Question

In a recent newspaper release, the president of Wanzo OAO asserted that something has to be done about depreciation. The president said, “Depreciation does not come close to accumulating the cash needed to replace the asset at the end of its useful life.” What is your response to the president?

Answer 1

I agree with the President's view “Depreciation does not come close to accumulating the cash needed to replace the asset at the end of its useful life. We need to explain it to the president that depreciation is a process of allocating the cost of an asset in the form of annual wear and tear to the profit & loss account over its useful life. At no point, recognition of depreciation is intended to result in the accumulation of cash for replacement of the asset.Depreciation is a non cash expenditure and is added back to profit while calculating cash flow.

Instead, the company can do one thing that is the creation of some fund named as "Assets replacement fund" where the company can transfer annually an amount equal to depreciation. This will ensure the company to have enough fund at the time of replacement of assets.