ANSWERS TO QUESTIONS
The differences among the terms depreciation, depletion, and amortization are that
they imply a cost allocation of different types of assets. Depreciation is employed to
indicate that tangible plant assets have decreased in carrying value. Where natural
resources (wasting assets) such as timber, oil, coal, and lead are involved, the term
depletion is used. The expiration of intangible assets such as patents or copyrights
is referred to as amortization.
The factors relevant in determining the annual depreciation for a depreciable asset
are the initial recorded amount (cost), estimated salvage value, estimated useful
life, and depreciation method.
Assets are typically recorded at their acquisition cost, which is in most cases
objectively determinable. But cost assignments in other cases—“basket purchases”
and the selection of an implicit interest rate in asset acquisition under deferred-
payment plans—may be quite subjective, involving considerable judgment.
The salvage value is an estimate of an amount potentially realizable when the asset
is retired from service. The estimate is based on judgment and is affected by the
length of the useful life of the asset.
The useful life is also based on judgment. It involves selecting the “unit” of measure
of service life and estimating the number of such units embodied in the asset. Such
units may be measured in terms of time periods or in terms of activity (for example,
years or machine hours). When selecting the life, one should select the lower
(shorter) of the physical life or the economic life. Physical life involves wear and tear
and casualties; economic life involves such things as technological obsolescence
Selecting the depreciation method is generally a judgment decision, but a method
may be inherent in the definition adopted for the units of service life, as discussed
earlier. For example, if such units are machine hours, the method is a function of
the number of machine hours used during each period. A method should be
selected that will best measure the portion of services expiring each period. Once a
method is selected, it may be objectively applied by using a predetermined,
objectively derived formula.
Accounting depreciation is defined as an accounting process of allocating the costs
of tangible assets to expense in a systematic and rational manner to the periods
expected to benefit from the use of the asset. Thus, depreciation is not a matter of
valuation but a means of cost allocation.
The carrying value of a fixed asset is its cost less accumulated depreciation. If the
company estimates that the asset will have an unrealistically long life, periodic
depreciation charges, and hence accumulated depreciation, will be lower. As a
result the carrying value of the asset will be higher.