If I asked you to describe depreciation in accounting in one sentence, would that sentence be something along these lines?
—— “The monetary value of an asset decreases over time due to use, wear and tear, or obsolescence. This decrease is measured as depreciation” – economictimes.com
If you said yes, cool, then you are like me and every other accountant. But, this definition is technically not correct.
This definition is used by many accountants, it’s simple and describes depreciation and its purpose well enough, but according to GAAP accounting, it is not an accurate description of deprecation and its purpose in accrual accounting. There is somewhat of a gap in accounting study that doesn’t fully conceptualize depreciation and its purpose to accounting students and only the surface level is taught. I think the reason why the concept isn’t fully understood is because accounting students get taught more of the technical side like calculating double declining balance method or sum-of-years’-digits method without first fully understanding the conceptual side of depreciation.
Let’s get into it.
First, let’s look at the authoritative guidance and its description of depreciation. FASB does not have depreciation in its master glossary, however, FASB’s Accounting Standards Codification topic 360 (Property, Plant, and Equipment), along with the conceptual framework outlined in SFAC’s, will be the sources we use for our understanding of depreciation as a concept.
ASC 360-10-35-4: The cost of a productive facility is one of the costs of the services it renders during its useful economic life. Generally accepted accounting principles (GAAP) require that this cost be spread over the expected useful life of the facility in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the facility. This procedure is known as depreciation accounting, a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation, not of valuation.
So what is the Argument?
Before we take a deeper dive into the authoritative description of depreciation, the argument I have against the economictimes.com description of depreciation is that monetary value is not the value being depreciated but simply the unit of measure for the usefulness of an asset being the value that is being depreciated.
In other words, the monetary value that is decreasing is simply a proxy or unit of measure, it is not the underlying value that is actually being depreciated. The underlying value that we are depreciating is economic benefit.
The initial cost of a productive asset is the measure of the value of its potential future economic benefit. The cost, being the unit of measure for the future potential economic benefit, is allocated to expense once the revenue generating capabilities of that economic benefit have been exhausted for the period. The cost, or monetary value as described in the economictimes.com definition, is simply a measurement attribute, this measurement attribute is assigned as a unit of measure to represent the potential future economic benefit (asset) on the balance sheet, which the potential future economic benefit further represents a usefulness to the entity in its capabilities to generate revenue.
Deep Dive
SFAC No. 5, which goes into detail about recognition and measurement in Financial Statements, says that the measurement attribute assigned to Property, Plant, and Equipment, which is the classification of productive assets, should be historical cost, or simply the initial consideration transferred in exchange for the productive asset (ignoring capitalized improvements, interest, etc). Monetary value, as used in economictimes.com’s definition, is attempting to describe this value as the measurement attribute.
The issue is, a decrease in monetary value, or historical cost, as a measurement attribute for the depreciation of productive assets is only a gauge, or a unit of measure, to represent the underlying value of the asset decreasing. What is the underlying value of the productive asset? Economic benefit.
The usage of the economic benefit is the underlying value being depreciated represented by the monetary value, or unit of measure. In other words, the numerical value assigned to the asset as a measurement attribute represents the unit of measure, while the actual value being depreciated is the usage of the economic benefit of the productive asset exhausted during the accounting period. We will get into this more deeply, but what represents the value of an asset? Surely it isn’t the measurement attribute, right? The measurement attribute is simply a measure for something, what is that something? Economic benefit, more precisely, the future potential economic benefit. Once again, monetary value defined in the economictimes.com definition as the measurement attribute is not what is being depreciated, it is simply the unit of measure in gauging the decline in the value of the economic benefit, a portion of the historical value that was used in the period is allocated to expense over the period it which it provided its value through revenue generation.
SFAC No. 5, recognition and measurement, lays down a foundation for measuring the items in Financial Statements. In the context of the economictimes.com definition of depreciation, what exactly do they mean by monetary value in the definition — “The monetary value of an asset decreases over time due to use, wear and tear, or obsolescence. This decrease is measured as depreciation”? We know from SFAC No. 5 that measurement involves a choice of an attribute by which to “quantify a recognized item” and a choice of a scale of measurement (unit of measure). When we have an item that qualifies for recognition by meeting the required recognition criteria, such as a productive asset as we are talking about, this item must have a relevant measurement attribute, in other words, a way for us to quantify its value in monetary units. The measurement scale of the attribute is the nominal unit of money (the dollar).
The numbers on the balance sheet under the classification of PPE, what do they represent? The numbers on the balance sheet are the result of a choice of measurement attribute, which in the case of PPE is historical cost. Still, that is not enough, what do the numbers mean? What value are the numbers trying to quantify?
The measurement attribute (historical cost) is quantifying, in a unit of measure, the potential future economic benefit of a productive asset, which is the usefulness of the asset in its revenue generating capabilities. The use of a productive asset produces revenue for the entity and this use has a cost which must be allocated to expense. The use (usefulness) is deducted from the original cost of the asset, it is now expensed for providing its services to the entity. ASC 360-10-35-4 says that “The cost of a productive facility is one of the costs of the services it renders during its useful economic life”, and the remaining cost of service is the figure that is represented on the balance sheet, in other words, the numbers represent the portion of the cost of the asset that is still in line to be used in the production of the revenue. How much revenue does each portion of use of the asset produce? Who knows, that is why ASC 360-10-35-4: says “this cost be spread over the expected useful life of the facility in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the facility”. When ASC says “as equitably as possible”, this simply means the cost of the use of the asset during a particular period cannot be specifically matched to that periods revenue that the cost generated. It’s indeterminable, therefore, we must use a cost allocation system to equitably apportion the cost to different periods.
The end of paragraph ASC 360-10-35-4 says that depreciation is a “process of allocation, not of valuation.” The idea here is that depreciation accounting is not attempting to value the asset in terms of its monetary value, but rather to allocate the cost of services to expense on a basis that matches the productivity of the asset in terms of its revenue generation for each period.
This brings up the question of whether the productive assets at their respective carrying values on an entity’s books have any correlation with their fair market value. The answer to that is no, and the reason why is because valuing productive assets on the basis of their fair market value does not serve our intended purposes. The job of a productive asset is to aid the entity in producing income, not to appreciate in FMV. Therefore, depreciation accounting is not concerned if the asset goes up in FMV because that has no use in figuring out the cost of services of the asset.
Fair value and Historical cost
There is huge debate in the accounting world about Fair Value and Historical Cost as measurement attributes. I won’t get into the debate too much but I will mention an argument for Historical Cost, or at least try to argue for why Historical Cost has still remained as a relevant measurement attribute in GAAP accounting. The purpose of a long-lived, revenue generating, productive asset is simply that, to directly or indirectly aid in the production of revenue. This is the single biggest misconception that people have in regards to valuing this sort of asset. Accountants often ask why these assets are not valued using the Fair Value Method, the reason why is because the fair value of these assets at any given moment is completely useless as a measurement attribute. Ask yourself this question again, what is the cost of the Property, plant, and equipment represent? It represents the remaining potential economic benefit that we have left in the asset, it is the cost of the portion of the asset that is still to deliver its revenue generating capabilities.
When a company purchases a long-lived, revenue producing asset such as a company truck, they record the initial consideration which represents the potential future economic benefit valued at what they paid for it. The systematic and rational allocation of that cost to expense is not due to the loss of monetary value, but rather the decrease of future economic benefit due to usage. The older the trucks get, the more wear and tear we put on them, the lower the future economic benefit that we can expect from the asset, therefore we must allocate the cost of the trucks to expense. It is not simply the monetary value that is decreasing due to usage, it is the economic benefit that is decreasing and therefore what is being depreciated.
If the fair value of our company truck increases, the economic benefit derived from its usefulness does not increase with it. This is why the Fair Value Method as a measurement attribute is useless in valuing PPE.
Let me explain my argument. We have already talked about what the cost of a productive asset represents, in the case with our company truck, the cost represents its usefulness in generating revenue by being used for its intended purposes. You can add upgrades to the company truck to increase its usefulness, make it more reliable, or perhaps better suited for a specific revenue generating activity (such as adding a crane on top for construction projects, etc), this definitely increases its usefulness to the company and should be added to the cost basis to be depreciated along with the historical cost. In the midst of all this, imagine the truck increased in its fair market value (perhaps it had a one-off color, the specific model was sought after, or a pandemic happens that causes all used vehicles to increase in value), the mere appreciation in fair market value adds absolutely no usefulness to the truck in generating revenue. Sure, the company truck appreciated in its fair market value and there is economic benefit in that, however, this increase in fair value could be treated as a separate economic benefit, as a separate return on investment, separate from the return on investment we are getting for the usage of the asset. The point is, just because the truck appreciated in fair market value, does not mean that it is now more useful and is able to generate more revenue through its use.
There is sort of two different values in a appreciated productive asset, one value (historical cost) represents the cost of use we expect to derive out of the asset to generate revenue, the other value (fair value, although not accounted for) is more of an investment and is valued monetarily as opposed to usefulness. Again, the appreciation in fair market value does not increase the usefulness of a productive asset and the cost must be matched with the use generated from the asset.
Conclusion
Usefulness defined as the capability to generate revenue is the underlying value that is being depreciated quantified by the measurement attribute (historical cost).
The decrease in the measurement attribute (historical cost) is to quantify the decrease in the economic benefit of the productive asset through the use of it to generate revenue. Monetary value, as defined in the economictimes.com definition of depreciation, is not the correct way of thinking about what is actually decreasing.
