciation“ on these long-term operating resources.
Fixed assets are long-term investments by a business. Over the years of their use the company has to recover through sales revenue the amount of capital invested in these assets. A business does not hold fixed assets for the purpose of selling them sometime in the future for more than it paid for the fixed assets. At the end of their useful lives fixed assets are sent to the junk pile or sold for their salvage value. Well, this is generally true, except for land and buildings.
The To and Not To Capitalized Purchase (acquisition) Of Fixed Asset
Machinery, equipment, tools, and vehicles do not appreciate in value over the years of their use. However, land and buildings are two different things. The cost of land is not depreciated. The cost of buildings is depreciated, even though the market value of the buildings may appreciate over time. It can be argued that the cost of buildings should not be depreciated if their market value increases. But GAAP says to depreciate the cost of buildings, no matter what. This is the first thing to keep in mind about depreciation. The next thing to keep in mind is …..hmm.. let’s construct a simple case example…
Suppose a business buys several new delivery trucks. The total purchase invoice cost paid to the dealer for the fleet of trucks is capitalized (i.e., recorded as an increase in the fixed asset account for these long-term operating resources). The term capitalized comes from the idea of making a capital investment.
The amount of sales taxes paid by the business is also capitalized; sales taxes are a direct and inseparable add-on cost of the trucks. So far there is no argument; both the total purchase invoice cost and sales taxes paid by the buyer are capitalized.
EXAMPLE: Suppose the business paints its new trucks with the company’s name, address, telephone number, and logo. Also, the business installs special racks and fittings in the trucks. In theory these additional costs should be capitalized and included in the cost basis of the fixed assets. These additional costs are not directly part of the purchase; these costs are detachable and separate from the purchase cost.
Nevertheless, the costs should be capitalized because the costs improve the value in use of the trucks, isn’t it?
When purchasing many long-lived operating assets a business incurs additional costs that should be added to the cost basis, but in fact may not be. Accounting theory says to capitalize these costs. As a practical matter, however, only purchase cost plus other direct costs of purchase are capitalized. Any additional costs are recorded as expenses immediately, instead of being depreciated over the useful lives of the fixed assets.
There are countless examples of such additional costs. A business may paint several signs on a new building it just moved into. It may fumigate the entire building before moving in. It may upgrade the lighting in several areas. Or, after purchasing new machines or new equipment a business usually incurs costs of installing the assets and preparing them for use. Such additional costs should be capitalized, according to accounting theory.
In actual practice, however, the additional costs are usually not recorded in a company’s fixed assets. Instead, the costs are charged to expense in the period incurred. One reason is to deduct these costs immediately for income tax purposes—to minimize current taxable income in the year the costs are incurred (a business should be very careful regarding what the tax office tolerates in this regard). Another reason for not capitalizing such costs is simply that of practical expediency. It is much easier to charge such costs to expense rather than adding them to the fixed asset cost.
The Assortment Of Low—cost Tool’s Depreciation
While on the topic of practical expediency I should mention that most businesses buy an assortment of relatively low-cost tools and equipment items—examples are hammers, power saws, drills, floor-cleaning machines, dollies, pencil sharpeners, lamps, and so on. The costs of these assets, since they will be used several years, should be capitalized and depreciated over their expected useful lives. Keeping a separate depreciation schedule for each screwdriver or pencil sharpener is ridiculous, of course.
Most businesses set minimum dollar limits below which costs of fixed assets are not capitalized but are charged directly to expense. This is accepted practice; CPA auditors tolerate this practice as long as a business is consistent one year to the next. The only question concerns the materiality of such costs. If these costs in the aggregate were extraordinarily high one year, the CPA auditors, as well as the tax office might object.
Annual Expenses If Only Direct Acquisition Costs Are Capitalized
In any case, business managers should understand the financial statement effects of not capitalizing the additional costs associated with buying fixed assets and not capitalizing the costs of small tools and equipment. For example: suppose a business purchased new fixed assets during the year. The sum of the invoice prices plus sales taxes for all these assets was $1,400,000 for the year. The $1,400,000 is capitalized; the business records this cost in its fixed asset accounts. If it didn’t, the company’s CPA auditors would object in the strongest possible terms, and the tax office [IRS for U.S] could accuse the business of income tax evasion.
In addition to the direct costs of the new fixed assets, suppose the business spent $120,000 during the year for the types of additional costs connected with buying new fixed assets which were just described, and spent another $20,000 for small tools and inexpensive equipment items. The $140,000 total could have been properly capitalized, but consistent with previous years the company recorded the amount to expense.
To simplify, assume that the various fixed assets are depreciated over seven years, and that the business uses the straight-line depreciation method. The effects of capitalizing only the direct costs versus capitalizing all costs are compared as follows:
Year 1: $200,000 depreciation + $140,000 = $340,000
Years 2–7: $1,400,000 /7 years = $200,000
Annual Expenses If All Costs Are Capitalized
Years 1–7: $1,540,000 / 7 years = $220,000
If the business chooses the first alternative, then expenses in the first year are $120,000 higher ($340,000 minus $220,000 = $120,000). But then annual depreciation expense is $20,000 less for the next six years.
If all costs are capitalized, every year is treated equally. Total expenses over the entire seven years are the same either way. It’s year by year that expenses are different.
Word of caution: The above comparison does not consider the carryover effects from previous years. We would have to know the history of the business regarding these costs in previous years to determine the final net effect on this year.
Charging the costs of small tools and equipment items to expense provides business managers yet another way to manipulate profit for the year. The timing of these expenditures is discretionary. Small tools can be replaced before the end of the year, or put off until next year. So, the expense can be recorded this year or delayed until next year.
Should Depreciation be Accelerated Or Not?
Most business buildings last 50, 75, or more years. Yet under the income tax law the cost of nonresidential buildings used by a business can be depreciated over 39 years (31.5 years before 1993). Most autos and light trucks used by businesses last 10 years or longer, but can be depreciated over 5 years under the tax law.
In brief, the income tax law permits business fixed assets to be depreciated over a shorter number of years than the actual useful lives of the assets. This is the deliberate economic policy of any government to encourage capital investment in newer, technologically superior resources to help improve the productivity of American business.
Accelerated depreciation deductions are higher and tax payments are lower in the early years of using fixed assets. Thus, the business has more cash flow available to reinvest in new fixed assets—both to expand capacity and to improve productivity. This accelerated depreciation philosophy has become a permanent feature of the income tax law, and is not likely to change anytime soon.
The income tax law regarding depreciation of fixed assets has effectively discouraged any realistic attempt at estimating the useful lives of a company’s long-lived operating resources. This is a fact of business life, like it or not. The shortest lives permitted for income tax are selected by most businesses for reporting depreciation expense in their financial statements. In the U.S, the schedules of these short, or accelerated, useful lives are found in the section of the income tax law named the “Modified Accelerated Cost Recovery System,” or MACRS for short. (Its predecessor was known as ACRS, or Accelerated Cost Recovery System.)
Alternatively, the income tax code permits businesses to adopt longer useful life estimates than the MACRS schedules. But even these longer lives are generally shorter than realistic forecasts of the actual useful lives of most business fixed assets.
MACRS also allows the front-end loading of depreciation, instead of a level and equal amount of depreciation each year (called the straight-line method). More depreciation is allocated to the early years and less in the later years.
Financial statement users should keep in mind that, with rare exceptions, business fixed assets are over-depreciated—not in the actual wearing out or physical using up sense but in the accounting sense. In balance sheets the reported book values of a company’s fixed assets (original cost less accumulated depreciation) are understated. A company’s fixed assets are written off too fast. Book values shrink much quicker than they should.
In summary, a business has two basic alternatives regarding how to record depreciation expense on its fixed assets:
- Adopt the accelerated income tax approach—use the shortest useful lives and the front-end loaded depreciation allocation allowed by the tax code.
- Adopt more realistic (longer) useful life estimates for fixed assets and allocate the cost in equal amounts to each year—straight-line depreciation.
For an example: assume that a business pays $120,000 for a new machine. Under MACRS this asset falls in the 7-year class. Alternatively, the business could elect to use a 12-year useful life estimate, which we’ll assume to be realistic for this particular machine.
The annual depreciation amounts determined by the double-declining accelerated depreciation schedule permitted by MACRS with the $10,000 annual depreciation amount according to the straight-line method. (Only one-half year depreciation can be deducted in the year of acquisition under the income tax law).
Suppose the machine actually is used for 12 years. Therefore, this asset adds value to the operations of the business every year of its use. The value added in some years may be more than in other years. It’s virtually impossible to determine exactly how much sales revenue any one machine is responsible for—or any particular fixed asset for that matter. Nevertheless, it would bother me that if the business chooses accelerated depreciation, then the last five years of using the machine would not be charged with any depreciation expense. What do you think?
Although accelerated depreciation has obvious income tax advantages, there are certain disadvantages. For one thing, the book (reported) values of a company’s long-term operating assets are lower. When borrowing money a lender looks at the company’s assets as reported in its balance sheet. The lower book values of fixed assets caused by using accelerated depreciation may, in effect, lower the debt capacity of a business (the maximum amount it could borrow).
One final point: Managers and investors are very interested in whether a business was able to improve its profit performance over the previous year. Ideally, when a profit increase is reported in an income statement, the increase should be due to real causes—better profit margins on sales, gains in operating efficiency, higher sales volumes, and so forth.
Spurious increases in profit can be misleading. Profit trends are difficult to track if there are drop-offs in annual depreciation expense, which happens under accelerated depreciation (see Exhibit M again). The straight-line method has one advantage: Depreciation expense is constant year to year on the same fixed assets.