Question

At a recent luncheon, you were seated next to Mr. Hopkins, the president of a local company that manufactures bicycle parts. He heard that you were a CPA and made the following comments to you:

Why is it that I am forced to recognize depreciation expense in my company's income statement when I know that I could sell many of my assets for more than I paid for them? I thought that the purpose of the balance sheet was to reflect the value of my business and that the purpose of the income statement was to report the net change in value or wealth of a company. It just doesn't make sense to penalize my profits when there hasn't been any loss in value from using the assets.

At the conclusion of the luncheon, you promised to send him a short explanation of the rationale for current depreciation practices.

Required:

Prepare a letter to Mr. Hopkins. Explain the accounting concept of depreciation and include a brief example in your explanation showing that over the life of the asset the change in value approach to depreciation and the allocation of cost approach will result in the same total effect on income.

Answer 1

Dear Mr. Hopkins,

    As I promised you I am trying to explain you the need to recognize depreciation in the income statement.

Depreciation is gradual recognition of the cost of a fixed asset the income statement as per matching principle. Every fixed asset are used for generating revenue and not for resale. But no fixed asset is going to give you revenue for an unlimited period except land. That means every fixed asset is having it's on useful life and it will help in generating revenue during this useful life.

Why depreciation should recognize in the income statement.

While our conversation you said that there is no loss value for an asset when it put in the production process. But really what happened is that when you use an asset for revenue generating purpose you are actually losing the value of the asset due to wear and tare obsolescence etc so how much value of an asset loosed in a particular financial year by using it in the process is a loss for you and it has to treated as expense for that year and recognized in income statement.

It can be viewed In another way. For purchasing an asset you are making a huge cash outflow at the time of purchase of the asset. But you can’t treat it as your expenses for that particular year because you are not making such cash outflow for that year only, that’s why we treat that outflow in form of fixed asset in your balance sheet. but when time goes you will use that asset to produce the product and thereby earn revenue. Up to what amount you used the asset to make revenue for a particular year that is a loss of value for your asset and you should treat it as your expense for that year and recognize that as an expense in your income statement to find out your actual profit.

Example.

   You purchased m machine at a cost of $100,000 to produce 20,000 units of products within 5 years. Assume that you produced 5000 unit in the first year, that means you can only produce 15000 units using that asset over next four years. So if we think logically It’s understood that in the second year we cant give the value of $100,000 to that machine in balance sheet because we used a certain value of it in last year. This amount of reduction is depreciation and you have to charge it against your last year profit in the income statement. the calculation will be as follows.

Cost of purchase (Value of Asset) = $100,000

Total useful life = 5years.

Total number of units produced using the asset=20,000

Units produced this year=5000

So depreciation under production method= (Total cost of purchase/Total number of units produced)/ Number of units produced in the current year.\

=$100,000/20,000)*5000=$25,000   

So out of total value of the asset, you used $25000 to make current years revenue and you have to reduce to find your actual profit by the way of charging it in the income statement. And as you used the value of $25000 in the current year the remaining usable value of the asset is $75000, so this $75000 should reflect in the balance sheet as the current value of the asset.

I think to know its clear for you,

       Thanks and Regards,

              Your friend.

Note :

Here I used the unit of production method to compute depreciation and there are so many other methods called the straight-line method, double declining method etc to compute depreciation. And I Assumed there is no salvage value for the asset. Salvage value means the value we expect to have for the asset at the end of its useful life.