Financial Accounting Depreciation | The Conceptual Framework

The Conceptual Framework: Depreciation
Rationalization of depreciation
Depreciation is the decrease in the value of assets or fair value depreciation. Depreciation may be rationalized from an ‘income and expense' view of conceptual primacy.In the ‘revenue and expense' view of conceptual primacy, income is the difference between outputs from and inputs to the earning activities of an enterprise during a period that is primarily defined in terms of its revenues, which are appropriately recognized, and expenses, which are either systematically or appropriately and rationally allocated to reporting periods in ways that do avoid income distortion (Carmichael & Graham 2012).

This involves the use of matching principle, where there is proper matching of costs and revenues using historical cost concept. Depreciation normally moves the cost of an asset to depreciation expense in the course of the useful life of the asset. As an expense, depreciation reduces the net income on the income statement, but it does not reduce the cash account in the balance sheet. The ‘income and expense' view can, therefore, rationalize the depreciation by the use of historical-cost accounting.

Rationalization of depreciation using ‘Asset and liability’ view of income

Depreciation may be rationalized from an ‘Asset and liability’ view of conceptual primacy. Assets have a ‘conceptual primacy’ in IASB and FASB frameworks. Since depreciation is the decrease in the value of assets leading to an increase in liability, it can be well rationalized by the ‘asset and liability’ view. Just as fair value is used in measuring depreciation, this view recognizes all assets and liabilities at their current prices or fair value in order to show the current value of an entity and this show that depreciation may be rationalized from this view (Carmichael & Graham 2012).

“Revenue and expense’ vs. ‘asset and liability' views of income and how they apply in depreciation

The current international accounting such as FASB that deals with depreciation has adopted the ‘asset and liability' view as it appropriately anchors the standard-setting process through the provision of the strongest conceptual mapping to the underlying economic reality (Carmichael & Graham 2012). The ‘revenue and expense' view does not define vital concepts such as revenues, incomes, expenses, appropriate matching as well as distortion of periodic net income, and this makes the view to be completely subjective. The ‘revenue and expense’ view could also not fulfill the functions of concepts having primacy, which are the concepts used in the definition of other concepts.  The ‘revenue and expense' view does not also provide a proper matching of costs and revenues, which may lead to the distortion of the periodic net income. The primary focus of including depreciation in financial reporting is to present the performance of a company through the measurements of its earnings and its components. The adoption of the ‘asset and liability’ view was to impose some kind of current value in accounting for depreciation where depreciation could be accounted based on its current value. 
The “qualitative characteristics” by IASB's Conceptual Framework

The ‘qualitative characteristics' by IASB's Conceptual Framework is quite useful as it helps in assessing which of the two rationalization of depreciation makes sense. The ‘qualitative characteristics' sets a number of accounting information qualities that make accounting information useful to its users when it comes to making economic decisions. The ‘qualitative characteristics' emphasize on the relevance and reliability of financial information, which are differently provided for in the two rationalization view of depreciation. The ‘qualitative characteristics' questions the trade-off between relevance and reliability and historical costs by ‘income and expense’ view are favorable over fair values by the ‘asset and liability’ view. Reliability should be the dominant characteristic of financial statements as it shows the economic reality or the current value of the entity and, therefore, the need to make use of fair values hence the ‘asset and liability' view (Carmichael & Graham 2012).  The reliability of accounting information is normally at stake if the statements do not conform to economic reality.