Operating Assets and Problems Under the Cost Allocation Approach

Written by True Tamplin, BSc, CEPF®

Updated on March 29, 2022

Depreciation is based on the cost allocation concept because of the unreliability of interim measures of value. This use of an approximation causes several problems, four of which are discussed below.

Actual Life Exceeds Estimated Life

Since depreciation allocates the full amount of the depreciable base over an estimated life, it is fairly common for firms to still own and operate an asset beyond its projected life.

If the misjudgment is found sufficiently early, a change can be made as described above. If that discovery is not made, the fully depreciated asset should be carried on the books at salvage value (if any).

In other words, no entry should be made to remove either the asset’s cost or its accumulated depreciation until it is sold.

Salvage Value Exceeds Original Cost

In a period of changing prices or for an operating asset with a long life (particularly a building), it is possible for the future salvage value to exceed the original cost. The theoretically proper treatment would result in simply not depreciating the item.

However, common practice calls for assigning a salvage value below cost and computing depreciation normally. This problem would not exist if the accountant decided that depreciation was to be charged based on changes in market value.

Book Value Differs From Fair Value

One of the major results of systematic cost allocation is that there is likely to be a difference between the asset’s book and the fair value.

If the fair value exceeds the book value, the generally accepted treatment ignores the difference. By contrast, if the fair value is less than the book value, there is some uncertainty as to whether the book value should be written down.

While no pronouncement calls for write-downs, that practice is used elsewhere in accounting (i.e., in inventory and investments). A write-down should not take place until the asset is worthless.

GAAP excludes operating assets from its requirements for recording probable impairments of value. Accordingly, it can be concluded that the assets should not be written down unless their fair value is permanently and significantly below book value.

Interrupted Service

When an asset is temporarily taken out of service, a question arises as to whether it should continue to have its cost allocated to the time period.

If the depreciation method was adopted to match the costs directly with revenues, the recognition of depreciation expense should be discontinued.

However, if it was decided that the asset loses value as time passes regardless of whether it is used, then depreciation should continue during the interruption. There is no apparent consensus in practice, and no authoritative statements have been given.

Operating Assets and Problems Under the Cost Allocation Approach FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.