Accrual accounting arises from the matching principle, which indicates that related revenues and costs should be recognized in the same period. If assets are acquired and totally consumed within an accounting period, the cost of the assets will be recognized as an expense of that period. When an asset is not totally consumed within a single accounting period, the cost of the asset must be allocated as an expense over the periods in which the asset is used to produce revenue. Depreciation arises from this attempt to match asset cost to the period of revenue production. The depreciation for an asset in a period is meant as an estimate of the portion of the original cost associated with the revenue generated in the period. Similar concepts are depletion, which is applied to natural resources used in generating income, and amortization, which is applied to intangible assets that decrease in value over time.
Since depreciation is an allocation of cost over accounting periods, it is not directly connected to market value. The book value of an asset, computed as the cost less the accumulated depreciation, is simply the unallocated cost of the item. The pattern of depreciation is fixed, and does not respond to changing market conditions. Depreciation is only incidentally related to market value and is not meant as an estimate of value.
Because depreciation is an expense but has no associated cash flow, it is sometimes described as being "added back" to arrive at cash flow for the firm. This gives the impression that depreciation is somehow a source of cash flow. The "adding back," however, is simply a recognition that no cash flow occurred, and since depreciation does not involve any cash flow, it cannot supply cash. This is clearest in the simple case of an asset acquired entirely by cash payment. Although the initial purchase is a cash flow, it is the only cash flow. The subsequent allocation of part of the cost as a period expense involves only a book entry.
Depreciation is not intended as a mechanism to provide for replacement of the asset. Since there are no cash flows associated with depreciation, there is no connection with any cash accumulated for replacement of the asset. The asset may or may not be replaced, but this is a capital budgeting decision that is immaterial to the recognition of expense through depreciation.
The concept and relevance of allocating the portion of the original cost of an asset "used up" in a period to generate revenue as an expense of the period is clear. In many practical cases, however, the proportion of cost to be allocated as an expense of a particular accounting period can only be estimated. Allocating cost as an expense requires estimation of the useful lifetime of the asset (which may be expressed in terms of time or in terms of units of production), and any residual or salvage value. These estimates must reflect obsolescence, and may be dependent on maintenance, rate of use, or other conditions.
Given the difficulty of accurately estimating the variables associated with depreciation, it is not surprising that a number of alternative techniques have arisen. Where the productive life of an asset can be expressed in terms of units of production, the units of production method can be applied. Under this approach, the amount of depreciation for an accounting period is the depreciable value of the asset (cost less any residual value) divided by the (unit) lifetime, multiplied by the units produced in the period, and depreciation in a period will be a function of production in the period. Straight-line depreciation is the allocation of equal depreciation amounts to accounting periods over the life of the asset. The straight-line depreciation amount is the depreciable value divided by the lifetime in accounting periods. For example, for an asset with a four-year useful life, yearly depreciation would be 25 percent of depreciable value. An argument against this procedure is that obsolescence and other factors are not linear over time, but rather reduce the usefulness or productivity of an asset by larger amounts in early years. Accelerated depreciation methods recognize this nonlinear decrease in productivity by assigning higher depreciation to early periods, and less depreciation to later periods. The declining balance accelerated method allocates depreciation as a constant percent of the straight-line rate, but applies this rate to the book value of the asset. For example, for an asset with a four-year useful life and a 200 percent declining balance, yearly depreciation would be two times 25 percent, or 50 percent of book value. The final year of double declining balance depreciation, however, is the amount necessary to equate book value to residual value. Sum-of-years' digits accelerated depreciation is computed by multiplying depreciable value by the remaining periods of useful life at the start of the period divided by the sum of the digits in the original useful life. For an asset with a four-year useful life, depreciation in the first year would be 4/(4 + 3 + 2 + I), or 40 percent of depreciable value.
Depreciation is an expense, and affects taxes by reducing taxable income. A firm may use different depreciation treatments for tax and financial statements. Typically, straight-line depreciation would be used for financial reporting because it produces more consistent earnings and is easily understood. An accelerated depreciation treatment would be chosen for tax accounting because the higher depreciation in early periods results in lower taxable income, and shifts tax payment to later periods when lower depreciation results in higher taxable income. This is solely a timing advantage. The total amount of taxes paid is not reduced, but a portion of the payments is shifted to later periods.
Because of the affect of depreciation on taxes, the depreciation methods used in tax accounting have been subject to government regulation. The method in use as of 1998 is called the Modified Accelerated Cost Recovery System. This system groups broad categories of assets into useful (depreciable) life classes (e.g., cars, light and heavy trucks, and computer and office equipment are in the five-year life class). The allowable depreciation per period is then specified, based on a declining balance method and assumed purchase at the middle of the first year. Real property is treated differently, with straight-line depreciation applied. The allowable accounting methods have been repeatedly changed over the years, and will undoubtedly be changed again as time passes and economic conditions change.
[ David E Upton ]
Emery, Douglas R., John D. Finnerty, and John D. Stowe. Principles of Financial Management. Upper Saddle River, NJ: Prentice Hall, 1998.
White, Gerald I., Ashwinpaul C. Sondhi, and Dov Fried. The Analysis and Use of Financial Statements. 2nd ed. New York: Wiley, 1998.