Depreciation is the most misunderstood accounting concept, and yet it is one of the most important. One of the best ways to understand the nature of depreciation is to explore what depreciation is not.
The Nature of Depreciation
Noncurrent, nonmonetary assets are purchased because they represent bundles of future benefits. All of these assets, with the exception of site land, eventually give up these benefits as the firm uses them to produce revenues.
Depreciation is the process of allocating the cost of plant and equipment to the period in which the enterprise receives the benefit from these assets.
Depletion refers to the allocation of the cost of natural resources, whereas amortization refers to intangible assets.
Next, we will analyze the concept of depreciation, but the theoretical concepts are the same. Furthermore, the analysis applies equally as well to depletion and amortization.
Depreciation Is an Allocation Concept
From an accounting perspective, depreciation is an allocation concept. That is to say, the cost of the asset is allocated to the periods in which the enterprise receives benefits from the assets. Theoretically, when an enterprise purchases an asset (e.g., delivery equipment), it can account for it in three different ways. These are:
- Write off the entire cost of the asset as an expense at the time of purchase (i.e., consider it an item of revenue expenditure)
- Record the expenditure as an asset at the time of purchase and make no further adjustment until the asset is sold, abandoned, or otherwise disposed of, at which time the entire cost of the asset is written off to expense
- Record the expenditure as an asset at the time of purchase and systematically allocate the cost to the periods in which the asset benefits the firm (i.e., depreciation)
Clearly, the third option provides the best matching of revenue and expenses; also, it is the only option that is considered to be a generally accepted accounting principle.
Although estimates such as useful lifetime and salvage value must be made, accountants believe that the benefits of the depreciation process outweigh the subjectivity of these estimates.
Depreciation Is Not a Valuation Concept
Unfortunately, many individuals think that depreciation represents a decrease in the value of an asset. Accounting records do not attempt to show the current value of an asset, and depreciation is not used to value a plant or pieces of equipment.
For example, due to market conditions, the value of a building may increase over a specific period of time. However, accountants will continue to depreciate the building because they know that, eventually, the building will give up its benefits to the firm.
Furthermore, the matching concept requires that as these benefits expire, they should be offset against the revenues they help produce.
The assumption is also made that productive assets will not be sold but will be consumed in the operations of the business (i.e., the going-concern assumption).
Thus, depreciation is used to allocate the cost of an asset over its estimated useful life, regardless of current market value.
Depreciation Is Not a Direct Source of Cash
Another common misconception regarding depreciation is that it is a source of cash.
Depreciation is a non-cash expense. This is because it does not require a cash payment at the time the expense is recorded.
This is no different from the write-off of prepaid insurance or rent. The cash outlay takes place when the payment for the related asset is made.
As a result, depreciation does not result in a direct cash outflow or inflow, nor does the balance in the accumulated depreciation account represent cash.
The balance in this account represents only the total of the expired costs of the particular asset and is recorded as a debit to the depreciation expense account and a credit to the accumulated depreciation account.
Neither cash nor any other current asset or current liability account is involved. Unless a company sets aside cash by moving it from its regular cash account into a special fund, there is no guarantee that the firm will have the funds to replace its plant and equipment.
There is one way, however, in which depreciation serves as an indirect source of cash to a firm.
Depreciation is a non-cash expense that reduces taxable income. The lower the firm’s income is, the lower the cash outflows due to tax payments will be.
Thus, the higher the depreciation expense for tax purposes, the greater the amount of cash that the firm will be able to retain through lower tax payments.
Only in this way does depreciation affect cash flow. As this example indicates, using depreciation for tax purposes is closely tied to the aim of reducing taxable income.
What Causes Depreciation?
There are two factors that cause a tangible asset to give up its economic benefits: physical deterioration and obsolescence.
Tangible assets deteriorate due to use, the passage of time, and exposure to elements such as weather and other climatic factors. Clearly, a good maintenance policy can keep a firm’s tangible assets in a good state of repair, ensuring they perform according to expectations.
However, even the best-maintained asset will wear out eventually and need to be replaced. Thus, depreciation is recorded for all tangible assets other than land, no matter how well maintained.
In addition, depreciation is recorded for those items included in the plant and equipment account, even if they are temporarily not in use. This is because as time passes, physical deterioration takes place to a certain extent, regardless of use.
Obsolescence refers to the process of becoming outdated, outmoded, or inadequate.
Certain pieces of high-tech equipment, such as computers and other electronic devices, are subject to rapid obsolescence. Although these assets continue to perform, new technology makes them outdated in a relatively short period of time.
Some assets, although technologically sound, become obsolete because they are no longer able to produce at the increased levels required as a result of expanded growth and sales.
Physical deterioration and obsolescence are factors that cause depreciation. However, it is not necessary to distinguish between them when determining depreciation.
They are primarily related to determining the economic useful life of assets, and no attempt is made to separate these joint factors in that determination.