Question

opic: At a recent luncheon, you were seated next to Mr. Fogle, the president of a local company that manufactures food processors. He heard that you were in a financial accounting class and asked: "Why is it that I'm forced to record depreciation expense on my property when I could sell it for more than I originally paid? I thought that the purpose of the balance sheet is to reflect the value of my business and that the purpose of the income statement is to report the net change in value or wealth of a company. It just doesn't make sense to penalize my profits when the building hasn't lost value".

Required: Prepare a detailed memo to Mr. Fogle. Explain the accounting concept of depreciation and contrast this with the dictionary definition of depreciation. Include in your memo why, for accounting and financial reporting perspectives, it is important and necessary for Mr. Fogle to record depreciation on the building even though its market value may have increased. What accounting concepts or pronciples are being applied here?

Answer 1

Concept of Depreciation

Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy. Depreciation represents how much of an asset's value has been used up. Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each year the asset is in use. If not taken into account, it can greatly affect profits.

Businesses can depreciate long-term assets for both tax and accounting purposes.

Depreciation is a non-cash business expense that is allocated and calculated over the period that an asset is useful to your business. Every business can take advantage of depreciation by deducting the expense of using up a portion of the value of an asset from taxable income. That result is tax savings.

Depreciation is an artifact of GAAP (generally accepted accounting principles). When you invest in certain types of property for your business, even though you may use cash to make the purchase, you typically can’t immediately deduct the entire cost as expense against revenue. That’s because of GAAP’s matching principle, which sets out that expenses should be recorded in the same period in which revenue is earned from them.

Tax Deductions

As mentioned above, depreciation will help you generate savings on your tax return. IRS rules change frequently, so you’ll probably want to work with an accountant in fine-tuning how you treat depreciation for tax purposes. But certainly one tactic might be to use an accelerated depreciation method in years that you acquire depreciable assets and anticipate higher revenues, to achieve a more manageable tax bill.

Matching Expenses to Balance Your Books

This matching principle matters to accountants, investors in your business and, potentially, auditors – but it should also matter to you. Simply put, depreciation, when executed properly, enables you to match your expenses to revenues, and come up with an accurate picture of your true business expenses over a specific accounting period.

Accurately Valuing Assets

Depreciation helps you arrive at a realistic number for the value of your company’s assets. Public companies need this valuation to correctly declare the net book value of assets in reports to shareholders. If you’re looking to secure a loan for your business, you’ll probably need an accurate valuation as well. But it’s also useful information for your business planning purposes. As an asset’s useful life wanes, you’ll need to set aside funds for its eventual replacement.