The underlying principle of depreciation is that profits would be overstated if

Question

The underlying principle of depreciation is that profits would be overstated if no allowance were made for the replacement of the asset. Therefore, periodic depreciation expense segregates a portion of earnings for reinvestment, “protecting” that sum from being distributed as dividends and taxes. Should this be interpreted to mean that money equivalent to the periodic depreciation expense is set aside and earmarked for investment in replacement assets?

A. Yes. Since income tax expense and income tax payable are lower because of the depreciation deduction, money is set aside for asset replacement.

B. Yes. Since lower earnings “protect” amounts from being paid out as dividends, money is set aside for asset replacement.

C. No. This should not be interpreted in the literal sense, but rather that the definition of income requires a subtraction for asset replacement.

D. No. Only the tax-effected amount of the annual depreciation charge is set aside for asset replacement

Explanation / Answer

B. Since lower earning protect amounts from being paid out as dividends money is set a side for asset replacement

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