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business, Joe may decide that he can help out some customers—as well as earn additional
revenues—by carrying an inventory of packing boxes to sell. Let's say that Direct Delivery
purchased 100 boxes wholesale for $1.00 each. Since the time when Joe bought them,
however, the wholesale price of boxes has been cut by 40% and at today's price he could
purchase them for $0.60 each. Because the replacement cost of his inventory ($60) is less
than the original recorded cost ($100), the principle of conservatism directs the accountant to
report the lower amount ($60) as the asset's value on the balance sheet.
In short, the cost principle generally prevents assets from being reported at more than cost,
while conservatism might require assets to be reported at less then their cost.
Depreciation
Joe also needs to know that the reported amounts on his balance sheet for assets such as
equipment, vehicles, and buildings are routinely reduced by depreciation. Depreciation is
required by the basic accounting principle known as the matching principle. Depreciation is
used for assets whose life is not indefinite—equipment wears out, vehicles become too old and
costly to maintain, buildings age, and some assets (like computers) become obsolete.
Depreciation is the allocation of the cost of the asset to Depreciation Expense on the income
statement over its useful life.
As an example, assume that Direct Delivery's van has a useful life of five years and was
purchased at a cost of $20,000. The accountant might match $4,000 ($20,000 ÷ 5 years) of
Depreciation Expense with each year's revenues for five years. Each year the carrying amount
of the van will be reduced by $4,000. (The carrying amount—or "book value"—is reported on
the balance sheet and it is the cost of the van minus the total depreciation since the van was
acquired.) This means that after one year the balance sheet will report the carrying amount of
the delivery van as $16,000, after two years the carrying amount will be $12,000, etc. After five
years—the end of the van's expected useful life—its carrying amount is zero.
Joe wants to be certain that he understands what Marilyn is telling him regarding the assets on
the balance sheet, so he asks Marilyn if the balance sheet is, in effect, showing what the
company's assets are worth. He is surprised to hear Marilyn say that the assets are not
reported on the balance sheet at their worth (fair market value). Long-term assets (such as
buildings, equipment, and furnishings) are reported at their cost minus the amounts already
sent to the income statement as Depreciation Expense. The result is that a building's market
value may actually have increased since it was acquired, but the amount on the balance sheet
has been consistently reduced as the accountant moved some of its cost to Depreciation
Expense on the income statement in order to achieve the matching principle.
Another asset, Office Equipment, may have a fair market value that is much smaller than the
carrying amount reported on the balance sheet. (Accountants view depreciation as an
allocation process—allocating the cost to expense in order to match the costs with the
revenues generated by the asset. Accountants do not consider depreciation to be a valuation
process.) The asset Land is not depreciated, so it will appear at its original cost even if the land
is now worth one hundred times more than its cost.
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