2. The Objective of Depreciation

Question 1

Why is depreciation important?

Answer 1

The need to depreciate tangible non-current assets arises from the accrual principle.

If money is spent on purchasing an asset, then this amount must at some time be charged against profits. If the asset contributes to the generation of income over a number of reporting periods it would be inappropriate to charge any single period (e.g., the period in which the asset was acquired) with the whole of the expenditure.

Instead, some method must be found of spreading the cost of the asset over its useful life.

Question 2

Give two common depreciation misconceptions.

Answer 2

1. It does not reflect the fall in value of an asset over its life.
2. It is not setting aside money to replace the asset at the end of its useful life. Even if the asset was not going to be replaced, its cost should still be allocated over its useful life.

Question 3

What accounting principle is is depreciation an example?

Answer 3

Depreciation is an application of the accruals principle. It matches the cost of the asset to the period that the business expects to gain the benefits from using it.