DEPRECIATION 1. Depreciation problem analyzed.—Depreciation is a phenomenon that attaches to durable physical assets like buildings and machinery and to intangible assets like franchises and patent rights. It is that part of the original outlay on fixed assets which is assignable as the cost of service that they have al ready rendered.
When a person buys a physical asset he purchases it for the purpose of obtaining the service that such an instrument is capable of rendering. If $1,200 is paid for an auto truck, in reality the payment is made for future auto truck service.
As an accounting operation, it is necessary to com pile the costs of all services rendered, not only for the sake of the direct information which the compilation will give, but also that the cost may be traced thru to the income that will eventuate—this income will be either a money income, or a pleasure, the cost of which it is desirable to ascertain so that an intelligent decision can be made as to whether it is worth while.
This service is not rendered all at one moment or in one day, but in a more or less continuous stream thru a considerable period of time. It is evident that the number of service units which an instrument can render is limited. If the service life of an in strument was identical with the fiscal period there would be no depreciation problem because the whole cost of the instrument (barring the instrument's "residual" or "scrap" value) would be the cost of the service received during the period.
If, however, the fiscal or operating period is but a part of this service life, there arises the problem of finding that part of the instrument cost which was the cost of service received during the period in question. This is the depreciation problem, and the part of the instrument cost thus found, is the depreciation of the instrument during the period.
2. Some popular misconceptions of depreciation.— Among the most popular misconceptions of deprecia tion are : (1) that it consists of a decrease in the market value of the depreciable instrument ; (2) that it may be identified with the diminishing operation efficiency or productivity of the instrument ; (3) that after the ac cumulated allowances for depreciation amount to thirty or fifty per cent of the original cost of the equip ment it is no longer necessary to make allowances for depreciation, because current replacements main tain the average investment in the aggregate equip ment at about a fixed amount.
3. Principle of allocated cost.—Let us assume the purchase of a certain instrument whose service life will be exactly five years, and whose operating effi ciency will be maintained uniformly until the end of the fifth year, when it will drop to zero. It may be assumed also that this service will be received at the end of each year ; that the value of each year's service will be the exact equivalent of $1,000 receivable at the end of the year ; and that in computing the present worth of this future service, its estimated value would be discounted at 15 per cent per annum. In this hypothetical case the problem will be to find the maxi mum price which would be paid for this instrument. The following table of amounts and present worth of one dollar at 15 per cent per annum will assist in the discussion: Discount Amount of $1 Present worth of Period at 15 per cent $1 at 15 per cent Beginning 1.000000 1.000000 1st year 1.150000 0.869565 2nd year 1.322500 0.756144 3rd year 1.520875 0.657516 4th year 1.749006 0.571753 5th year 2.011357 0.497177 The present worth of the first year's service, that is the maximum amount which will be paid in advance for it, reckoned at 15 per cent, is $869.56. The pres ent worth for the second year's service, likewise paid in advance, is $756.14, and so on for the succeeding years. The maximum amount that would be paid in advance for the entire five years' service is the sum total of the present worth of those years or $3,352.15.