The Difference between Costs and Expenses
What’s a cost and what’s an expense? Consider an example. Assume that Penway Manufacturing, Inc., makes toasters and needs to buy some new metal fabrication machines to form the outer shell of the toaster.
When the company buys the machines, the price Penway pays or promises to pay is a cost. Then as Penway uses the machines, it reclassifies the cost of buying the fabrication machines as an expense of doing business. So the resources Penway uses to purchase the machines move from the balance sheet (cost) to the income statement (expense).
Under generally accepted accounting principles (GAAP), every transaction you record has to satisfy the matching principle. This means you associate all relevant expenses the business incurs to revenue earned and realizable during the accounting period.
If a company buys a long-lived tangible asset that it reckons will be in use for more than 12 months past the balance sheet date, it must allocate the cost of the asset (in other words, depreciate the asset) to financial periods beyond the current one.
Tangible assets are those you can touch and feel, such as desks, vehicles, and equipment. Intangible assets such as patents and copyrights don’t have a physical presence.
Companies have to record all asset purchases on the balance sheet at their original cost, along with all the ordinary and necessary costs to get the asset ready to use. For example, these costs may include the asset’s purchase price, sales tax, freight-in, and assembly of the machine on the factory floor. (Freight-in is the buyer’s cost to get the machine from the seller to the buyer.)
When moving the cost of an asset from the balance sheet to the income statement, you have to answer the following three questions:
What is the depreciable base of the asset?
The depreciable base is the original cost of the asset minus any salvage value. Salvage value is how much the company estimates it’ll get when it disposes of the asset — for example, when the company sells it.
Suppose a company buys a piece of machinery for $10,000. It expects to use the machinery for three years until it’s obsolete and then sell it for $3,000. Depreciable base is $7,000 ($10,000 – $3,000).
What is the asset’s useful life?
Well, you know it’s more than one year, or else you wouldn’t be depreciating it. But how much more than a year? Here’s an example of an accounting estimate.
Companies use various ways to estimate useful life. One method is prior experience with the same type of asset. In any event, all your intermediate accounting assignments and test questions provide useful life, so you won’t have to estimate.
Which cost allocation (depreciation) method is best for the asset?
Again, deciding which of the allowable methods under GAAP to use is an estimate the company makes.
Companies use various ways to decide which method to use to allocate balance sheet costs to income statement expenses. One way is the business purpose of the asset in question. If it’s a piece of factory machinery, the units-of-production method may be more appropriate. In any event, all your intermediate accounting assignments and test questions provide a useful life.
The depreciation cost allocation method the business uses is a matter of choice, as long as the method is appropriate for the asset. For financial accounting, the method meets the standard of appropriateness if the company uses the method that most closely matches revenue to expense or the method that’s common in that industry.