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.