Discuss the concepts of depreciation and amortization
FUNDAMENTAL CONCEPTS OF DEPRECIATION AND AMORTIZATION
Firms spread the acquisition cost of long-lived assets over their expected service lives,
Depreciation and Amortization: A Process of Cost Allocation
The acquisition cost of a long-lived asset is the cost of a series of future services. The asset is a prepayment, similar to prepaid rent or insurance, a payment in advance for services a firm will consume in the future. As the firm uses the asset in each accounting period, it treats a portion of the cost of the asset as the cost of the service received.
Long-lived assets benefit several accounting periods, so their cost is a joint cost of these accounting periods. Each of the periods of the asset's use benefits from its services. There is usually no single correct way to allocate a joint cost. Firms select a depreciation or amortization method for a long-lived asset that allocates the acquisition cost minus salvage value to each period of expected useful life in a systematic, predetermined manner.
Depreciation and Amortization: Not a Measure of the Decline in Economic Value.
Depreciation and amortization involve cost allocation, not valuation. In ordinary conversation and in economics, depreciation and amortization frequently mean a decline in value. Over the service life of a long-lived asset, the asset's value usually declines from acquisition until the firm retires it from service. The charge to each accounting period does not measure that decline in value, nor does it intend to. Depreciation and amortization represent a systematic process of cost allocation. If, in a given period, an asset increases in value, the firm still records depreciation and amortization during that period. In such a time period, there are two offsetting processes: (1) a holding gain on the asset for the increase in value, and (2) an allocation of the asset's acquisition cost to the period of benefit in the form of depreciation and amortization. U.S. GAAP precludes recognition of the holding gain. IFRS permits recognition of the holding gain under certain circumstances.
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