Economic depreciation


As for the problem below, since it was impaired and it has been depreciated for the past 3 years. the depreciation should be overstated, why understated?


Lakeside Co. recently determined that one of its processing machines has become obsolete three years early and, unexpectedly, has no salvage value. Which of the following statements is most consistent with this discovery?

A) Historically, economic depreciation was overstated. B) Lakeside Co. will owe back taxes. C) Historically, economic depreciation was understated.

Your answer: A was incorrect. The correct answer was C) Historically, economic depreciation was understated.

Historically, economic depreciation was understated. If an asset becomes obsolete and its useful life is less than expected, accounting methods for depreciation have understated the economic depreciation. In addition, if there is no salvage value when positive salvage value was expected, the understatement problem is compounded.

If depreciation was recorded as $100k for 10 years, for a machine purchased for $1 million, but then you discover that you should have given it only 7 years life, then you should have recorded depreciation as $1 million/7 = $142k every year…thus you understated your recorded depreciation.