ANSWERS TO QUESTIONS
1. The differences among the terms depreciation, depletion, and amortization are that they
imply a cost allocation of different types of assets. Depreciation is employed to indicate
that tangible plant assets have decreased in carrying value. Where natural resources
(wasting assets) such as timber, oil, coal, and lead are involved, the term depletion is used.
The expiration of intangible assets such as patents or copyrights is referred to as
amortization.
2. The factors relevant in determining the annual depreciation for a depreciable asset are
the initial recorded amount (cost), estimated salvage value, estimated useful life, and
depreciation method.
Assets are typically recorded at their acquisition cost, which is in most cases objectively
determinable. But cost assignments in other cases—“basket purchases” and the selection of
an implicit interest rate in asset acquisition under deferred-payment plans—may be quite
subjective, involving considerable judgment.
The salvage value is an estimate of an amount potentially realizable when the asset is
retired from service. The estimate is based on judgment and is affected by the length of the
useful life of the asset.
The useful life is also based on judgment. It involves selecting the “unit” of measure of
service life and estimating the number of such units embodied in the asset. Such units may
be measured in terms of time periods or in terms of activity (for example, years or machine
hours). When selecting the life, one should select the lower (shorter) of the physical life or
the economic life. Physical life involves wear and tear and casualties; economic life
involves such things as technological obsolescence and inadequacy.
Selecting the depreciation method is generally a judgment decision, but a method may be
inherent in the definition adopted for the units of service life, as discussed earlier. For
example, if such units are machine hours, the method is a function of the number of
machine hours used during each period. A method should be selected that will best
measure the portion of services expiring each period. Once a method is selected, it may be
objectively applied by using a predetermined, objectively derived formula.
3. Accounting depreciation is defined as an accounting process of allocating the costs of
tangible assets to expense in a systematic and rational manner to the periods expected to
benefit from the use of the asset. Thus, depreciation is not a matter of valuation but a
means of cost allocation.
4. The carrying value of a fixed asset is its cost less accumulated depreciation. If the
company estimates that the asset will have an unrealistically long life, periodic
depreciation charges, and hence accumulated depreciation, will be lower. As a result the
carrying value of the asset will be higher.
5. A change in the amount of annual depreciation recorded does not change the facts about
the decline in economic usefulness. It merely changes reported figures. Depreciation in
accounting consists of allocating the cost of an asset over its useful life in a systematic and
rational manner. Abnormal obsolescence, as suggested by the plant manager, would justify
more rapid deprecia-tion, but increasing the depreciation charge would not necessarily
result in funds for replacement. It would not increase revenue but simply make reported
income lower than it would have been, thus preventing overstatement of net income.
Recording depreciation on the books does not set aside any assets for eventual replacement
of the depreciated assets. Fund segregation can be accomplished but it requires additional
managerial action. Unless an increase in depreciation is accompanied by an increase in
sales price of the product, or unless it affects management’s decision on dividend policy, it
does not
Questions Chapter 11 (Continued)
affect funds. Ordinarily higher depreciation will not lead to higher sales prices and thus to
more rapid “recovery” of the cost of the asset, and the economic factors present would
have permitted this higher price regardless of the excuse given or the particular
rationalization used. The price could have been increased without a higher depreciation
charge.
The funds of a firm operating profitably do increase, but these may be used as working
capital policy may dictate. The measure of the increase in these funds from operations is
not merely net income, but that figure plus charges to operations which did not require
working capital, less credits to operations which did not create working capital. The fact
that net income alone does not measure the increase in funds from profitable operations
leads some non-accountants to the erroneous conclusion that a fund is being created and
that the amount of depreciation recorded affects the fund accumulation.
Acceleration of depreciation for purposes of income tax calculation stands in a slightly
different category, since this is not merely a matter of recordkeeping. Increased
depreciation will tend to postpone tax payments, and thus temporarily increase funds
(although the liability for taxes may be the same or even greater in the long run than it
would have been) and generate gain to the firm to the extent of the value of use of the extra
funds.
6. Assets are retired for one of two reasons: physical factors or economic factors—or a
combination of both. Physical factors are the wear and tear, decay, and casualty factors
which hinder the asset from performing indefinitely. Economic factors can be interpreted
to mean any other constraint that develops to hinder the service life of an asset. Some
accountants attempt to classify the economic factors into three groups: inadequacy,
supersession, and obsolescence. Inadequacy is defined as a situation where an asset is no
longer useful to a given enterprise because the demands of the firm have increased.
