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Tuesday, August 30, 2011

Accumulated Depreciation Accounting

The basic theory of depreciation accounting is unarguable: The amount
of capital a business invests in a fixed asset, less its estimated future
residual (salvage) value when it will be disposed of, should be allocated
in a rational and systematic manner over its estimated useful life to the

A fixed asset’s cost shouldn’t be charged entirely to expense in the year
the asset’s acquired. Doing so would heavily penalize the year of acquisition
and relieve future years from any share of the cost. But the opposite approach
is equally bad: The business shouldn’t wait until a fixed asset is eventually
disposed of to record the expense of using the asset. Doing so would heavily
penalize the final year and relieve earlier years from any share of the fixed
asset’s cost.

Essentially, cost less residual value should be apportioned to every year
of the fixed asset’s use. (Land has perpetual life, and therefore, its cost
isn’t depreciated.) The theory of depreciation is relatively simple, but
the devil is in the details. And, I mean details!

Frankly, there’s not much point in discussing the finer points of
depreciation accounting. I could refer you to many books written
by accounting scholars on depreciation. But as a practical matter the
federal income tax law dictates the depreciation methods and practices
used by most businesses. The IRS publication “How To Depreciate
property” (2005 edition) runs 112 pages. You ought to read this
pamphlet— if you have the time, and the stamina.

Let me step on the soapbox for a moment. The depreciation
provisions in the income tax law are driven mainly by political
and economic incentives, to encourage businesses to upgrade
and modernize their investments in long-term operating assets.
By and large, businesses follow income tax regulations on
depreciation. As the result, useful lives for depreciating
fixed assets are too short, salvage value is generally ignored,
and depreciation is stacked higher in the early years. In
other words: fixed assets generally last longer than their income
tax depreciation lives; when disposed of fixed assets often have
some salvage value; and, a strong case can be made for allocating
an equal amount of depreciation to each year over the useful life
of many fixed assets. In short, actual depreciation practices
deviate from depreciation theory. Okay, I’m off my soapbox now.

The cost of land is not depreciated. Land stays on the books at
original cost as long as the business owns the land. Ownership
of land is a right in perpetuity, which does not come to an end.
Land does not wear out in the physical sense, and generally holds
its economic value over time. Buildings, machines and other fixed
assets, on the other hand, wear out with use over time and generally
reach a point where they have no economic value. Assume the business
decides to maximize the amount of depreciation recorded in the year,
according to the provisions of the income tax law.


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