From the point of view of financial accounting, depreciation accounting is concerned with the allocation of the cost of an asset over its useful life and charging the revenues of a period with the expenses of earning those revenues.

The first objective of depreciation accounting is that the depreciation policy may be aimed at recapturing from a period’s revenue sufficient monetary units either to provide for asset replacement on retirement or to recover the original investment.

Revenue availability is an important consideration to ensure that depreciation is charged when current revenues exceed current operating costs exclusive of depreciation.

Another objective of depreciation accounting is that the amortization charge for any 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 management or investors.

It also seems reasonable that the recovery of the initial costs of plant assets must take precedence over the payment of dividends or taxes.

If provision for depreciation is inadequate from this point of view, such payments may become distributions of capital rather than earnings.

This is 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 charges on an 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, which—to a certain extent—is reflected 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 seen with reference to certain management decisions, techniques, and areas of interest.

1. Internal Investment Decisions

The provision of depreciation in accounting reports does not in any way affect investment decisions 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.

2. Measuring Performance

Performance is generally measured either using income or return on investment, both of which depend on the method of depreciation accounting. The usual accounting treatment of depreciation will almost invariably distort both indices of performance.

Straight-line depreciation gives a reasonably good measure of income if the revenues and maintenance requirements are constant throughout the life of the asset.

However, straight-line depreciation distorts the return on investment, which would increase with the decrease in the book value of the asset due to depreciation.

3. Fund Generation

The general view is 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 reserves for depreciation give no assurance regarding the availability of funds for replacement, unless they are in some way earmarked for the purpose.

4. Make or Buy Decisions

In a make or buy decision, a relevant cost is any cost that could be avoided if the part was not made and that would not be relevant for the cost incurred, irrespective of the decision taken.

Depreciation of factory buildings cannot be avoided by eliminating a phase of production, and so this would not be relevant to making the decision.

The issue becomes complicated when factory buildings that are dedicated to the production of the part could be used to make an alternative product.

In this case, although the depreciation of factory buildings would not be relevant, the opportunity cost of foregoing the production of the product would be very much relevant.

5. Pricing Decisions

A firm is expected to produce at a point where its marginal cost equals marginal revenue. Companies are also expected 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) and a reasonable profit must be covered in an industry 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 does not mean that businesses must consider fixed costs when determining the selling price of their products.

Despite the fact that competitors’ decisions may influence pricing, businesses can recover not only the fixed costs but also make a profit if they are skillful in market manipulations through timely pricing decisions.

Frequently Asked Questions

What is depreciation?

In accounting, Depreciation refers to two aspects of the same concept: the decrease in value of assets (fair value method) and allocation of the cost of assets over its useful life (Depreciation expense).

What are examples of depreciable assets?

Depreciable assets include land improvements such as buildings and paving, land (if it is not held for sale), equipment used to manufacture products or provide services, furniture and fixtures owned by the business, all long-term operating assets such as heavy trucks and excavators.

How can depreciation be calculated?

Depreciation is calculated using a method based on time (linear Depreciation) or on the number of units produced or processed (output method). To calculate Depreciation using a time method , determine the expected life of the asset and assign it to a year. For example, an asset with an economic life of 10 years is assigned to each year for 10 years. The annual Depreciation amount can be calculated by multiplying the depreciable cost by the Depreciation rate.

What is the depreciable cost?

The depreciable cost of an asset includes all costs necessary to acquire it, bring it into use and put it into working condition. Costs associated with the construction or production of buildings are capitalized as part of their building cost before they are fitted out for use. The depreciable cost of an asset is allocated to its useful life for accounting purposes.

Are there other methods to calculate depreciation?

Depreciation also can be calculated using the output method, which allocates a greater proportion of the depreciable cost in earlier years when the asset’s book value is low and smaller proportions in later years as the asset’s book value is higher.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, 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.

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