Most of us want to have a long Useful Life, except when it comes to accounting. Then, we might want our Useful Life long or short, depending on who’s asking.
After the invention of writing, which I’m taking credit for on behalf of all accountants throughout history, the idea of depreciation may be the most significant contribution to the way businesses operate. It’s certainly the most “accounting-y” notion and an Accountant’s Full Employment Act, since even the simplest calculation takes years.
Is It an Asset? Is It an Expense? It’s Both!
The underlying purpose of having a Useful Life is to suggest that there’s a point where it’s not useful. If you buy a car, at some point, it belches enough white smoke to tell you it’s time for Eddie’s Junkyard. Computers give you the blue screen of death just one too many times, or printers won’t stop making that grinding noise.
Suppose a sandwich restaurant buys a toaster oven. Without depreciation, they would pay cash and put the asset on their balance sheet, where it would sit, forever. One day, the wiring would go wonky, and the entire oven would have to be replaced. The company would have to take a significant loss in a single year. If they’re trying to attract investors, that would be bad. Similarly, if they treated the entire oven as an expense when they bought it, that might also eat up a huge chunk of earnings.
Accountants have those many Principles that they worship, in this case, the Matching Principle. The timing of revenue and expense should go together. Realistically, that oven helps the business earn revenue for years, so its value should be distributed over those years.
Depreciation Is for Other People
The history of depreciation is relatively short, compared with double-entry bookkeeping (1470) or taxation (3000 BCE). It arose during the early 1800s at the time of the steam engine. Large machines were being built during the Industrial Revolution, and companies were repeatedly faced with that expense-when-purchased or huge-loss-when-replaced choice. Depreciation allowed the smoothing of those losses. Yet, why did the company care what was on their books, especially privately-held railroads?
One interested group was Insurers. The insurers would want an accurate estimate of the value in order to pay fairly for a loss. They wouldn’t want to pay for a brand new machine when the failed one was a decade old.
Another interested group was the potential buyers. A modern concept you might know is Kelley Blue Book, the independent agency that values cars based on their age and attributes. People don’t want to buy used cars at the same price as new ones because the useful life has been shortened. Same thing with equipment and other business assets. Depreciating the asset, reducing its value little by little over time, helps tell future buyers how much it may be worth.
The Eternal Struggle Between the Taxer and the Investor
The last party which became very interested in depreciation is the IRS. Writing down bits of your assets as expenses allows you to reduce your income. Since we tax businesses on income in the U.S. (as of 1913, see letter “T”), management wants income for tax purposes to be as low as possible.
If you ever wonder why tax law is complicated, hate the people being taxed, not the IRS. Complexity was created by lobbyists, trying to find a way to reduce the income being taxed. One rule that businesses persuaded the IRS to create was something called MACRS depreciation: Modified Accelerated Cost Recovery System. MACRS allows businesses to depreciate a bigger portion of their assets in the early years. It was enacted in 1981 by Congress expressly to encourage businesses to buy equipment, after companies suggested they’d do so if they could somehow reduce their tax burden.
Furthermore–and here’s where accountants find steady employment–there’s no rule saying that companies can’t have their cake and eat it, too. The depreciation method can be MACRS on the tax form, so that taxable income is as low as possible, and Straight-line on the financial statements, so that publicly-revealed income is as high as possible. Everybody wins! Except now there’s a difference between book depreciation and tax depreciation, which somebody has to calculate, forever.
Or over their Useful Life as an accountant, whichever is shorter.
*For a source of cheap (but mean) entertainment, the explanation of depreciation at Accountants Day Info is hilariously full of grammatical errors. It reads like an unedited Google translation from another language, starting with the title “What is Depreciation and What Are the Benefits Taken Out of It.” (Wait–isn’t depreciation an expense taken out? how can it be both revenue and expense? What an accounting faux pas, ha ha!)