This in an excerpt from this book
There are a lot of talks going around when it comes to adjustment of fixed assets and depreciation expense in accounting terms. Depreciation is almost similar to that of any other expenses in the fact that all expenses are deducted from sales revenue to determine profit. Keeping this apart, however, depreciation is very different from most other expenses. (Amortization expense, which we get to later, is a kissing cousin of depreciation.) When a business buys or builds a long-term operating asset, the cost of the asset is recorded in a specific fixed asset account. Fixed is an overstatement; although the assets may last a long time, eventually they’re retired from service.
The main point is that the cost of a long-term operating or fixed asset is spread out, or allocated, over its expected useful life to the business. Each year of use bears some portion of the cost of the fixed asset. The depreciation expense recorded in the period doesn’t require any cash outlay during the period. (The cash outlay occurred when the fixed asset was acquired, or perhaps later when a loan was secured for part of the total cost.
Seeing both numbers gives you an idea of how old the fixed assets are and also tells you how much these fixed assets originally cost. In the example in this chapter, the business has, over several years, invested $12,450,000 in its fixed assets (that it still owns and uses). The business recorded $775,000 depreciation expense in its most recent year.
You can tell that the company’s collection of fixed assets includes some old assets because the company has recorded $6,415,000 total depreciation since assets were bought – a fairly sizable percent of original cost (more than half). But many businesses use accelerated depreciation methods that pile up a lot of the depreciation expense in the early years and less in the back years.
A business could discuss the actual ages of its fixed assets in the footnotes to its financial statements, but hardly any businesses disclose this information – although they do identify which depreciation methods they’re using. Operating expenses and their balance sheet accounts The sales, general, and administrative (SG&A) expenses of a business connect with three balance sheet accounts.
The broad SG&A expense category includes many types of expenses in making sales and operating the business. (Separate detailed expense accounts are maintained for specific expenses; depending on the size of the business and the needs of its various managers, hundreds or thousands of specific expense accounts are established.) Many expenses are recorded when paid. For example, wage and salary expenses are recorded on payday. However, this record-as-you-pay method doesn’t work for many expenses. For example, insurance and office supplies costs are prepaid and then released to expense gradually over time. The cost is initially put in the prepaid expenses asset account. (Yes, we know that “prepaid expenses” doesn’t sound like an asset account, but it is.) Other expenses aren’t paid until weeks after the expenses are recorded.
For details regarding the use of these accounts in recording expenses. Remember that the accounting objective is to match expenses with sales revenue for the year, and only in this way can the amount of profit be measured for the year. So expenses recorded for the year should be the correct amounts, regardless of when they’re paid. Intangible assets and amortization expense Although our business example doesn’t include tangible assets, many businesses invest in them.
Here are some examples of intangible assets:
A business may purchase the customer list of another company that’s going out of business.
A business may buy patent rights from the inventor of a new product or process.
A business may buy another business lock, stock, and barrel and may pay more than the individual assets of the company being bought are worth .
You can imagine the value of Coca-Cola’s brand name, but this “asset” isn’t recorded on the company’s books. However, Coca-Cola protects its brand name with all the legal means at its disposal. Whether or when to allocate the cost of an intangible asset to expense has proven to be a difficult issue in practice, not easily amenable to accounting rules.
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