Continuing down the list of assets on a balance sheet (beyond those described in our last discussion of such a sheet), we come to a line for prepaid expenses. If our business has
paid $1,800 for a year of insurance coverage, it will own something, a claim
against the insurance company. This may not sound like an “asset” in a rough
commonsensical sense of the world but … hey … the common sense cookie often
crumbles. We have to recognize this as an asset in order to convey fairly the
economic realities our books are designed to describe.
We’ll move now to tools & equipment. Perhaps our
business involves a conveyer belt, which we use to move a product from the back
room to the front, where it is shown to the customers and, with luck,
purchased. The conveyor belt is a fixed asset or, in less formal parlance, it’s
part of our “overhead.” When we bought
the conveyor belt and had it installed (for, we will say, $500) we might have
paid $100 cash, charging the other $400 to our credit account with that seller
(our accounts payable, a liability). If so, then this transaction has
consequences for three items on our balance sheet. We have increased our
liabilities by $400, decreased one asset (cash) by $100, and increased the
value of another (equipment) by $500.
Again, if we went into this
transaction in obedience to the fundamental equation, we remain in obedience.
The total value of assets and the total value of liabilities have each
increased by $400, and the value of equity hasn’t changed at all.
Insert ILLUSTRATION:
Widget Retailer’s Balance Sheet, Equity Unchanged
You see already, from these very
simple examples, how the fundamental equation means that our various accounts
serve as a check on one another. If we make a mistaken, then the left side of
the balance sheet will get out of line with the right side, and we’ll know
enough to check again.
Introducing Depreciation
One key and tricky point about a
conveyor belt though (and about many fixed costs) is that its value decreases
over time. Eventually, it will just be a piece of scrap that needs to be
replaced.
Ideally, the process of physical
deterioration over time would have balance-sheet consequences. If we knew that
the conveyor belt would have to be replaced after five years, it would seem
sensible to write off one-fifth of its value at the end of each year of its
life. This would be a loss of the asset value under Tools and Equipment, and a
loss also on the equity side of the sheet of the same amount (again, preserving
balance.)
But we don’t have a crystal ball
handy. Some items of equipment last
longer than we expect: others not so long. This suffices to explain why
depreciation can’t simply record the fact of physical deterioration.
[Notice that tool and equipment are
different in this respect from the sort of prepaid expense we mentioned above.
We can be very precise about how much of our fire insurance we’ve used up. We
paid for a full year’s coverage a month ago. There has been no fire in the
intervening month. Presumably we’re happy about that. But the simple passage of
time means that we’ve used up one-twelfth of that asset. No crystal ball
needed.]
Another complicating factor with the
physical deterioration of a conveyor belt: our used-up equipment will probably
still have some salvage value at the
end of its life. This is the age of recycling: we’ll be able to get something
for it in a scrap market. If we do, though, and if over the preceding five
years we have been consistently subtracting a full one-fifth of its value, then
we will have talked ourselves into the inference that the money obtained from
the scrap value consisted of pennies from heaven.
It isn’t coming from heaven of
course. If the conveyor belt is worth $20 as a recyclable at the end of its use
for us, and if it was worth $500 when brand new, then presumably the right
number for its physical deterioration in each of the five intervening year was
$96, not $100.
Some standard rules-of-thumb have
been adopted in connection with depreciation by accounting as an industry and
by the legislators and regulators who concern themselves with tax issues.
Remember what we said above about how the tax and financial accounting biases
offset? A company might want to understate depreciation in order to show a high
asset value to potential investors and creditors. But at the same time it will
want to fix a high number for depreciation in order to offset its income tax.
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