Entrepreneurs tend to treat details about business expenditures the way a rushed parent prepares breakfast. If they accidentally pour orange juice on the corn flakes, they tell the kids to eat it anyway because it all goes to the same place. Like the bad aftertaste experienced by the children as the parent dashes off to work, the accountant for a hasty proprietor is stuck with addressing the aftereffect of negligent financial records.
Trouble arises from handling all outlays of business funds identically merely because they are utilized for a common purpose. Purchases of assets must be addressed differently. Equipment, buildings, and other property have long periods of use. This characteristic distinguishes them from ordinary expenses that are used up immediately. Unlike expenses, an asset is accounted for by deducting the cost over the item’s useful life as depreciation expense.
Property Type
The most obvious asset category is buildings and land. Actually, this comprises two categories because the land is separate. The cost for land is never written off as an expense. By contrast, the cost for a building is deducted over time. Since a building and land are commonly purchased together, the owner must apportion a separate amount for the land and depreciate the building cost over several years. The acquirer’s cost includes financed amounts. Closing costs are counted as part of the purchase price. Newly constructed business buildings include depreciable costs for architect fees and land clearing.
Adding or replacing structural components of a building increases its life and thus these costs are also depreciated rather than immediately expensed. This includes such features as a new roof, plumbing system, interior walls, or exterior façade. Additions or changes to the structure of a building leased from someone else are also assets. These are called leasehold improvements.
Various types of equipment are purchased for use in business. Distinctive depreciation periods are assigned to machinery, vehicles, computers, software, and other asset types. Small items – like staplers and disk drives – are expensed immediately rather than depreciated due to their minimal costs.
Depreciation
The key ingredients to accurate calculation of depreciation are historical cost, in-service date, and property description. Costs for business assets are depreciated over defined periods that depend upon the type of property. Changes in tax laws occasionally alter these depreciation periods but the law in effect when an asset is placed in service applies for as long as that property is deployed in business.
The in-service date is the day that the asset is initially used for business purposes. For instance, the costs for a building are not depreciated until the enterprise occupies the structure.
Asset value recorded on small business financial statements is not adjusted for fluctuation in market value. Rather, the historical cost remains on the organization’s books along with accumulated depreciation. This historical cost method is primarily practiced in the U.S., where depreciation is a tax requirement in addition to being an accounting standard. Large companies outside the U.S. may use international financial reporting standards that account for changes in asset market values. The historical cost method has the advantage of averting market value assessments, which are typically impractical for small operations.
The Finance Writer 