Operating assets and problems under cost allocation approach

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on June 22, 2021

Depreciation is based on the cost allocation concept because of the unreliability of interim measures of value. This use of an approximation causes several problems, four of which are discussed below.

Actual life exceeds estimated life

Because depreciation allocates the full amount of the depreciable base over an estimated life, it is fairly common to find that the firm still owns and operates an asset beyond the projected life. If the misjudgment is found sufficiently early, a change can be made as described above. If that discovery is not made, the fully depreciated asset should be carried on the books at salvage value (if any). That is, no entry should be made to remove either its cost or its accumulated depreciation until it is sold.

Salvage value exceeds original cost

In a period of changing prices or for an operating asset with a long life (particularly a building), it is possible for future salvage value to exceed original cost. The theoretically proper treatment would result in simply not depreciating the item. However, common practice calls for assigning a salvage value below cost and computing depreciation normally. This problem would not exist if depreciation were to be based on changes in market value.

Book value differs from fair value

One of the major results of a systematic cost allocation is that there is likely to be a difference between the asset’s book and fair values. If fair value exceeds book value, the generally accepted treatment ignores the difference. If fair value is less than book, there is some uncertainty as to whether book value should be written down.
While no pronouncement calls for write-downs, that practice is used elsewhere in accounting (inventory and investments).  A write-down should not take place until the asset is worthless. GAAP exclude operating assets from its requirements for recording probable impairments of value. Accordingly, it can be concluded that the assets should not be written down unless their fair value is permanently and significantly below book value.

Interrupted service

When an asset is temporarily taken out of service, a question arises as to whether it should continue to have its cost allocated to the time period. If the depreciation method was adopted in order to match the costs directly with revenues, the recognition of depreciation expense should be discontinued. On the other hand, if it was decided that the asset loses value as time passes regardless of whether it is used, then depreciation should continue during the interruption. There is no apparent consensus in practice, and no comment is provided in the authoritative literature.

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