Wedding Gown Depreciation (#357)

Wedding Gown Depreciation

What is the accounting for rented wedding gowns – specifically, the depreciation? The case study is as follows:

“We depreciate gowns over three years, but this means depreciating some dresses that have not been rented out in a year, so we are overstating our expenses and understating profits. After the end of the gown life, we will have a dress that is still in the shop and still being hired, at which point we will be recognizing revenue without any cost of sales, which will overstate profits and understate expenses.”

The reason this is so interesting is that there aren’t really any other expenses. You buy the wedding gown and then rent it out, and presumably charge the customer for the dry cleaning afterwards, and maybe for any repairs to the gown. So, the cost of goods sold is pretty much the depreciation – which is very unusual. If you conduct a normal depreciation routine, you guesstimate what the useful life will be – and I can’t help pointing out that it’s gown life, not useful life – awesome new accounting terminology there – and then charge a standard amount to expense in each month. If a dress never rents out, then the charge is still there, and really messes up your profits.

The Matching Principle

This is a good example of the matching principle not working. Under that principle, you’re supposed to recognize all revenues and expenses associated with a sale transaction in the same reporting period. But in this case, there may very well be months when there’s no revenue, and yet that pesky depreciation charge keeps coming up.

Usage-Based Depreciation

So what can be done? A possibility is to only recognize depreciation when a wedding gown is rented. This means that you’d have to estimate the likely gown life, not in terms of years, but in terms of rentals. There must be some standard point at which a gown is too beat up to be rented any more, and you have to retire it. I have no idea what that number is, but let’s call it fifty rentals. And let’s say that the gown originally cost $3,000 to purchase. In this case, you’d have to charge $60 to depreciation every time you rented out the gown.

By taking this approach, you’d be doing a better job of matching the rental revenue with depreciation. But that does not mean that this is a perfect solution, for a couple of reasons.

Problems with Usage-Based Depreciation

First, this involves extra accounting. Instead of just making the same old depreciation entry every month, you’d have to track gown rentals, and then calculate the depreciation for each individual gown for each month – which could be pretty time-consuming.

The second issue is that this system doesn’t work too well if a gown is rarely rented out. You could go years with maybe just a couple of rentals. So, to guard against this, you’d have to do an impairment review of the fair value of the gowns, to see if any of their fair values have declined below their book values. If they have, you’d need to write them down to their fair values, which could involve a fairly hefty charge. Some of the gowns might have to be written off entirely.

A Justification for Usage-Based Depreciation

And yet, I’d still say that a usage-based depreciation scheme is the way to go, for one reason – and that is the Pareto principle, which in this case states that 80% of all gown rentals will probably come from 20% of the gowns. This means that a small number of gowns are probably getting worn out fast, while the rest probably have a long tail on the distribution – which is to say that some gowns are very, very rarely rented. And so, based on that principle, this really is a case where depreciation should probably be based on usage.