Page 416 - Accounting Principles (A Business Perspective)

every plant asset except land. They record depreciation even when the market value of a plant asset temporarily
rises above its original cost because eventually the asset is no longer useful to its current owner.

Exhibit 81: Factors affecting depreciation

Major causes of depreciation are (1) physical deterioration, (2) inadequacy for future needs, and (3)
obsolescence. Physical deterioration results from the use of the asset—wear and tear—and the action of the
elements. For example, an automobile may have to be replaced after a time because its body rusted out. The

inadequacy of a plant asset is its inability to produce enough products or provide enough services to meet current
demands. For example, an airline cannot provide air service for 125 passengers using a plane that seats 90. The
obsolescence of an asset is its decline in usefulness brought about by inventions and technological progress. For
example, the development of the xerographic process of reproducing printed matter rendered almost all previous
methods of duplication obsolete.
The use of a plant asset in business operations transforms a plant asset cost into an operating expense.
Depreciation, then, is an operating expense resulting from the use of a depreciable plant asset. Because

depreciation expense does not require a current cash outlay, it is often called a noncash expense. The purchaser
gave up cash in the period when the asset was acquired, not during the periods when depreciation expense is
recorded.
To compute depreciation expense, accountants consider four major factors:
• Cost of the asset.
• Estimated salvage value of the asset. Salvage value (or scrap value) is the amount of money the company
expects to recover, less disposal costs, on the date a plant asset is scrapped, sold, or traded in.
• Estimated useful life of the asset. Useful life refers to the time the company owning the asset intends to
use it; useful life is not necessarily the same as either economic life or physical life. The economic life of a car

may be 7 years and its physical life may be 10 years, but if a company has a policy of trading cars every 3 years,
the useful life for depreciation purposes is 3 years. Various firms express useful life in years, months, working
hours, or units of production. Obsolescence also affects useful life. For example, a machine capable of
producing units for 20 years, may be expected to be obsolete in 6 years. Thus, its estimated useful life is 6 years
—not 20. Another example, on TV you may have seen a demolition crew setting off explosives in a huge
building (e.g. The Dunes Hotel and Casino in Las Vegas, Nevada, USA) and wondering why the owners decided
to destroy what looked like a perfectly good building. The building was destroyed because it had reached the

end of its economic life. The land on which the building stood could be put to better use, possibly by
constructing a new building.

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