"Time destroys the groundless conceits of men;
it confirms decisions founded on reality."
it confirms decisions founded on reality."
(In this post and subsequent posts, I am walking though 12 different examples of household budgeting mistakes and how they can all be corrected with accrual accounting techniques. Accrual accounting recognizes income when it is earned and expenses when they are incurred. An alternate definition is that accrual accounting records events that change your net worth.)
Depreciation doesn't feel like a cost.
Two years ago, you felt like your household finances were completely out of control. That was the year both you and your spouse each bought a new $25,000 car, not to mention a new computer, a new entertainment center, and new carpet throughout the whole house! It was almost reckless, and you used up almost all your savings on those spending binges. But then things changed. Without all that crazy spending on big-ticket items, you managed to save almost $10,000 last year, and you're on track to do it again this year! You congratulate yourself on your self-control, and you feel good that you finally have your act together.
The good news is that the original spending spree wasn't as bad as you might think. The bad news is that a lot more money is being spent each year than you might realize. To be blunt, the above budget is not in great shape, and to understand why, we need to talk about depreciation.
I seem to have a hard time convincing some people that depreciation is a real cost. Some people think depreciation is just an arcane accounting device, while others only see it as a tax giveaway on their rental property or their business equipment. But the fact is that depreciation is very real and very significant.
What is depreciation?
In the most general sense, the word depreciation simply means a lowering in value. Beginning in the 20th century, however, the word often began to be used to mean something more specific: the reduction in value of an asset, usually due to normal wear. In accounting, the word is further narrowed to mean the allocation of an asset's cost across its useful life.
Exactly how a corporation calculates that allocation is based on many factors, including the item being depreciated, the accounting standard used, the particular financial statement being prepared, and even the discretion of management. But like the other accrual concepts we've discussed so far, you don't need to get bogged down in those details to use the basic concepts in your household budget.
Why is depreciation important?
If you ask an accountant why depreciation is important, you might get a technical answer that depreciation is necessary to fulfill the matching principle, the time-period principle, and accrual basis accounting in general. (The matching principle attempts to match related revenue and expenses in the same time period, while the time-period principle makes the assumption that you're using an accounting system where it's possible to divide things into whatever time periods you desire.)
But let me keep it simple and practical. Corporations are required to use depreciation because it provides much more useful information to investors and creditors. Similarly, if you account for depreciation in your household budget, it will provide you with much better information.
If you merely record all your cash outflows, you're missing a lot of valuable information about your finances. A $3,000 cash outflow for a week at a resort is fundamentally different than a $3,000 cash outflow to purchase a used car. Why? It's different because after you've stayed at the resort, the money is truly gone. The car, on the other hand, still has value. The car will last for a while, and in the mean time, you can sell it to someone else and get some of the money back.
Like the inventory example a couple of posts back, it's misleading to view the $3,000 payment in isolation as an immediate cost. When you purchase the car, you are exchanging money for the car. You actually then incur the cost of the car as you hold onto it and use it. Your real cost each year for the car is the depreciation - how much it declines in value. That's how much the car is costing you each year. (Of course there are other car costs, like gasoline, maintenance, and insurance, but the depreciation cost is the basic cost just to hold onto it as opposed to selling it.) It's also your change in net worth due to owning the car.
What if depreciation still doesn't feel like a real cost?
If you are still having trouble grasping that depreciation costs are real, try these three exercises.
- Imagine buying the item in question at the beginning of the time period and then selling it at the end of the time period. For example, imagine buying a two year old Camry at the beginning of the year and then selling a three year old Camry at the end of the year. This is one way to understand how much the car is costing you just to own it over the year. (This roughly corresponds to an accelerated depreciation method such as the declining-balance method.)
- Imagine a way to finance the item so that the cash costs are evenly spread out over the life of the item. For example, suppose you pay $15,000 in cash for a car and then run it into the ground over five years. Instead of paying $15,000; $0, $0, $0, $0 for five years, you could have paid $283/month for 5 years at 5% interest. And if you were able to get a 5% return on the money you didn't pay up front for cash, you could reduce the effective cost down to $250/month. (This roughly corresponds to straight-line depreciation.)
- Imagine that you will need to buy the same item after it is used up and that you need to save up for it in the mean time. For example, suppose you currently have a brand new car and that after 5 years, you would like to sell it and get another new car. How much will you need to save per year so that you will have the money to pay for it? For example, suppose you have a $20,000 brand new car and suppose you figure it will be worth $10,000 in five years as a trade-in for your next vehicle. That means you will need to save $2,000/year for the next 5 years in order to have the $10,000 (plus the trade-in vehicle) to buy the new car in 5 years and maintain your same standard of living over time. (This also roughly corresponds to straight-line depreciation.)
How do I calculate depreciation in my household budget?
Like all of these accrual accounting concepts, the biggest benefit is the ability to think correctly about your finances. However, unlike some of the other concepts, depreciation costs are large enough (for most people) that it is worth actually calculating at least some of these costs. If you own cars (or boats), I would suggest marking them to market each year. If you use budgeting software, simply create an asset account for your vehicle and adjust the value each year. You can easily find out the value of your car in just a few minutes at sites like edmunds.com. If you live in a jurisdiction that has a car tax, this information may already be sent to you each year.
For most other common items, there is no meaningful resale market, so I would suggest simply dividing the original cost of the item by its life (i.e. straight-line depreciation). The only decision to make is to determine how long the item will last. In most cases, it won't be that difficult to guess what an average lifespan will be. Just be honest with yourself, be reasonably conservative, and keep it simple. For example, if you buy a water heater and it has a 9-year warranty, then just use 9 years as its life.
An important thing to understand is that repair costs are not the same as depreciation costs. Even if you don't need to make any repairs, most kinds of items will still depreciate. For example, suppose you only needed to spend $100 on vehicle repairs last year. In that case, your repair costs are small. However, your vehicle is still worth considerably less than last year simply because it is a year older. Also note that you can't (substantially) increase the value of the car just by performing more and more repairs. In fact, some legal definitions stipulate that depreciation is the decrease in value that cannot be offset by repairs! This distinction is very important and will come in handy with a couple of the budgeting examples in future posts.
What are the consequences of ignoring depreciation?
Depreciation recognizes that if you own something that is gradually going down in value, it is costing you something to hold onto it. Recognizing that shows you how much it costs you to maintain your current lifestyle. It also allows you to compare those costs with other years and with other alternatives. In contrast, ignoring depreciation gives you a totally distorted view of your finances. It makes you feel that ownership of a depreciating item is "free" and makes it very hard to compare different alternatives and different time periods.
There is also a psychological danger in using cash based accounting for big ticket items like vehicles. It is human nature for people to mentally frame their personal finances to isolate gains and integrate losses. (I have previously discussed this phenomenon in an earlier post about mental accounting.)
In the above example, the couple spent approximately $60,000 in one particular year for a variety of things they will use for many years. The temptation is to lump all the original purchases into the past and forget about them, perhaps viewing them as "one time events" or undisciplined spending of your "former self". Then we would like to take each subsequent year in isolation and gloat over the fact that we aren't spending anything on those items this year. That seems much nicer than saying that these things are costing us something each year. So without recognition of the depreciation, costs appear much less than they really are, which in turn gives the pleasant illusion of $10,000 per year in savings. However, the yearly savings are largely an illusion.
It would not be unusual for the yearly depreciation of a new vehicle to be 15% per year during the first two years. Hence, the depreciation costs on the two vehicles alone would be $7,500 the first year and $6,375 the second year, and the depreciation on the other items would likely eat up another couple of thousand dollars per year. The sobering reality is that real savings may be close to zero.
When corporations engage in this sort of behavior it is called big bath accounting. Hence, a corporation may take a $5 billion "one time" charge, followed by a $500 million yearly profit for 10 years. As you can imagine, the original charge is long forgotten as something that happened in the distant past and is completely behind the company. The subsequent yearly profits, however, are trumpeted as consistent and reflective of the company's true earnings power.
What's wrong with just using the cash costs?
I understand why people question whether costs have to be allocated in your personal budget. Why not just keep it simple? In the above example, why not just recognize that $60K was spent on these items in the first year and nothing else was spent on those items in the next 5 years? Doesn't that fully capture everything?
I would be completely willing to accept that argument if those items were the only household spending and if we agreed to frame all financial discussions as a 5 year time period. Then the cash based and accrual based systems would converge.
But in fact people don't frame their financial discussions that way at all. Instead, we talk all the time about our costs for this year and next year and whether we saved more money last year than this year. Without allocating costs into yearly buckets, all these yearly numbers and yearly comparisons become meaningless. Additionally, various items are typically purchased at different times and have different lifetimes. Depreciation provides a way of generalizing all that spending information so that different time periods can be correctly compared.