Question

To improve comparisons of profitability of firms, an analyst could use the average depreciation expense in the industry to compute a company’s hypothetical depreciation expense.

TRUE OR FALSE

Answer 1

FALSE.

Depreciation is the reduction in the value of an asset due to its usage or wear, and tear. The total cost made to acquire or to build an asset is charged to the income statement over the useful life of such assets in the form of depreciation.

Depreciation is debited as an expense, which makes an adverse impact on profitability by reducing profits or increasing losses. Hence, Depreciation may play a crucial role in determining profitability. While making an inter-firm comparison of profitability, It is essential to consider the actual depreciation of such firms because the volume of depreciation may vary drastically from firm to firm due to an inhomogeneous asset base.

Firms may have different volumes of depreciable assets with the uncomparable useful life of such assets. This may lead to uneven depreciation costs among firms under analysis. This may lead to erroneous comparison if average depreciation is applied to analyze profitability in such a scenario.