Basic Accounting

One of the fundamental accounting principles is matching revenue with cost in any period. This is relatively simpler while dealing with items in cost of goods sold, such as purchase of raw materials, supplies, and cost incurred in conversion to finished goods for sale etc. But this becomes more complex while dealing with assets that have longer lives. There are two different types of fixed assets that a company invests in, tangibles and intangibles. Tangible fixed assets are assets such as Buildings, Plant and equipment that have nearly definite lives. In most cases the value of the fixed assets also depreciates over time. At the end of its useful life assets may have a salvage value. This is true for plant and machinery but not for buildings. Although the value of the buildings might increase from year to year, GAAP requires that depreciation be calculated and accounted as an expense.

A business invests in fixed assets to make and sell products and/or services in its business. So, the cost of the long term operating resource needs to be allocated over the years these fixed assets are used. One cannot charge the entire cost of fixed asset in the year of purchase. The cost needs to be segregated over its useful life and applied to the period as a period expense. Sales revenue, recovers, in part a charge for the use of the assets every time a product or service is sold. This is the underlying logic for Depreciation as an expense.

Land may depreciate in value, but has an indefinite life. So depreciation is not calculated for land.

The treatment of depreciation for intangibles is different. A company may have an amount for Goodwill in its asset list. Let us see how and why does goodwill arise? Let us say the company buys a business at $2M. Let us assume that the value of the assets that are taken over is $1M. The excess of $1M over the asset value is termed as Goodwill. Goodwill has an indefinite life. So this is not amortized. At the end of each year, an assessment is made of the remaining value of the goodwill for the business. The reduction in value is charged as an expense for the period.

Depreciation although is simple in theory is extremely complex in its practical application.

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