Assets and expenses both have a “debit” balance on the financial statements, but that’s where their similarities end. Spending on one can build wealth while spending too much on the other can break the bank.
The accounting definition of an expense is “an asset consumed in the normal course of business”; typically this asset is cash. To qualify as an expense, the benefit received from the expenditure is typically received immediately, or at the longest, does not exceed one year. Expenses reduce net income for the year so most business owners try to “write-off” as many of their purchases as quickly as possible to get the corresponding tax savings.
On the other hand, an asset is an expenditure that helps to generate revenue for a year or longer. An asset is placed on the balance sheet. Not all assets are created equal, however. Some assets increase in value over time, while some assets lose their value. Real estate typically increases, while a car always loses value quickly in its first few years. Both of these items are assets, but real estate can build wealth, a car typically will not.
A great example of an asset versus an expense is spending on a mortgage versus rent. When a person or company makes a mortgage payment, more of the property is “owned” than last month because the outstanding loan is reduced. One day when the property is sold, the amount of equity (any increase in the value of the property plus the loan balance reduction) in the asset is converted to cash. With rental payments, there’s no accumulated value. The trade-off is the upfront cost of buying (down payment), risk of having a large mortgage, and being tied to one location. Renting is usually quicker, a shorter commitment, and less headache. Every business owner has to weigh these trade-offs and make their own decision.
There’s often a lot of confusion over the way classifying an expenditure as an asset ends up being deducted for tax purposes. This process is called depreciation and the goal is to allocate a portion of the asset’s cost to the number of years it will benefit the business. Note that this term depreciation has nothing to do with a car losing value. Say landscaper buys a truck for $50,000 that will last a 5 years. In its simplest form, 20% or $10,000 a year, will be depreciated to match the cost of the asset with the period it’s being used by the business. This $10,000 becomes an expense each year and is deducted. This process results in a better matching of the revenue the truck helps produce to the expense of owning the vehicle.
Just because assets help build wealth, doesn’t mean a business owner should snap up every deal they see in the Equipment Trader magazine. The expenses of maintaining, insuring, and just owning a lot of “stuff” (taxes and registration) add up quickly. We advise our clients to put off acquiring assets until it’s absolutely necessary and more beneficial than any alternative. Sometimes it’s making due without a new computer; other times it’s renting a specialty piece of equipment. At some point, a business owner can “run the numbers” to determine if it’s worth continuing to rent or making the decision to buy. This is called a cost-benefit analysis and a topic we’ll discuss in a future article.
Investing in long term, revenue producing assets and keeping expenses as low as possible is the time-tested way to build your business’s net worth and increase the bottom line. Look for ways to apply this to your business or personal finances and watch your wealth grow. As always, reach out if you’d like to take a closer look at the details of dollars hitting your financial statements.