At an early stage in an accounting course, we teach our students how to account for long-life assets and we introduce them to depreciation. This is an area that students often misunderstand. So I have taken two common misunderstandings about depreciation here and explained how I deal with them.
One is an easy misunderstanding to deal with because it just confuses different measurement bases.
The other is more interesting because there is a grain of truth in it. And yes, I have oversimplified things. By all means argue about that in the comments.
Depreciation reflects the fall in the value of an asset. True or false?
The answer is ‘false’. It doesn’t. Depreciation has very little to do with the value of an asset and everything to do with the cost of an asset.
Let’s go back to the definitions in the Conceptual Framework for Financial Reporting. An asset is defined as an economic resource, and an economic resource is in turn defined as something which is capable of producing economic benefits1. That addresses the question of recognition.
Turning to measurement, if an asset is simply a collection of future economic benefits then it is logical to measure an asset at the amount of economic benefits that will be recovered in the future. Our initial estimate of the future economic benefits embodied in a resource is (usually) based on cost. Anything less than cost and it would not make sense to acquire the asset in the first place; anything more than cost is just speculation.
If our asset is a bond, and our business involves buying and selling bonds; or if our asset is a building, and our business involves buying and then renting or selling that building, then the market value of the bond or the building is a pretty good estimate of the amount of economic benefits that we will recover – because we will be selling it in the near future, or we will be renting it out to tenants and the rental income we can get will go up and down in line with market values.
So in these cases market value is the best base to use for measuring our asset because that reflects the way in which we will generate benefit from the asset.
But if we are a railway company, and our asset is, for example, a railway locomotive, which is going to be used for the next 30 years moving freight around before being scrapped, then the market value of that machine is irrelevant to us, because we are never going to sell it. We are going to keep it, and use it in moving goods around, because that is our business. Now if we assume, based on previous experience and informed predictions, that the locomotive will operate for those 30 years at steady speeds and efficiency, then it would be fair to say that the economic benefits will be consumed over those 30 years at a fairly steady rate.
So after 1 year, 1/30 of the benefits will have been consumed and 29/30 will be left in the future. Therefore, using the language of the Conceptual Framework, we measure the asset (future economic benefits) as 29/30 of the initial cost2 and the expense (consumed or past economic benefits) as 1/30 of the initial cost.
In other words, depreciation is used to measure the resources still available to a business – which is another way of saying that it is used to apportion the cost over the accounting periods in which it is useful.
Depreciation is cash set aside to replace the asset at the end of its useful life. True or false?
The short answer is ‘false’.
We have seen above that depreciation is an expense, ie a way of changing the amount at which an asset is measured over time. It is not a fund from which we can draw cash to replace an asset.
The long answer is ‘Ah, well, it sort of was. Let me explain…’
When railway companies were first operating in Britain, in the nineteenth century, one challenge they faced was dealing with the long-term costs inherent in their businesses, as their tracks, signals, locomotives, wagons, carriages and everything else gradually wore out, but at different rates.
In 1846, Mark Huish (1808–1867) was General Manager of the enormous London and North Western Railway. At this time, LNWR was the largest joint-stock company in existence. Huish insisted on using double entry bookkeeping (by no means universal then) to maintain a record of the company’s resources and commitments. Commitments included planned future costs that were regarded as necessary for continued operation.
This was unusual among railway companies at the time. Many directors took a rather more gung-ho approach to their company finances – as long as cash operating costs were lower than cash operating revenues they happily dished out any excess in dividend payments to keep their investors happy and then when the cheaply built railway needed expensive repairs there was nothing left.
Railway mania, as it became known, was partly sustained by the illusion of ever-increasing easy gains that existed for as long as the music kept playing and no one had to think beyond this year’s net cash flow.
Huish insisted that an amount of cash generated from profitable operations should be set aside in a ‘depreciation fund’. It was therefore obvious that using up finite life assets was a cost each year and any assessment of the company’s long-term future had to include a plan for how to cover the long-term investment requirements.
In future years, as railway accounting became ever more complicated and professionalised, it was the company’s auditor who insisted on respectable accounting practices. One of the earliest railway auditors, Edwin Waterhouse (the ‘W’ in PwC) caused ructions at the London Brighton and South Coast railway when he prevented the directors from paying dividends out of capital.
Depreciation is recognition of a decrease in the ability of an asset to generate future cashflows. So while depreciation is not setting cash aside, it is a way of stopping companies from frittering away cash needed for investment to keep the business running.
1 Conceptual Framework for Financial Reporting, paras 4.3 – 4.4. ‘An asset is a present economic resource controlled by the entity as a result of past events. 4.4 An economic resource is a right that has the potential to produce economic benefits.
2 Actually net cost i.e., cost less residual value – the residual value being the amount of benefit, if any, expected to be recovered from the eventual disposal of the machine rather than from its use. IFRS refers to this net cost as the depreciable amount.