Question

Your supervisor is on the company’s capital investment decision team that is to decide on alternatives for the acquisition of a new computer system for the company. The supervisor says, “The book value of the existing computer system for the firm that we are considering replacing is nothing but an accounting amount and as such is irrelevant in the capital expenditure analysis.” Does this reasoning make sense? Why or why not?

Answer 1

This reasoning makes NO sense.

The value of asset that exist in the books at the time of replacement of the asset holds a very important position in the capital expenditure analysis. Disposal of asset is the removal of company's long term asset from the books of accounts permanently. It is comsidered very important primarily because it involves the removel of that asset which was utilized for the revenue generation and economic benefit generation by the company. It is als o considrered as an important concept because it relates to the company’s capital assets that are essential to successful business operations. Moreover, the proper accounting of the disposal of an asset is critical to maintaining updated and clean accounting records.

The asset disposal may be a result of several events:

• An asset is totally depreciated in the books and must be disposed of.
• Sale of an asset at a gain/loss when it is no longer useful or needed.
• An asset must be disposed of due to unforeseen circumstances (e.g., theft).

While the company do a capital expenditure analysis, the company needs to match the total expenditure made for the purchase of the capital asset with the total benefit that the company earn from such an asset. Companies purchase capital assets with a view to use it for a given number of years. But it so happens that, in many companies, the asset purchased no longer gives any economic benefit or the asset has become obsolete and an altrernative asset is available in the market for replacement. In these situations, the companies plan to dispose off the existing asset and purchase a new one. While disposing off, the company should ensure that the company is not incurring a higher amount of loss. Instead, they must even try to make some profit out of the sale of such an asset. If the company is able to ensure that they are able to dispose off the asset at a profit, it adds to the overall performance of the company.

Also, while purchasing the asset, the company would estimate a salvage value that they expect from the asset at the end of the useful life. Companies would have already considered a salvage value at the time of taking the investment decisio; ie, to buy or not buy a particular asset. In this case, the company must ensure that they are able to realise the said salvage value at the time of disposal of the asset.

In some cases, we will observe that the book value of the asset will be Nil (0). This means that the asset has been completely depreciated over the years and the useful life of the asset has also expired. In this case, the can dispose off the asset at Nil value as stated in the question, considering it as irrelevant. But on the other hand, if the company is able to recognise even $1 from the sale of such an asset, it would be an extra addition for the company's profitability. Hence I conclude that the asset disposal decision plays a crucial role for the company at the time of replacement of the asset with a latest one and in the overall capital expenditure analysis.