If a piece of equipment is going to provide value for twenty years, then should it not be depreciated over this period? An alternative perspective might suggest that in most industries new technology will render most equipment obsolete long before twenty years and so a shorter time frame is more appropriate. And so the interpretation and judgment calls continue!
It is important to keep in mind that depreciation is not about reflecting the value of the asset; depreciation is the allocation of cost. Assets are rarely worth the same as their balance sheet value. Remember, accounting is transaction-based. Something was bought (a transaction) and now the amount that we paid is allocated to the periods during which the asset will be used.
When there is a significant difference in asset and market values, auditors may revalue an asset in the accounts but this happens less frequently than you might imagine. To begin with, the auditors would have to have an awareness of the market values and be prepared to spend the time – and time is money!
Many companies specialize in identifying companies with undervalued assets – the balance sheet value is below the market value. In some cases, there is more money, at least in the short-term, in closing down a company and selling off its assets (asset stripping). (From a bookkeeping perspective, if assets are disposed of at a higher value than that recorded in the Balance Sheet, then the difference is posted to an Asset Realization account and the depreciation entries reversed.)
Amortization is the depreciation of an intangible – that is, an asset that doesn’t have a physical presence. Examples include patents, copyrights and goodwill. We will explore this further when we look at the Statement of Financial Position (Balance Sheet).