Question

The plant manager of a manufacturing firm suggested in a conference of the company’s executives that accountants should speed up depreciation on the machinery in the finishing department because improvements were rapidly making those machines obsolete, and a depreciation fund big enough to cover their replacement is needed. Discuss the accounting concept of depreciation and the effect on a business concern of the depreciation recorded for plant assets, paying particular attention to the issues raised by the plant manager.

Short answer

Answer

A change in the amount of annual depreciation recorded does not change the facts about the decline in economic usefulness. It merely changes reported figures.

Step-by-step solution

Meaning of Depreciation

The term depreciation refers to the loss of value in assets due to abrasion and erosion over time. Companies use different methods to value their assets, but straight-line depreciation is the easiest one to apply.

Explaining the accounting concept of depreciation and the effect on a business concern of the depreciation recorded for plant assets 

The fact that economic usefulness is eroding is unaffected by a change in the quantity of yearly depreciation recorded. It only modifies the statistics that have been reported. Depreciation is the systematic and sensible allocation of an asset's cost over its useful life in accounting.

The plant manager's suggestion of abnormal obsolescence might warrant more fast depreciation, but raising the depreciation charge would not always result in money for a replacement. It would not raise revenue; rather, it would make reported income lower than it would have been, preventing net income overstatement.

Depreciation is not recorded on the books since no assets are placed aside for the eventual replacement of depreciated assets. Fund segregation is possible, but it necessitates significant administrative intervention. It has no effect on funds unless a rise in depreciation is accompanied by an increase in the product's sales price or unless it influences management's dividend policy choice.

Normally, higher depreciation does not result in higher sales prices and, therefore, a faster "recovery" of the asset's cost because the economic circumstances in place would have allowed for this higher price regardless of the justification or explanation utilized. Without a greater depreciation charge, the price may have been raised.

A profitable company's finances grow, but they can be used to whichever purpose working capital regulation dictates. Net income + charges to operations that did not require working capital, fewer credits to operations that did not produce working capital are the measures of the rise in these funds from activities. Because net income alone does not reflect the rise in funds resulting from profitable operations, some non-accountants mistakenly believe that a fund is being established and that the amount of depreciation recorded has an impact on fund accumulation.

Acceleration of depreciation for income tax reasons falls into a somewhat distinct category since it is more than just a question of recordkeeping. Increased depreciation will tend to delay tax payments, resulting in a temporary rise in funds (although the tax liability may be the same or even higher in the long term than it would have been) and a gain to the business to the extent that the worth of the extra funds is valued.