Question

Assume that you are the accountant for Computer Consultants. Prior to this year, Computer Consultants operated out of a leased office. However, the company purchased its own office building this year. The building is in an area where real estate values have been increasing an average of 6 percent per year.

The owner of Computer Consultants has asked why you recorded depreciation on the building if real estate values are appreciating. Write a response to the owner explaining why depreciation must be recorded on the company’s accounting records.

Answer 1

The following points must be explained to the owner:

1. Depreciation is accounted to record the wear and tear of the building due to use.

2. Depreciation is a way of accumulating cash for future use i.e. either for repairs, renewal or replacement of the asset.

3. Also, the realty prices do not stay the same always, they may increase or decrease depending on the market conditions and year's increase is not indicative of the future.

4. As per historical concept in accounting, all assets are recorded at their historical cost i.e. the acquisition cost and any subsequent increase or decrease of the asset is ignored and only depreciation is charged.

5. Taking in to consideration the prudence concept, any gains which have not materialized must not be recorded and only anticipated losses must be accounted for.

6. A revaluation of the asset can be done if the business feels necessary to reflect the true value of the asset and increase the value accordingly.