The Statement that ‘depreciation is a process of allocation not of valuation’ is found in the following definition of AICPA (US):
“Depreciation accounting is a system of accounting which aims to distribute the cost of tangible capital assets, less salvage (if any) over the estimated useful life of the unit in a systematic and rational manner. It is a process of allocation, not of valuation”.
This definition represents depreciation as an allocation of cost and is based on the following assumptions:
(i) Depreciation is that part of the cost of a fixed asset which is not recoverable when the asset is finally put of use.
(ii) Depreciation is related to the expected benefits derived from the asset and it is possible to measure the benefits.
(iii) Depreciation accounting is not an attempt to measure the value of an asset at any point of time. But there is only an attempt to measure the value of the benefit the asset has provided during a given accounting period and that benefit is valued as portion of the cost of asset. In other words, the balance sheet value of depreciable asset is that portion of the original cost which has not been allocated as a periodic expense in the process of income measurement.
(iv) Depreciation accounting does not itself provide funds for the replacement of a depreciable asset, but the charging of depreciation ensures the maintenance, in fact, of the original money capital of the entity. Indeed, a provision for depreciation is not identified with cash or any other specific asset, or assets.
Allocation in accounting refers to the process of partitioning a set or an amount and the assignment of resulting subsets or amounts to separate periods of time or classifications. Depreciation accounting attempts to allocate in a rational and systematic manner the difference between acquisition cost and estimated salvage value over the estimated useful life of the asset.
The main emphasis in depreciation accounting is on the computation of the periodic charge to be allocated as an expense and to be matched with revenues reported in each period. Depreciation considers the original cost as a deferred expense and the original cost is charged against the profits of the various periods by allocating it over a given period in a systematic manner.
Depreciation does not refer to physical deterioration of an asset or decrease in market value of an asset over time. If this is so, then it can be claimed that periodic repairs and sound maintenance policy may keep buildings and equipment is good running order or as good as new, and thus, physical deterioration can be stopped or checked.
However, every building or machine, at sometimes or the other, has to be discarded and replaced. The need for depreciation is not eliminated by repairs and depreciation does not depend on physical deterioration alone or on no physical deterioration.
Similarly, depreciation process is not affected by what happens to the price level, in general, or to the price of asset in particular. It is related to the income statement which shows the net income after accounting for depreciation. Depreciation is simply the allocation of the cost of a plant asset to the periods that benefit from the services of the asset.
The net income under allocation concept of depreciation would be overstated in times of rising prices. That is, the allocation concept does not consider the problem of asset replacement at a higher price in future. It is rightly argued that an additional reserve out of net profits can be provided for replacement of assets along-with historic cost basis of providing depreciation.
Alternatively, replacement cost can be made the basis of allocating the cost of an asset which would reflect current business situations and the net income would also be realistic. Whatever methods or adjustments are done, the allocation basis of determining depreciation is followed. However, when replacement cost is used in place of historic cost of asset, the objective of current revenue matching with current cost is also achieved.
Depreciation Not a Valuation Process:
Depreciation is not a process of valuation. The valuation concept considers depreciation as the decline in the value of the asset over a period of time. It requires the valuation of assets at two points of time, and assuming decline in value, the amount of depreciation is determined as the difference between the value of asset at the beginning and the end of an accounting period.
However, depreciation does not arise due to decline in value during that period, but rather from the process of ensuring a return of capital invested. If, in a given period an asset increases in value, there will still be depreciation during that period.
A depreciation problem will exist whenever:
(i) Funds are invested in services to be rendered by a plant asset, and
(ii) At some date in the future, the asset must be retired from service with a residual value less than its original cost.
The valuation concept is related to the balance sheet which aims to reflect the values of different assets at a particular date or point in time.
The valuation concept implies that depreciation should reflect the decrease in value of the asset over a period of time.
The term value means:
(i) Market value
(ii) Value to the owner.
The valuation concept would provide a very unsatisfactory basis for distributing the depreciation charges. Decline in the value of asset with time is likely to be unequal and would make net income comparison difficult and unreliable. When the value of the new asset increases, it is not brought into accounting records because the increase in value may not be permanent and also no profits (due to increase in value of asset) should be taken into account unless they are realized.
Further, even if the market value of a plant or building increases, depreciation should be recorded as a result of allocation. Eventually, the building will wear out; the plant will lose its utility or become obsolete regardless of interim fluctuations in market value.
Under ideal conditions, i.e., when prices are stable, all facts are clear, estimates are correct, the amount of depreciation under the allocation process and valuation process are likely to be identical. In other words, after deducting the amount of depreciation under the allocation procedure from the cost of an asset at the beginning of the year, the resulting remaining cost of an asset will reflect the value of the asset at the balance sheet dates that one could obtain while following valuation process of determining depreciation.
For example, assume the cost of an asset to be Rs 10,000 with zero scrap value. If the useful life of the asset is 10 years, the amount of depreciation under allocation process will be Rs 1,000. Further, assume that price of this asset and prices, in general, are stable and the asset is available for purchase in the market.
In this ideal situation, value of asset will decline because prices are stable and the asset will have wear and tear and will not maintain the same potential or utility when it was purchased. Since the useful life of the asset is 10 years, the value of asset should be zero at the end of 10 years. It means for each year, the amount of decline in value comes to Rs 1,000 which is also the amount of depreciation under the allocation process.
However, the trouble is that practical conditions are far from ideal. It is difficult to determine depreciation on the changes in market value because a reliable, objective and practical source for such data is rarely found. Any attempt to accomplish the objectives of allocation and valuation, simultaneously, would be impossible and create confusion. The better approach is, therefore, to ignore the valuation aspect and to concentrate on a satisfactory distribution of the cost of the asset.
Cost allocation is a matching principle and the objective is to find a particular method that, more or less, coincides with the pattern of services or benefits provided by the asset to future periods of time. The Accounting Principles Board (US) has said “the allocation method used should appear reasonable to an unbiased observer and should be followed systematically”.
Need for Depreciation:
The need for charging a reasonable amount of depreciation over the estimated useful life of the asset arises for the following purposes:
1. To ascertain the true income:
The basic need of depreciation is to ascertain the true income. If depreciation is ignored, the loss that is occurring in respect of fixed assets will be ignored. The loss will suddenly loom large when the assets become useless or valueless.
From another angle, when goods are produced it involves use of fixed assets-the reduction in their value should be treated as element of cost of production of goods. Therefore, depreciation should be debited to P&L A/c before profit is ascertained.
2. To show the asset at its proper value:
In the absence of depreciation charge, the asset will be shown at its acquisition cost every year in the balance sheet. If depreciation is not allowed, the Balance sheet would fail to show the true financial position. Therefore, depreciation must be accounted for in order to present the assets at their proper value.
3. To maintain the capital invested:
Depreciation helps to maintain the capital invested in the asset intact in the business so that it can be reinvested in the profit earning process.
4. To retain out of profit fund for replacement:
The other need for depreciation is to retain out of profit funds for replacement of assets. The amount debited in P&L A/c is retained in the business. These are available for replacement of the assets when its life is over.
5. To allocate the cost of fixed asset to product:
The business firms, to find out the accurate cost of production, require to allocate the cost of fixed asset to product.
6. To compute tax liability:
In such a case the rate of depreciation is influenced by tax laws.