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Intermediate Accounting (Kieso)
Found in: Page 582

Short Answer

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.

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.

See the step by step solution

Step by Step Solution

Step 1: 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.

Step 2: 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.

Most popular questions for Business-studies Textbooks

(Depletion and Depreciation—Mining) Khamsah Mining Company has purchased a tract of mineral land for $900,000. It is estimated that this tract will yield 120,000 tons of ore with sufficient mineral content to make mining and processing profitable. It is further estimated that 6,000 tons of ore will be mined the first and last year and 12,000 tons every year in between. (Assume 11 years of mining operations.) The land will have a salvage value of $30,000.

The company builds necessary structures and sheds on the site at a cost of $36,000. It is estimated that these structures can serve 15 years but, because they must be dismantled if they are to be moved, they have no salvage value. The company does not intend to use the buildings elsewhere. Mining machinery installed at the mine was purchased secondhand at a cost of $60,000. This machinery cost the former owner $150,000 and was 50% depreciated when purchased. Khamsah Mining estimates that about half of this machinery will still be useful when the present mineral resources have been exhausted, but that dismantling and removal costs will just about offset its value at that time. The company does not intend to use the machinery elsewhere. The remaining machinery will last until about one-half the present estimated mineral ore has been removed and will then be worthless. Cost is to be allocated equally between these two classes of machinery.

Instructions

  1. As chief accountant for the company, you are to prepare a schedule showing estimated depletion and depreciation costs for each year of the expected life of the mine.
  2. Also compute the depreciation and depletion for the first year assuming actual production of 5,000 tons. Nothing occurred during the year to cause the company engineers to change their estimates of either the mineral resources or the life of the structures and equipment.
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