In a recent newspaper release, the president of Keene Company asserted that something has to be done about depreciation. What might a response be?
The president said “Depreciation does not come close to accumulating the cash needed to replace the asset at the end of its useful life.”
The concept of depreciation is used in accounting to manage assets that are bought by a firm but their use is not restricted to the accounting period in which they were purchased; instead they are used over an extended duration of time.
When an asset is bought there is a cash outflow. The depreciation of assets is an expense without an accompanying cash flow, there is no cash inflow associated with depreciation.
The president should be told that it is incorrect to treat depreciation as a cash inflow that is meant to generate a corpus to enable a repurchase of the asset after its useful life. Methods adopted in calculating depreciation are neither dependent on how the market value of the asset changes nor on what its market value is when it has to be replaced.