Analysis: 3 different aspects of depreciation

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The cost of an asset that has long but nevertheless limited life is systematically reduced over that life by the process called depreciation.

Anthony and Recee

We know, the allocation of the depreciable amount of an asset over its estimated useful life is termed as depreciation. We are trying to discuss some other aspects of depreciation which is worth to note.

Is depreciation a process of allocation of cost?

There are various arguments both in favour and against regarding whether depreciation is allocation of cost or not.

Arguments in favour

  1. Assets are used in the production process and gradually, loose their service potentiality. Hence, it is necessary to take expired cost of such usage in the production cost. Gradually, expired cost of fixed assets is allocated over several accounting periods by way of depreciation.

    Depreciation is an allocation of cost or other value over the service life of the asset in a systematic and rational manner.
    Financial Accounting Standard Board (FASB)

  2. Cost of an asset is treated as deferred charge. Depreciation is the way to amortise the cost of asset over the estimated life of the asset in a systematic and rational manner.

    Depreciation is the allocation of the depreciable amount of an asset over its estimated life.
    – International Accounting Standard Committee (IASC)

  3. Depreciation is charged even if market value of assets shows increasing trend. Hence, it is not a process of valuation of assets but it is a process of allocation of cost.

    Depreciation accounting is a system of accounting which aims to distribute the cost of tangible capital asset less salvage value (if any) over the estimated life of the unit in a systematic and rational manner. It is a process of allocation, not valuation.
    – American Institute of Chartered Public Accountants
    (AICPA)

  4. Accumulated depreciation is restricted to the cost of fixed asset. Hence, it is only an allocation of cost.
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Arguments against

  1. Depreciation is treated as production cost, but benefits arising from the asset or service potentiality lost in each accounting year cannot be measured accurately.
  2. When asset is re-valued, depreciation is provided on the re-valued amount. Hence, it is not strictly an allocation of cost.

Conclusion

In spite of the above criticisms, no one can deny that it is a process of allocation of expired cost. Share your views too.

Is depreciation a decline in service potential?

Assets are acquired for deriving benefits in the course of generating income. However, an asset cannot provide benefit with constant capacity forever due to its wear and tear. In other words, assets loose its service potentiality gradually. Such decrease in service potentiality is depreciation. Hence, depreciation represents decline in service potentiality of an asset. Further, following definitions also emphasis it:

Depreciation may be defined as the measure of the exhaustion of the effective life of an asset from any cause during a period.
– Spicer and Pegler
Depreciation is a gradual decrease in the value of an asset from any cause.
– William Carter
Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes.
– The ICAI.
AS 6 ‘Depreciation Accounting’
Depreciation must be based on current cost of restoring the service potential consumed during the period.
– American Accounting Association (AAA)

Is deprecation a charge against profit or an appropriation of profit?

Arguments for depreciation is a charge against profit

  1. Assets are acquired and employed in the production process to earn income. Fixed assets like machinery, plant etc. are not fully exhausted in the production process but loose their service potentiality. Hence, it is necessary to take into consideration cost of such usage in the production cost. Cost of usage of fixed assets is included in the production cost by way of depreciation. For calculating and determining true production cost, sale price and correct profit, depreciation is matched against revenue.
  2. Fixed assets loose its value through wear and tear. Such loss is termed as depreciation. Since all losses are charged to Profit & Loss Account, hence depreciation is charged against profit.
  3. Depreciation is charged even if concern does not earn any profit. A reserve is created only by appropriating profit and not in case of loss. Hence, it is a charge against profit.
  4. Further, charging depreciation to Profit & Loss Account (and not Profit & Loss Appropriation Account) is a legal obligation on the concern.
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Argument for depreciation is an appropriation of profit

Firm reduces its profit by charging depreciation and creates a fund for replacement of such asset. Such retained profit may be invested in external securities or elsewhere. Gradually, a large amount is accumulated which can be utilised for replacement of exhausted fixed asset. Hence, it is a reserve created by appropriating profit, which strengthens the financial position of the concern and keeps capital intact.

Conclusion

Though depreciation is also provided to created a fund to support replacement of asset, still it is a production cost and is a charge to Profit & Loss Account. Dont’ forget to share your view.

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