Funny Expenses:
The Ones From Long Past Expenditures

There are really two kinds of expenses:  real expenses created by current activity, and funny expenses that come from money spent a long time ago. Funny expenses are depreciation and amortization.

What are funny expenses? Why are they funny expenses? We'll use a series of transactions to illustrate.

Let's pretend that you own a company that makes lemonade. Nice, fresh-squeezed lemonade. What do you need to make and sell lemonade? You need supplies, like lemons, water, sugar, cups to serve the lemonade, and ice to keep it cold. You also need some assets to make the lemonade with:  a bucket to mix the lemonade in, a ladle to serve the lemonade with, somewhere to make the lemonade, and a place to sell it from. All of these are assets. The lemons, water, sugar, ice, and cups are inventory, a current asset. The bucket and the ladle are assets, too. They are equipment.

So you start the business. You invest some money to buy your raw materials inventory, your assets to mix and serve, and rent the place to operate in. Business is good, and you are squeezing a lot of lemons. But your hands are tired from all the squeezing, and you can’t keep up. A customer tells you that you need a lemon-squeezing machine. Get the machine and you can make more lemonade to sell, and you won’t tire out your hands.

Great idea! So you go online and you find the Acme Lemons-Squeezer Company. You find a great machine that can squeeze a hundred lemons an hour. The machine costs $1,000. Wow, that is a lot of cash. But you think it will last you several seasons and that you will make enough lemonade to enable you to pay it off quickly.

If you decide to buy the machine, you are making an investment in a long-term asset. Long-term assets have what accountants call a life. This is simply the number of years you expect to be able to use the machine. The life is nothing but an assumption by the accountant, who follows certain guidelines to make the decision. Some items, like computers, can have lives as short as three years. Other assets can have longer lives—five years, seven years, ten years, even fifteen years or longer. The life of the machine is really a function of how long you will use it before you need to replace it.

The last of the twelve basic principles of accounting is the Accrual Basis of Presentation. Accountants calculate profit and loss for all the money-making activities that take place in a specific accounting period. In accrual accounting you must report all product costs and business expenses incurred within the same period as any revenue or profit transactions. Key to this is the Matching Principal, where the costs associated with making a product, or the expenses associated with selling a product or service, are accounted in the exact same period in which the revenue is recorded.

When you decide to buy the lemon-squeezing machine, you spend $1,000 in cash out of your bank account. However, the machine is an asset with a life of three years. In accrual accounting, you can expense one third of the value of that machine in the current period.

You expect your lemon-squeezing machine to last at least three years, so the accountant would depreciate one third of the value of the machine each year. The value of your machine is reduced on the balance sheet, and the expense charged to the operating-cost section of the income statement. After three years, the asset has no value on your balance sheet. You may still use the machine, but as far as your balance sheet is concerned, the machine has no value.

Amortization is very similar to depreciation. In this case, you have invested not in an asset but a service; you will enjoy the benefit of that service over time, perhaps for many years. Again, you paid upfront cash to invest in the service, and you spread the expense of that service over a number of years.

The reason I called these funny expenses is that you really don't pay them in the period for which they are charged. You paid for the equipment or the service sometime in the past, not in the current timeframe. But because of accrual accounting, you are charged as an expense for the amount of depreciation on a long-term asset you actually paid for some time ago.

Depreciation affects the profit that a business entity makes and reports on its income statement. Depreciation is not a cash expense, so it doesn't really reduce the cash the company generates. But the initial investment does affect the cash the company makes.

Let's go back to your lemonade stand. You have your nifty lemon-squeezing machine from the Acme Machine Company squeezing lemons. You have been buying ice from the local grocery store, but buying it this way presents a challenge keeping up with the demand for ice. You decide it would be better to own an ice machine and make your own ice. You buy a used ice machine for $1,000, and you expect it to last for about three years. The accountant does not agree, and says it has a five-year life, so your annual depreciation is $200. You spend $1,000 in cash today, but only get to expense $200 each year for the next five years until the machine fully depreciates.

The cash investments you made this year in your lemonade company come to $1,000 for the lemon-squeezing machine and $1,000 for the ice machine. That's $2,000 out of your checking account. On your income statement, however, you're only allowed to expense $333 for the lemon-squeezing machine and $200 for the ice machine, a total of $533.

We will come back to this example to show how the lemonade company may show a profit in the first year but actually lose cash. Next, we will learn how cash is fact and profit is opinion.

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