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Depreciation: record no expense for 2008 - Evaluate argument

The managements of two different companies argue that because of specific conditions in their companies, recording depreciation expense should be suspended for 2008. Evaluate carefully their arguments.

(a) The president of Guzman Co. recommends that no depreciation be recorded for 2008 because the depreciation rate is 5% per year, and price indexes show that prices during the year have risen by more than this figure.

(b) The policy of Liebnitz Co. is to recondition its building and equipment each year so that they are maintained in perfect repair. In view of the extensive periodic costs incurred in 2008, officials of the company believe that the need for recognizing depreciation is eliminated.

Solution Preview

What a curious idea these two companies have had! First, let's review some definitions of depreciation:

1. Depreciation
An expense recorded to reduce the value of a long-term tangible asset. Since it is a non-cash expense, it increases free cash flow while decreasing reported earnings.
Notes:
Depreciation is used in accounting to try and match the expense of an asset to the income that the asset helps the company earn. For example, if a company bought a piece of equipment for $1 million and expected it would have a useful life of 10 years, it would be depreciated over the 10 years. Every accounting year the company would expense $100,000 (assuming straight line depreciation), and this would be matched with the money that the equipment helps to make each year.
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2. Depreciation
A non-cash expense (also known as non-cash charge) that provides a source of free cash flow. Amount allocated during the ...

Solution Summary

The cited solution first quotes three definitions of depreciation from three different perspectives. For this problem, the solution explains the results of the company's plan, but also provides a viable solution for their review.

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