Question

Select ONE of the questions below and provide a response. Distinguish between depreciation, depletion and amortization. What are reasons that plant assets retire? Define inadequacy, superession and obsolescence. What basic questions must be answered before the amount of the depreciation charge can be computed? What are the major factors considered in determining what depreciation method to use?

Answer 1

MAJOR FACTORS CONSIDERED IN DETERMINING WHAT DEPRECIATION METHOD TO USE

• Financial Reporting:

The goal in financial reporting for long-life assets is to seek a statement of income that realistically measures the expiration of those assets. The only difficulty is that no one knows, in any satisfactory sense, just what portion of the service potential of a long- life asset expires in any one period. All that can be said is that financial statements should report depreciation charges based on reasonable estimates of assets’ expiration so that the goal of fair presentation can more nearly be achieved.

• Inflation:

Depreciation is a process to account for decline in the value of assets and for this many methods such as straight line, different accelerated methods are available. In recent years, inflation has been a major consideration in selecting a method of depreciation.

• Capital Maintenance:

During inflation, depreciation, if based on historic cost of assets, helps a business firm to gather an amount equivalent to the historical cost of the asset less its salvage value. This treatment of depreciation facilities in maintaining only    the ‘money capital’.

• Legal Provisions:

The statute governing an enterprise may the basis for computation of depreciation

Where the management’s estimate of the useful life of an asset of the enterprise is shorter than that envisaged under the provision of the relevant statute, the depreciation provision is appropriately computed by applying a higher rate. If the management’s estimate of the useful life of the asset is longer than that envisaged under the statute, depreciation rate lower than that envisaged by the statute can be applied only in accordance with the requirements of the statue.

• Technology:

Depreciation is vital because it decides the regenerating capacity of industry and enables enterprises to set aside an amount before submitting profits to taxation, for replacing machines. Realistically, the depreciation that enterprises are eligible for and capable of accumulating should cover the purchase price of assets, when the time comes for replacement.

• Effect on Managerial Decision:

The suitability of a depreciation method should not be argued only on the basis of correct portrayal of the objective facts but should also be decided in terms of their various managerial effects.

Depreciation and its financing effect take the less basic but still realistic approach that, regardless of any effect which depreciation may have upon the total revenue stream, the recognition of depreciation either through the cost of product or as an element in administration and marketing expenses, does cut down the showing of net income available for dividends, and thus, restricts the outflow of cash.