| One of the fundamental accounting principles is | | | | the year of purchase. The cost needs to be |
| matching revenue with cost in any period. This is | | | | segregated over its useful life and applied to the period |
| relatively simpler while dealing with items in cost of | | | | as a period expense. Sales revenue, recovers, in part |
| goods sold, such as purchase of raw materials, | | | | a charge for the use of the assets every time a |
| supplies, and cost incurred in conversion to finished | | | | product or service is sold. This is the underlying logic |
| goods for sale etc. But this becomes more complex | | | | for Depreciation as an expense. |
| while dealing with assets that have longer lives. There | | | | Land may depreciate in value, but has an indefinite life. |
| are two different types of fixed assets that a | | | | So depreciation is not calculated for land. |
| company invests in, tangibles and intangibles. Tangible | | | | The treatment of depreciation for intangibles is |
| fixed assets are assets such as Buildings, Plant and | | | | different. A company may have an amount for |
| equipment that have nearly definite lives. In most cases | | | | Goodwill in its asset list. Let us see how and why does |
| the value of the fixed assets also depreciates over | | | | goodwill arise? Let us say the company buys a |
| time. At the end of its useful life assets may have a | | | | business at $2M. Let us assume that the value of the |
| salvage value. This is true for plant and machinery but | | | | assets that are taken over is $1M. The excess of $1M |
| not for buildings. Although the value of the buildings | | | | over the asset value is termed as Goodwill. Goodwill |
| might increase from year to year, GAAP requires that | | | | has an indefinite life. So this is not amortized. At the |
| depreciation be calculated and accounted as an | | | | end of each year, an assessment is made of the |
| expense. | | | | remaining value of the goodwill for the business. The |
| A business invests in fixed assets to make and sell | | | | reduction in value is charged as an expense for the |
| products and/or services in its business. So, the cost | | | | period. |
| of the long term operating resource needs to be | | | | Depreciation although is simple in theory is extremely |
| allocated over the years these fixed assets are used. | | | | complex in its practical application. |
| One cannot charge the entire cost of fixed asset in | | | | |