Financial Literacy Appreciation for Depreciation and Time Value of Money

In today’s society, instant gratification and the desire to buy everything brand-new seems to be a typical behavior among most consumers. However, many consumers may decide to reevaluate their spending habits and proposed purchases if they better understood how quickly the book value of various items depreciated. Cars (vehicles), jewelry, books (especially text books), electronics, cds, dvds, power tools, and furniture all represent commodities with book values that depreciate at an exponentially fast rate. All of the aforementioned items could be bought at full price, but buying a used item could save consumers a considerable amount of money as well as still allow them to benefit from the useable life of the item. Ideally, enhancing financial literacy regarding depreciation would help individuals to reduce personal debt by reinforcing the disproportion between the quality of an item and what it cost. Nevertheless, having a working understanding of the various depreciation methods would definitely assist consumers to make conscious decisions when making purchases.

Depreciation is defined as the expenses associated with spreading-out or allocating the cost of an asset over its useful life by accounting for physical wear and tear, decay, and obsolescence. In order to measure depreciation several factors must be determined which include, the cost of the asset, the estimated useful life, and the estimated residual value. Typically, the cost to purchase an asset is a known amount by the purchasing entity, but the estimated useful life and the estimated residual value need to be determined. The estimated useful life of the asset represents the length of service that is expected from using the asset, which can be indicated in years, units of output, miles, and other measures. Next, the estimated residual value (which is also commonly referred to as the scrap value or salvage value) is expected to be the cash value of an asset at the end of its useful life or when the asset is sold or discarded. Typically, the estimated residual value will be determined by the owner of the property or another reliable source (i.e. Kelley-Blue Book). Straight line (SL) depreciation represents the simplest and most-often-applied depreciation method, in which an equal amount of depreciation is assigned to each year (or period) of asset use. For the most part, depreciation on goods purchased by consumers can be calculated through the SL depreciation method. In essence, SL depreciation per year = Cost-Residual Value/ Useful life in years. With this method, the depreciable cost can be determined by deducting the estimated residual value from the asset’s original cost. Consumers should also keep in mind that depreciation decreases the value of the asset, because the amount of depreciation continues to accumulate each year. Also, the valued equity of the asset decreases as a result to the depreciation expense. Thus, as the asset is used during operations, the accumulated depreciation increases while the book value of the asset decreases. In SL depreciation, the asset depreciates until the book value equals salvage value. When the estimated useful life is achieved, the asset is considered to be fully depreciated. For example, if an individual purchases a sports car for $55,000, with an estimated useful life of 10 years and an estimated salvage value of $8,000. The SL depreciation for the sports car would be determined by using the SL depreciation equation of (Cost-Residual Value/ Useful life in years) which equates to ($55,000-$8,000/10 years). In essence, the sports car would depreciate by $ 4, 700 per year.

In addition, many consumers that can’t afford to buy brand new big ticket items, often satisfy their wants and needs through participating in rent to own agreements with companies like Rent- A-Center and Aaron’s. Most consumers that make agreements with rent to own businesses often don’t fully understand the ins and outs of their contract. Typically, these rent to own business organizations earn revenue through marking up the retail price of items and by charging high interest rates, which are most likely compounded daily. In the end, the consumer that shops at rent to own stores sometimes end up paying twice as much as the item is worth and in many cases once the customer finally owns the item, it most likely has depreciated to its salvage value.

Prudent consumers should also become familiar with the time value of money and how this relates to the compounding of interest on rent to own agreements and credit cards. Typically, in the U.S., credit card interest rates are compounded daily based on the unpaid principal and then they are applied to the monthly billing cycle. Compounding refers to the process of calculating interest for a specific time period on the sum of the principal and any interest accumulated at the beginning of the period. Basically, with credit cards, the holders are paying interest on any interest charges as well as continuing to pay for the loan. Consequently, the compounding of interest on credit cards is what makes them so difficult to pay off. In the end, the sooner consumers learn to appreciate the benefits of financial literacy, the sooner they will understand the concept of depreciation and the time value of money.