The strangest piece of knowledge I learned at Tarleton State University, while obtaining my Bachelors of Business Administration degree in Accounting, blew me away. I have worked in cost control for Roche and BASF and thought I had a pretty good understanding of how accounting worked. Before that I was and estimator for several private companies, the largest of which did 300 million dollars of business a year.
Putting together bid proposals for multi-million dollar projects is very serious work. Large companies depend on getting enough work every year to keep their many employees working. Tracking cost, on large multi-month and multi-year projects, is equally important to keep the project and budget on track. Both private companies and large public companies depend on accurate managerial accounting in preparing estimates and tracking project cost. Both private and public companies also depend on accurate financial accounting to indicate profitability of the company.
As it turns out, expenses are charged to a temporary accounts which are zeroed out every year. However, not all purchases are considered items that may be expensed. When companies purchase items that serve to generate revenue for multiple years, those items must be capitalized. A capital expense must be partially expensed of several years.
Accounting rules are very specific. One of these many rules concerns capital assets. To capitalize an asset is to depreciate the asset over the life expectancy of the asset. This rule is not a suggestion, this rule is a mandate.
The idea is to expense a capital asset of the life of the asset. It would not present an accurate accounting picture of the yearly financial records if an asset, that generated revenue over several years, was totally expensed the first year the asset was placed in service.
When a tangible asset is expensed over multiple years, the asset is referred to as a capital asset and the expensing is referred to as depreciation. If the capital asset is intangible, the annual expensing is referred to as amortization. Either way, assets have a predetermined life expectancy. Depreciation also takes into account any expected salvage value at the end of the assets life.
This all makes perfect sense to me. The strange part is when the IRS becomes involved. Our government manipulates our revenue and income to stimulate or slow the economy. They manipulate the economy through their control of interest rates, personal, and corporate earnings. Tariffs and other tools are at their disposal too.
The IRS Tax Code does not care to see actual annual financial reports. They imply that tax assessments are based on earnings, but that is not correct. Taxes are based on adjusted earnings. The IRS uses adjusted earnings to manipulate the economy. I am not implying this is a bad thing. A strong economy is important to all of us. I am glad that our government has professional economist watching our economy. When our economy is weak, inflation is high, or the value of the dollar is low, I appreciate the fact that our government has systems in place to manipulate the economy.
But still, it seems strange to me, that we all have to keep two sets of books. We keep detailed estimates, job cost, income and expense records for our annual financial reports. All of that is at considerable expense. Then on top of that, we must keep a separate set of records for the IRS. The IRS encourages depreciation and amortization to be accelerated. By speeding up the expensing of these capital cost, which lowers the amount of revenue to be recognized that year, tax liability is less. This process encourages purchasing capital assets, which stimulates the economy, which in turn will save on the amount of income taxes owed.
Not only is it strange that we have to legally keep two sets of books, the set we maintain for IRS tax records really is just an unrealistic set of numbers. The IRS Tax Code allows us to fully depreciate an asset before the life expectancy of that asset. Accounting rules specifically prohibit this type of accounting for financial records. Once fully depreciated, the value of that asset on the books is set at zero or its salvage value. Also, once fully depreciated, that asset should not continue to generate income. Of course, our other set of books knows differently.
It just seems strange to me that our society would allow for this phony information to exist. We strive for our financial reports to be as accurate as possible. When two sets of books are maintained for one entity, how can they both be accurate? Our tax code should be based on the accurate set of financial records. Just because one set of financial records is accurate per accounting rules and the other set of books is accurate per the IRS Tax Code, how can that be right? Accounting is simple math, 2 + 2 = 4. The answer should not depend on which set of rules are being used.
My next article will be on the definition of the word, “Lease”. As it turns out, just like so many other buzz words in our society, certain words have legal definitions that do not coincide with Webster’s definitions. Go figure.
Brett Bickham
Clifton, TX