Question

In a recent newspaper release, the president of Magnusson Company asserted that something has to be done about depreciation. The president said, “Depreciation does not come close to accumulating the cash needed to replace the asset at the end of its useful life.” What is your response to the president?

Answer 1

I would agree that the president is correct with the statement regarding depreciation not accumulating the necessary cash for replacement. There is little they can do regarding the actual depreciation of an asset. Depreciation is a fact of life in business when it comes to assets. What they could do to help with cash flow, at least in the long run, is do what they can to get the most out of their assets. For example if the company purchases a truck for $40,000 and they account for 5 years of depreciation and a salvage value of $5,000 at the end of those 5 years, they would have a straight-line depreciation expense of $7,000 annually. At the end of the 5 years if they've done an excellent job of maintaining the vehicle and it is still quite useful, they can continue to use the vehicle well beyond the 5 years. During the extra years they will not have this expense and can accumulate some cash for the eventual replacement, as the company is not required to do away with an asset at the end of the 5 years. As the president said, depreciation does not come close to accumulating the cash needed for replacement, but taking care of assets and extending the life of them can help towards accumulating cash for replacement equipment.