Each week, our TechRepublic financial team answers your questions about the mysteries of making those budget sheets balance. This week, a TechRepublic member asked a question about computer purchases.
TechRepublic member: It seems that most computer hardware—PC’s in particular—are supposed to be depreciated over a five-year life. Actually, their seven-year life items were reduced to 5 years under Modified Accelerated Cost Recovery System (MACRS ). This seems like an exceptionally long lifetime these days. After five years, a PC is really quite obsolete. Do you find that more people are adjusting to a lower “actual life span” these days or just expensing them when purchased?
The Accountants: This is a really good question, and it’s something we struggle with here at TechRepublic from time to time. Since we have 300 employees and they each have a PC, the way purchases and dispositions are handled can have a significant effect on the company financially and in other ways.
Here’s a basic scenario that we’ll use for our discussion. Your company is going to buy several computers at a total cost of $24,000. These computers will be used for three years. (I know, even that is a stretch these days.)
The asset argument
Do we consider these assets or an expense? This difference is very important. Without getting too detailed, an asset is something that will have a future benefit to us. Since these computers will be used over three years, that is definitely the case here.
Depreciation is used to spread the expense of an asset over its useful life. In this case, we’ll record $8,000 in depreciation expense each year (assuming the computers won’t have any salvage value). For our financial accounting at TechRepublic, we use a three-year life for depreciating computer equipment.
The expense approach
Why not record the entire purchase as an immediate expense? There are two major problems with this method:
- You would have a $24,000 expense for this year. That cost for this year would be too high. When you purchased the computers, you bought three years of use, and the cost should be allocated over those three years.
- For the next two years, you won’t show any expense for these computers. Again, this is not accurate. Your company’s assets will be understated. These computers do have some value to your company, and by not recording them as such, you are understating your assets.
One way to make the expense approach more accurate is to use an accelerated depreciation technique. Instead of dividing the cost of the computers evenly over their life, an accelerated depreciation method would record larger depreciation expenses early in the asset’s life and it would record less depreciation in later years. In our case, this method may more accurately reflect how a computer loses value over time.
Ask our TechRepublic Budget Crunchers for pointers on making financial sense out of all those IT expenditures. Due to the volume of submissions, we may not be able to answer every question we receive, but we will review all the e-mails you send and write about the questions that are asked most frequently.
Accounting for assets
There are a number of ways that assets may be acquired and accounted for, but most fall into three basic categories:
- Operating lease/rental
- Capital lease/loan
Each has its advantages and disadvantages.
You order the computer from your vendor, the vendor delivers and invoices you for the total cost, and you pay the invoice. Now you own the computer, and your cash outlay is completed.
In this case, the computer would be recorded as an asset and depreciated over its useful life. The advantage to this arrangement is that it is relatively simple. No further payments and no scrambling around to find the equipment so you can return it three years from now.
However, it may not always be practical to pay the full price up front. Depending on your company’s finances, you may prefer an arrangement that would allow you to spread out your payments.
You sign an agreement to lease a computer for x months at a charge of $y per month. The vendor delivers the computer for you to use for the duration of the lease provided you continue to make the monthly payments. When the lease expires, you could either renew it or return the equipment.
This is the one case where you would not record the computer as an asset, because you don’t ever take ownership of it. The organization that has leased the equipment is the legal owner, and you are simply paying for the use of the equipment—much like you would pay to rent an apartment.
This is also relatively simple. Each monthly payment is considered an expense, and you don’t have to part with a large sum of cash up front. One practical downside is that eventually you need to recover what was leased and return it to the company that leased the PCs to you. The CPU and monitor may be easy to track down, but it’s amazing how quickly some of the accessories get mixed and matched with those of other employees.
You sign a lease that will give you ownership of the equipment at the end of the lease—or you will own it after paying a bargain price at the end of the lease term.
Either way, your payments are spread out, and eventually you become the owner. Here you record the computer as an asset, and you will also record what you owe on the lease or loan as a liability. Part of your monthly payment goes toward reducing that liability and part is expensed as an interest payment. Depreciation is also recorded every period.
The nice thing about ownership is that it gives you more options for disposal of the asset. You can try to sell it, give it to charity, or junk it altogether.
Here is one caution about capital lease/loans: Instead of a bargain purchase option, many leases will give the option of purchasing the equipment at its fair market value. These leases must be examined carefully in order to determine whether they should be considered operating or capital leases. The criteria are beyond the scope of this discussion.
The MACRS method
This is the system by which depreciation is calculated for tax purposes. And yes, right now, computers are considered five-year assets under MACRS. Certainly, this is much longer than the average computer’s life, but we don’t get to write the tax rules. Also, this is an accelerated depreciation method, meaning the bulk of your expense will be recorded in the early years of the asset’s life. One advantage to this is that the more expense you have, the less income you earn, so you’ll pay less income in the early years.
As you can see, making the decision on how to account for purchases of equipment involves a series of trade-offs. As always in matters involving taxes and accounting, you should consult with your accountant or finance department and choose the system that best fits your company.
Do you use a five-year or three-year life span for PCs? Post a comment or send us a letter.