Bev & Cheryl’s Ice Cream Shop is growing! Its wacky 32 flavors leave customers with sticky fingers and happy hearts. Who can resist Churro Chip Cinnamon Explosion, PB & Banana Split Supreme, and Strawberry Basil Bliss on a sugar cone?
The bank, that’s who.
Bev & Cheryl recently applied for a business loan to purchase more ingredients. Their ice cream shop was recently featured in a regional news segment and now ice cream faces from all over are swooping in to try a lick. The women need more whole milk, ice cream machines and storage freezers to keep up with demand but need a loan to help.
Unfortunately, the bank says they don’t have enough assets to serve as collateral and rejected their loan application. The women are confounded as to why the bank won’t recognize their ice cream truck and pop-up ice cream stand equipment as assets. As they sulk in the sticky mess they find themselves in, they crack open a pint of “Brainstorm Berry Blast” as they consider what to do next.
Eureka! Bev & Cheryl remembered that their #1 customer, Geneve Huxley (hey, that’s me!), is not only an ice cream lover, but a Fractional CFO. They invite her to sit down over a pint of “Cash Crunch Caramel” and their financial books to discuss their options.
As it turns out, Bev & Cheryl are stuck in a bowl of one boring financial flavor when it comes to their business books. They have been recording their books the same way they do their taxes, not considering how asset depreciation is affecting their financial outlook. They had no idea that they had multiple options when it came to recording depreciation. They thought the method they were using was the only way, when in fact, it caused the bank to unnecessarily say no to a much-needed loan.
I’d love to introduce you to the world of financial flavors that can get your business out of the bowl of boring vanilla that is stunting your business growth. There are many financial flavors to consider when recording and preparing your business books. I’m ready to help you find the flavor that works best for your business…perhaps Profit Pistachio Powerhouse? Schedule a consultation with me today and let’s sample a few financial flavors together.
Understanding Depreciation in Business
Most people understand that depreciation is the reduction of an asset’s value over time. Unfortunately, most business owners don’t understand how to properly record depreciation on their financial statements.
Businesses sometimes need to purchase things that last a long time and are very expensive. According to Accrual Basis accounting principles, you are supposed to spread the cost of the asset over the life of the item. This is called its “estimated useful life.” How long do you plan to use the item? Estimate the answer and then spread the cost over that amount of time on your books.
For Bev & Cheryl, they purchased their ice cream truck for $80,000 two years ago. For a big-ticket item like this, it doesn’t make sense to expense the entire cost on their books in the year it was purchased…but that is what they did to match the tax return, and why they were not able to obtain a loan. Their financial records showed assets worth nothing, because the truck was fully depreciated on their current financial statements.
Types of assets subject to depreciation include vehicles, machinery, office equipment, furniture and fixtures, and copy machines, etc. How you purchase these assets, whether it’s a loan, lease, or cash, doesn’t change depreciation or how it is recorded on your books.
The Matching principle also applies here, as it dictates that you record revenue, and the expenses associated with receiving that revenue, in the same time period (month/year). So Bev & Cheryl should have been recording their ice cream truck depreciation expense for each month in which they are bringing in revenue from their truck. Learn more about this GAAP Principle and others to live by, here.
How Do I Create a Capitalization Policy?
It’s best practice to create a policy for recording fixed assets and the associated depreciation, called a capitalization policy.
First, decide on your threshold for capitalization. This is a dollar amount tipping point to determine if an asset is a one-time expense or should be capitalized into fixed assets. You won’t add the cheap lunchroom toaster as a depreciating asset, but you will the company car. This threshold should be the same for all categories of assets.
You will also need to decide on an asset’s estimated useful life and salvage value when creating your capitalization policy:
As mentioned above, estimated useful life is how long the asset will last before needing replacement. When creating your policy, determine the length you are able to use assets by category. For example, a computer may last your company 3 years, while a company truck may last ten.
When you are ready to dispose of an asset, the salvage value is the estimate for how much you will be able to sell it for, if anything. A computer might have a salvage value of $0 but a company car might be able to sell for a few thousand dollars.
Finally, you need to decide which depreciation method best reflects your financial reality:
The tax method is the most common because business owners (like Bev & Cheryl) don’t know there is another way. This method usually expenses the entire cost of a fixed asset in the year it was purchased, thereby reducing net income. Obviously, this is hugely tax advantageous, especially for really expensive assets, but is not helpful for you when showing the realistic value of assets you own on your books.
The good news is that recording depreciation on your books doesn’t have to match your tax depreciation. It’s a myth that they have to be the same. Instead you want to choose the method that most accurately reflects the value of your assets.
The straight-line depreciation method is usually a much more accurate method for recording depreciation in which you spread the cost of an asset evenly over the years it will be used. In the case of Bev & Cheryl, their $80,000 ice cream truck has an estimated life of 5 years. So each year should have $16,000 recorded as depreciation expense. Straight-line is the recommended method for most businesses.
Units of production method: For some manufacturing machinery, estimated useful life is not measured in years, but in how much it can create. For example, if the machine can create 100,000 ice cream cones before it needs to be replaced, calculate depreciation based on how many ice cream cones you produce each month; let’s say 1,000. You then record an expense of 1/100th of the machine’s cost each month.
Embrace The Best Financial Flavor for Your Business
Are you worried that you’ve been scooping vanilla financial methods for too long that you’ll never get to enjoy another flavor? Don’t worry – not all is lost! Your books can be converted to a new flavor that will provide financial statements that better reflect the value of your company, making it easier to get a loan or sell it. In many cases, after working with me, business owners will see a one-time increase in their net income in the year of adjustment!
Book a meeting with me today to learn about the variety of financial flavors available to you. Not only will you get out of your vanilla rut, you can even choose a cone with sprinkles!
