Depreciation accounting, from the financial accounting point of view, is concerned with the allocation of the cost of an asset over its useful life and charge the revenues of a period with the expenses of earning those revenues. The first objective is that the policy might be aimed at recapturing from period revenue a sufficient number of monetary units either to provide for replacement of the asset on retirement or alternatively to recover the original investment, viz., the acquisition cost. Revenue availability is an important consideration so that depreciation might be charged on when current revenues exceed current operating costs exclusive of depreciation.
Another Objective of depreciation is that the amortization charge for any given period should reflect the share of the total asset service that has expired during that period.
Developing Depreciation Policy
The maximum rates allowable under tax legislation should not be treated as the most important factor in developing data for use by either maragement or investors. It seems also reasonble that the recovery of the initial costs of plant assets must have precedence over the payment of dividend or taxes.
If provsion for depreciation is inadequate from this point of view, such payments may become really speaking distributions of capital rather than earnings despite the fact that inadequate depreciation would certainly result in losses at the time of retirement of the asset, losses which are deductible for tax purposes in the period of retirement. This does not imply that depreciation chareges on existing asset should be directly related to the expected future cost of replacing that asset.
Substantial variations can be expected in both the output and operating characteristics of different types of plant assets manifested to a certain extent in the application of different depreciation methods, a variety of systems must be employed if periodic depreciation charges are to serve as meaningful indices of the expiration of productive capacity.
Managerial Significance of Depreciation Accounting
The significance of depreciation accounting can be discussed with reference to certain management decisions, techniques and areas of interest.
(i) Internal Investment Decision
The provision of depreciation in accounting reports does not in any way affect investment decision implied by the replacement of an asset. Depreciation is taken into consideration indirectly by comparing the cash proceeds generated by the asset with the cost thereof.
(ii) Measuring Performance
As the performance is generally measured by either income or return on investment both of which depend on the method of depreciation accounting. Usual accounting treatment of depreciation will almost invariably distort both the indices of performance. The straight line depreciation gives reasonably good measure of income in case of the revenues and maintenance requirements are constant throughout the life of the asset, but it distorts the return on investment which would increase with the decrease in the book value of the asset due to depreciation.
(iii) Fund Generation
Generally, it is thought that depreciation is a source of funds. It is not the function of depreciation accounting to provide funds for replacement which must come from the revenues of the business and the charge for depreciation neither increases nor decreases the amount available to purchase equipment. Even the making of charges to income and setting up of reserves for depreciation give no assurance regarding the availability of funds for replacement unless they are in some way earmarked for the purpose.
(iv) Make or Buy Decisions
In a make or buy decision, a relevant cost would be a cost that could be avoided if the part was not made and it would not be relevant of cost would be incurred irrespective of the decision taken. The depreciation of the factory building cannot be avoided by the elimination of one phase of production and in this would not be relevant in making the decision. The position would get complicated where factory building devoted to the production of this part could be used to make an alternative product so that, though the depreciation of factory building would not be relevant, the opportunity cost of foregoing production of the product would be very much relevant.
(v) Pricing Decision
A firm is expected to produce at a point where its marginal cost equals marginal revenue and to charge a price equal to the average revenue that will sell the appropriate quantum of output. In this context, depreciation is not taken into account in arriving at decisions regarding price fixation. As all costs (fixed and variable) as well as reasonable profit must be earned in an industry the long sum so as to keep the factors of production engaged in that line of business, all fixed costs including depreciation must be covered by the selling price.
This is no way means that businessman must consider fixed costs in the fixation of selling price of his products. In spite of the fact that he may set the price as dictated competition, he is bound to recover not only the fixed costs but also make a profit if he is skillful in market manipulations through timely pricing decisions.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.