The matching principle dictates that the cost of fixed assets such as machinery, furniture, and real estate ought to be spread over the number of periods that they will help generate revenue.
Example. You may recall that Jim, the owner of Joint Ventures, was less than thrilled with the need to lease a plane from Hurt’s Plane Rental. So he decided to buy a used plane for $75,000.How should the payment be recorded?
Since the expenditure is very large and the plane should be useful for several years, it is not reasonable to treat the acquisition as an expense. Clearly, the plane is a fixed asset. Because the plane will help generate revenue over several periods, it is not a current period expense. This is the entry for the acquisition:
One asset account, Equipment, has increased while a second asset account, Cash, has decreased.
Notice that no expense has been recognized. Notice also that Joint Ventures will no longer be leasing planes. If no other entries are made, no expense will be recognized in association with the use of an aircraft. This, of course, would not make economic sense, because to make deliveries a plane is needed. Also, the plane has a limited useful life, so at some point it will run down and need to be replaced.
From both a physical and economic standpoint, the value of Joint Ventures’ plane declines over time and use. The decline in an asset’s economic and physical value is called depreciation. According to GAAP, depreciation is an expense that must be periodically reflected on Joint Ventures’ books. Depreciation is recorded to allocate an asset’s economic benefits over its useful life.
The tricky issues in recording depreciation are estimating the asset’s useful life and choosing an appropriate rate of depreciation. Welcome, once again, to the world of accounting estimates. Equipment manufacturers often give estimates of the range of expected useful lives of their equipment, subject to variations in maintenance and operating conditions. Management must choose a realistic assessment of an asset’s useful life from this range.
Estimating an asset’s useful life solves half of the depreciation question. What about the rate of depreciation? Will the physical deterioration of equipment occur evenly over its useful life or will the decline be more rapid at the beginning or end of an asset’s useful life? Should depreciation be based on the decline in an asset’s economic value instead of its physical deterioration? The two forms of decline do not necessarily occur simultaneously. For example, the market value of computers declines very rapidly compared to their physical deterioration.
Because there is wide variation in the physical and economic characteristics of assets, GAAP sanctions several depreciation methods. The straight-line method divides the purchase price of the asset by the expected useful life. If an asset is expected to rapidly decline, an accelerated method can be used.
Example. Assume that Joint Venture’s plane will last twenty years. There is no reason to assume that this plane will physically deteriorate more rapidly in the beginning or end of its useful life, so the straight-line method is used. Dividing $75,000 by 20 years gives an annual depreciation amount $3,750 per year. The entry for recording the annual depreciation is:
Accumulated depreciation is known as a contra asset account. It is found on the left (asset) side of the balance sheet, but unlike other assets, it normally has a credit balance. The idea is to allow an asset’s acquisition price to be reflected at its original cost, offset by the amount of depreciation taken against it. The fixed asset section of Joint Ventures’ balance sheet as of 12/31/04 would look like this:
Because businesses usually have several fixed assets purchased at different times, with different useful lives and different depreciation methods, it is necessary to keep a separate schedule of these assets called a fixed asset schedule. An example of a portion of a fixed asset schedule is:
Under GAAP rules, asset acquisitions are initially recorded at their original cost. Although an allowance for depreciation is reflected against most assets, no attempt is made to adjust these historical costs to current market values. This is called the historical cost principle.
The failure to adjust fixed assets for changes in market value may, to a certain extent, impair the usefulness of the balance sheet. Recall that the balance sheet attempts to reflect the financial condition of the business by listing the values of the firm’s assets, liabilities and equity at the end of the accounting period. Most readers of the balance sheet would hope that the values reflected are at least close to current market values. Current market value is the amount that would be realized if the asset were sold. If the values associated with various fixed assets do not reflect current market values, the balance sheet provides a less than accurate portrayal of economic condition.
The extent of the balance sheet distortion caused by the historical cost principle depends upon the nature of a firm’s asset holdings. If the business does not hold many fixed assets or the net depreciated values do not diverge too much from current market values, the distortion will be minimal. However, significant distortions can occur if a business owns a significant amount of real estate.
Land is never depreciated. However, its current value is likely to deviate significantly from its historical acquisition price. Improved real estate, such as office buildings and warehouses, are depreciated, but their current market values may actually increase over time. So if a business owns significant amounts of real property, the historical cost principle can significantly distort the portrayal of its economic condition.
GAAP does not allow the adjustment of fixed assets, such as real estate, to current market values primarily because managers would constantly be tempted to overstate the value of their fixed assets to improve the appearance of their firms’ economic condition. In effect, the historical cost principle is applied because accountants believe that distortions of economic condition that involve understatement of asset values are preferable to distortions caused by overstatements.
Example. The Chump Realty Group constructed a luxury apartment complex, Le Brut Pompidour, at a cost of $36,000,000 in 1995. The cost included $3,000,000 for acquisition of the land. The remaining $33,000,000 associated with the construction was subject to straight-line depreciation over 30 years. For each year through 2004, depreciation expense was recognized at $1,100,000 per year. At the end of 2004, Chump’s balance sheet reflects the project in this way:
A recent appraisal shows the fair market value of the complex, including the building, to be $65,000,000. Assuming this appraisal is realistic, the difference between the historical cost of the asset reported on the balance sheet and its fair market value is $40,000,000!