Question

What is depreciation and the purpose? Does the book value of a fixed asset (cost minus accumulated depreciation) communicate to a user what the asset is worth? Why or why not? Should the financial statements reflect the value of fixed assets? Why or why not?

Answer 1

Solution: Depreciation is the reduction in the value of fixed assets due to wear and tear, obsolescence, passage of time etc. The purpose of depreciation is to match expenses to revenues by allocating the cost of the asset over the period of time in which it is used. If an asset has a useful life of 7 year, then the organisation would want to recognise the expense of the asset over those 7 years.

The book value of a fixed asset (cost minus accumulated depreciation) does not correctly communicate to a user what the asset is worth because when we take the accumulation depreciation from the cost of an asset then in that case we are doing an estimate. Sometimes the market value of an asset can be much higher or much lower than the book value, depending on the asset.

The Financial statements should reflect the book value of fixed assets and not the market value because users such as investors and others are interested in knowing how much the asset is worth.