Accounting objectives for the use and disposal of operating assets
The usefulness of most operating assets is consumed as they are applied to the production of goods or the providing of services. This consumption is known as either depreciation, depletion, or amortization, according to the type of asset that is being used. The actual processes of the consumption are dependent upon a number of factors, including the type of asset, the environment, and the manner in which the firm uses the asset. For this discussion, it is helpful to identify the three main causes of changes in the asset’s utility:
1. Deterioration—the decline in the physical condition of the asset while it is used directly in production or exposed to the elements.
2. Obsolescence—the decline in the economic usefulness of the asset as new technology allows its output to be produced more cheaply with new assets.
3. Revaluation—the change in the asset’s market value as the forces of supply and demand shift; this effect is caused by factors other than deterioration and obsolescence.
Because the amount of depreciation is usually significant in assessments of earning power and solvency, accountants have been highly concerned with how to measure and report it in the financial statements.
Assessment of earning power
The assessment of a firm’s earning power is affected by depreciation accounting primarily through its impact on the firm’s reported earnings. Because an asset’s life typically covers several reporting periods, the accountant must determine how much depreciation to assign to each period. In order to achieve this matching of depreciation expense to a time period, two fundamentally different theoretical concepts could be applied.
Under the allocated cost concept, the amount of depreciation reported for a given period would equal a computed fraction of the asset’s cost. This approach attempts to anticipate deterioration and obsolescence but ignores changes through revaluation at the time that they occur. Consequently, only expense is reported until the time of the asset’s disposal. Then, if it is sold, a gain or a loss can occur when the proceeds of the sale differ from the unallocated portion of the asset’s cost.
In contrast to the allocated cost concept, the value concept considers not only deterioration and obsolescence but also revaluation resulting from supply and demand shifts. In applying this concept, it is necessary to determine the change in the asset’s value over the reporting period. If the value declines, depreciation expense is reported. If the value increases, a holding gain is reported. When the asset is sold, the change in value since the prior balance sheet date is reported as depreciation or a holding gain, and there is no gain or loss. from the disposal.
The reliance of this approach on nontransactional data has prevented it from being generally accepted.
It should be observed that both approaches produce identical amounts of total income for the entire period that the asset is owned, even though there is likely to be a substantial difference between the amounts reported as expense in any particular year.
This result can be demonstrated through a brief example. Assume that the Sample Company acquired an asset at the beginning of year I for $50,000. Its market value at the end of the next four years and the change in value in each year are as follows:
Below example shows the income that would be reported if the asset produces $60,000 revenue each year and is sold for $17,000 at the end of its life. Notice that total income is $207,000 for the four-year period.
The point B of above example shows the calculation of income when the original cost is allocated over the four-year life at $12,500 per year. The asset is sold at the end of year 4 for $17,000, which results in a gain of the same amount because the asset has a book value of zero. Notice that the total income is also $207,000, but that there is less variation among the annual reported income figures. Further, observe that the fourth year shows a large adjustment for the fact that using the asset did not consume all of the asset’s value.
The generally applied allocation approach assigns to expense only the amount of expected decrease in the value of the asset that is anticipated because of use. The point C of the above example shows the income that would be reported if the expected salvage value at the end of the fourth year is $14,000. The $36,000 net cost is allocated at $9,000 per year. Because the actual disposal price is $17,000, a gain on the sale of $3,000 is reported.
Notice that total income over the asset’s life is again $207,000 and the use of the salvage value results in less variability in the reported income figures and causes the depreciation expense in each year to come closer to the average annual decline in value. In essence, a better approximation of the annual expense was achieved by using a reasonable salvage value.
Because of the consistency of the allocated cost concept with the historical cost theory used in general practice and the potential for subjectivity and other factors of unreliability inherent under the value concept, GAAP for depreciation are based on allocations of original cost. The discussion in the accounting practice section of this article explains the procedures and alternate methods used.
Depreciation and return on assets
Insight into the firm’s earning power might be obtained by comparing earnings with the resources committed to achieving those earnings. As the rate of return ratio takes on higher values, management appears to be more efficient in using its resources and the firm appears to have more earning power than those with lower ratios.
Accountants have found that this ratio is difficult to provide for investors because of the lack of agreement as to what amount to use in describing the committed resources. For example, the following alternatives have been proposed: full original cost, residual book value, current cost to replace, and current disposal value. Further, the choice of the asset value has implications for the measurement of earnings in the numerator.
Assessments of solvency
Three items of information about the use and disposal of operating assets help statement users assess the firm’s solvency. First, the amount of funds generated from operations describes the firm’s ability to meet its cash needs from its primary activity. While the indirect approach to computing funds from operations shows depreciation as an addition to net income, depreciation is clearly not a source of funds.
It is especially important to recognize that there is no relationship between depreciation, which is merely the allocation of an asset’s historical cost to an accounting period, and the accumulation of funds for replacing a firm’s assets.
A second item of information is the amount of funds actually provided from the disposals of existing assets. Because the disposals are nonroutine, disclosure of their results helps the statement reader assess how many of the firm’s funds were generated by unusual sources. Adjusting net income to remove gains and losses gives better descriptions of the amount of funds provided by these transactions.
Third, some idea of the amount of cash that would be available to the firm if it sold its existing assets might be viewed as helpful for assessing the firm’s ability to meet its payment commitments. However, even this approach to valuation is not likely to be helpful unless the firm intends to liquidate its operating assets.
The application of the net cost allocation approach under GAAP requires that three factors be established about an asset at the time it is put into service. These factors are:
1. Service life—the time period during which the asset’s usefulness is expected to be consumed.
2. Depreciable basis—the value of the usefulness that is expected to be consumed.
3. Depreciation method—the pattern in which the usefulness is expected to be consumed.