Depreciation
Joe also needs to know that the reported amounts on his balance sheet for assets such as equipment, vehicles, and buildings are routinely reduced by depreciation. Depreciation is required by the basic accounting principle known as the matching principle. Depreciation is used for assets whose life is not indefinite—equipment wears out, vehicles become too old and costly to maintain, buildings age, and some assets (like computers) become obsolete. Depreciation is the allocation of the cost of the asset to Depreciation Expense on the income statement over its useful life.
As an example, assume that Direct Delivery's van has a useful life of five years and was purchased at a cost of $20,000. The accountant might match $4,000 ($20,000 ÷ 5 years) of Depreciation Expense with each year's revenues for five years. Each year the carrying amount of the van will be reduced by $4,000. (The carrying amount—or "book value"—is reported on the balance sheet and it is the cost of the van minus the total depreciation since the van was acquired.) This means that after one year the balance sheet will report the carrying amount of the delivery van as $16,000, after two years the carrying amount will be $12,000, etc. After five years—the end of the van's expected useful life—its carrying amount is zero.
Joe wants to be certain that he understands what Marilyn is telling him regarding the assets on the balance sheet, so he asks Marilyn if the balance sheet is, in effect, showing what the company's assets are worth. He is surprised to hear Marilyn say that the assets are not reported on the balance sheet at their worth (fair market value). Long-term assets (such as buildings, equipment, and furnishings) are reported at their cost minus the amounts already sent to the income statement as Depreciation Expense. The result is that a building's market value may actually have increased since it was acquired, but the amount on the balance sheet has been consistently reduced as the accountant moved some of its cost to Depreciation Expense on the income statement in order to achieve the matching principle.
Another asset, Office Equipment, may have a fair market value that is much smaller than the carrying amount reported on the balance sheet. (Accountants view depreciation as an allocation process—allocating the cost to expense in order to match the costs with the revenues generated by the asset. Accountants do not consider depreciation to be a valuation process.) The asset Land is not depreciated, so it will appear at its original cost even if the land is now worth one hundred times more than its cost.
Short-term (current) asset amounts are likely to be close to their market values, since they tend to "turn over" in relatively short periods of time.
Marilyn cautions Joe that the balance sheet reports only the assets acquired and only at the cost reported in the transaction. This means that a company's reputation—as excellent as it might be—will not be listed as an asset. It also means that Bill Gates will not appear as an asset on Microsoft's balance sheet; Nike's logo will not appear as an asset on its balance sheet; etc. Joe is surprised to hear this, since in his opinion these items are perhaps the most valuable things those companies have. Marilyn tells Joe that he has just learned an important lesson that he should remember when reading a balance sheet.
