Is it true that as depreciation reduces profits and does not take cash out of business, it is a way of keeping cash inside the business to provide for the eventual replacement of the asset at the end of its life?

October 30th, 2010 Comments off
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It is wrong to think that way due to:

(a)    By charging depreciation on fixed assets, it does not mean that a business will set aside the same amount of cash in a bank account to provide for the replacement of the asset. It is important to understand that depreciation is NOT a way of saving for replacement assets

(b)   Depreciation merely allocates the purchase cost of a fixed asset over its life. At the end of its life, the asset might cost more to replace( because of inflation) or it might not be replaced at all, because a similar new asset might not be worth having. Note that even when a fixed asset will not be replaced, its purchase cost should still be charged as depreciation to accounting periods over its life.

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Financial Accounting

 
 

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