The nature of depreciation
Understandably students get into a bit of a muddle when considering the nature of depreciation. This article clears up some of the common misconceptions.
We teach students how to account for long-life assets early in our courses. This introduces them to the nature of depreciation, an area they 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 it has a grain of truth. And yes, I have oversimplified things. By all means, argue about that in the comments.
True or false? Depreciation reflects the fall in the value of an asset
The answer is ‘false’. It doesn’t.
Depreciation has very little to do with the value of an asset and everything to do with its cost.
Let’s go back to the Conceptual Framework for Financial Reporting definitions. It defines an asset as an economic resource. An economic resource is, in turn, defined as something capable of producing economic benefits [Note 1].
That addresses the question of recognition, so let’s turn to measurement.
We accept that an asset is simply a collection of future economic benefits. In that case, it is logical to measure it 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.
Say our asset is a bond. If our business involves buying and selling bonds, we would probably expect to sell them in the near future. Their market value is, therefore, a pretty good estimate of the economic benefits we’ll recover.
If our asset is a building, and our business involves buying, renting or selling buildings, the market value would be an appropriate measure. Sale values and rental income will go up and down in line with market values.
In these types of cases, market value is the best base to use for measuring our asset because that reflects how we will generate benefit from the asset.
But if we are a railway company, and our asset is, for example, a railway locomotive, which will be used for the next 30 years, moving freight around before being scrapped. The market value of that machine is irrelevant to us because we will never sell it. We will keep it and use it to move goods around because that is our business. Now, based on previous experience and informed predictions, if we assume 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 reasonably steady rate.
So after one 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 cost [Note 2] 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.
True or false? Depreciation is cash set aside to replace the asset at the end of its useful life.
The short answer is “false”.
Depreciation is an expense — it records changes to the amount at which an asset is measured over time. But 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 long-term costs. Their tracks, signals, locomotives, wagons, carriages, and everything else gradually wore out 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 records of the company’s resources and commitments. Commitments included planned future costs that were regarded as necessary for continued operations.
This was unusual among railway companies at the time. Many directors took a more gung-ho approach to their company finances. To keep investors happy, they happily dished out dividend payments as long as cash operating costs were lower than cash operating revenues. And then, when the cheaply built railway needed expensive repairs, no cash was left.
Railway mania, as it became known, was partly sustained by an accounting illusion — ever-increasing easy gains that existed for as long as the music kept playing. No one had to think beyond this year’s net cash flow.
Huish insisted that some cash from operations be set aside in a ‘depreciation fund’. It was, therefore, evident that using up finite life assets was a cost each year. Any assessment of the company’s long-term future had to include a plan to cover its long-term investment requirements.
As railway accounting became more complicated and professionalised, the company’s auditor insisted on better accounting practices in future years. 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 adjustments recognise a decrease in the ability of an asset to generate future cash flows. So while the nature of depreciation is not setting aside cash, it stops companies from frittering away money needed for investment to keep the business running.
This is part of the Concepts series of articles.
Notes and further reading
Note 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. An economic resource is a right that has the potential to produce economic benefits.
Note 2: What IFRS refers to as the ‘depreciable amount’ is cost less residual value. The residual value is the amount of benefit, if any, expected to be recovered from the eventual disposal of the machine rather than from its use.