Financial Accounting: In an Economic Context

COST ALLOCATION: AMORTIZING CAPITALIZED COSTS

Once the cost of a long-lived asset has been determined, it must be allocated over the asset's useful life. Such allocation is necessary if the costs are to be matched against the benefits produced by the asset. The allocation process requires three steps: (1) estimate a useful life, (2) estimate a salvage value, and (3) choose a cost allocation (depreciation) method.

Estimating the Useful Life and Salvage Value

Accurately estimating the useful life and salvage value of a long-lived asset is extremely difficult. An important consideration is the physical obsolescence of the asset. At what time in the future will the asset deteriorate to the point when repairs are not economically feasible, and what will be the asset's salvage value at that time? It is virtually impossible to predict accurately the condition of an asset very far into the future, let alone predict the salvage value, the dollar amount that can be recovered when the asset is sold, traded, or scrapped.

Robert Olstein, a veteran accounting expert, once noted, “Beware of companies that overestimate how much their fixed assets will be worth down the road. Optimistic assumptions allow a company to reduce the amount of depreciation it reports.” Explain what he means. Who is he warning and why?

The problem of predicting useful lives and salvage values is complicated further by ...