What is the purpose of depreciation? Does the book value of a fixed asset, cost minus accumulated depreciation, communicate to a user what the asset is worth? Should the financial statements reflect the value of fixed assets?
What are the different methods used to calculate depreciation? How does a company decide which method to use? How does its choice affect the financial statements? Should companies standardize the method of depreciation to enhance comparability?
The purpose of depreciation is to reduce the carrying value of an asset to show the wear, tear, and used portion of the asset's lifespan. By using depreciation, the asset reduces in value and the depreciation is used as a non-cash expense against taxable income. The book value gives the user an idea of what the asset is worth because it shows the historical cost of the asset less the accumulated depreciation, and can give the user an idea of how close the asset is to becoming fully depreciated near the end of its lifespan, but it does not give the user a detailed impression of what the asset is worth, because there are additional variables that affect the actual value of the machine. Excessive wear and tear, lifespans on assets that have been shortened but not yet adjusted by the company, and other factors would be unknown to the user when trying to assess value based on book value. The financial statements should reflect the value of the fixed assets. ...
The solution provides a very detailed discussion on fixed assets, purposes of depreciation, book values, financial statement presentation of depreciation, depreciation methods, deciding which method to use, how the method choice affects the financial statements, and other related issues. The solution is based on 25+ years experience in the accounting industry.