In business, when you pay for something that you use to generate sales, you treat the item as an expense. Buying office supplies, printing marketing brochures, or paying for newspaper advertising are some of the items that you would normally consider as expenses that are necessary for generating business.
[related|post]But what about your purchase of a computer or machinery equipment or the renovation of a new office for your business? Can you also treat them as expense?
The answer is yes, but you have to allocate the total cost of the expenditure over the useful life of the equipment purchased. Let\\\'s say you purchased a delivery van for your business. This delivery van loses value from the very first minute that you drive it out of the dealership. It is considered an operational asset in running your business, one that loses part of its value each year that you own it until it no longer runs and has no more value to your business. The measure of the loss in value of an asset like your delivery van is known as depreciation expense.
There are three advantages when you depreciate an asset. Firstly, depreciation enables you to properly match your expense with your revenues. When you depreciate, you will recognize a portion of the asset\\\'s cost as "used up" in generating the revenues for that particular period.
For instance, consider that you acquired a franchise for an ice cream outlet. You paid P150,000 for the franchise good for three years, plus P450,000 for the construction of the outlet and equipment. To compute for your depreciation expense, you simply allocate the costs of the construction over the franchise period at P150,000 per year (P450,000 / 3). For the franchise fee of P150,000, you also need to depreciate it by three years, so that your annual franchise fee expense is P50,000 (P150,000 / 3).
Depreciation of an intangible asset like the franchise fee is called amortization. Although different terminologies, they are related concepts. Your total depreciation and amortization for the period is P200,000 (P150,000 + P50,000), which shall then be listed in the income statement under operating expenses.
Secondly, depreciation helps you avoid overstating your assets in your books. This is because it disciplines you to periodically adjust the historical cost of your assets to its current book value. Thus, an asset that you acquire now may not have the same value five years from now. Also, when you know the book value of your assets, you are better informed when you have to make decisions about disposing of those assets in the future.
Following the earlier example given above, after you have recorded the depreciation expense, the book value of your outlet shall be P300,000 (P450,000 - P150,000) and your franchise fee shall be P100,000 (P150,000 - P50,000). The total carrying value of P400,000 (P300,000 + P100,000) shall be listed in the balance sheet under fixed assets. This way, if you decide to sell your outlet later on, you will have a better idea on how much you should sell it.