Joe Epps 2013-05-03 00:13:12
Depreciation is a common expense shown in the financial statements and tax returns of businesses. The purpose of recording depreciation expense is to recognize the decline in value of an operating asset over time. An operating asset is something purchased for use in a business. Common operating assets include equipment, furniture and fixtures, vehicles and buildings. The decline in value of an operating asset can occur due to a number of factors. Those factors include, for example, wear and tear and obsolescence. The first thing to understand about depreciation expense is that it is a real expense of doing business. People sometimes refer to depreciation expense as representing a “paper” expense. Their meaning is to imply that depreciation expense is not real. This is totally false. The second thing to understand about depreciation expense is that the expense shown in the tax returns and financial statements of a business usually has little relationship to the actual decrease in value of the asset being depreciated. Many businesses record depreciation expenses based on the shortest useful life that the IRS will allow. It has been my experience that the depreciation expenses recorded using such useful lives is significantly overstated. That is to say that the IRS allows businesses to depreciate assets over a much shorter time period than the length of time the asset will actually be in use. The clearest example of this is where the business owner is allowed to take a Section 179 depreciation expense and write the asset off in the year it is purchased. If the asset was purchased for $5,000, the depreciation expense in the year it was purchased would be $5,000. This would be true even if the asset was purchased in mid-year and is expected to be in use for 10 years. Clearly the depreciation expense in the year the asset was acquired is overstated which in turn understates the net income of the business. One common example of depreciation is the purchase of a new truck. The moment the truck leaves the new truck dealership, it has a lower value than the time of purchase. If you want to test this example, purchase a new truck, drive it for a day and then try to sell it. As time passes, even with good maintenance, the truck will decrease in value. One factor which will impact value is wear and tear. Scratches and dings in the body and wear spots on the upholstery affect the appearance and thus, decrease the value. Use is another factor which decreases value; the higher the accumulated mileage on the vehicle, the lower the value. As new trucks are brought to market and buyer preferences change, older trucks become less valuable. One additional factor is technological obsolescence. As newer trucks improve mileage and emission controls, there is a corresponding decrease in the value of older trucks. Continuing the truck example, assume the purchase cost was $20,000 and the truck was purchased on May 1, 2012. During 2012 the truck was used for 7 months. Depending on how the truck is used, it may have a useful life of 7-10 years. Yet, if the business owner elects to fully depreciate the truck in 2012, the depreciation expense will be $20,000 and on the books of the business the truck will have a net asset value of $0. This transaction, although perfectly legal, totally distorts both the value of the truck to the business and the net income of the business in 2012. In this example, the income of the business is understated by the difference between the recorded depreciation expense of $20,000 and the actual decrease in value of the truck. In answer to those who argue that depreciation is a “paper” expense, they would argue that during 2012 the business incurred no expense even though they used the truck for 7 months and if they were to sell it, they would receive far less than the $20,000 purchase price. Again, such a position clearly distorts the book value of the asset and the actual income of the business in 2012. In this situation, the recorded net asset value of the truck would be overstated and the net income of the business would also be overstated to the extent of the difference between the recorded depreciation expense of $-0- and the actual decrease in value of the truck. There are two conclusions that can be stated from the information provided in this article: (1) depreciation is a real cost of doing business; and (2) the recorded depreciation expense is overstated for most businesses.
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