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What is depreciation?

Definition

Depreciation may be defined as a fall in the value of a fixed asset due to usage, wear and tear, passage of time or obsolescence. The loss is clearly a direct consequence of the services an asset gives to its owner. It would, therefore, be quite in order to assume that “the loss in the value of a fixed asset in a period is the worth of the service provided by that asset over that period”.

or

Depreciation is a diminution in the value of assets due to wear and tear and obsolescence. Depreciation is a procedure for allocating the cost of a long-lived asset over its useful life. It is an accounting process of conversion of fixed assets into expense.

Explanation

Depreciation is a systematic procedure for allocating the acquisition cost of a capital asset over its useful life. Capital assets such as building, machinery and equipment are of use to a company for a limited number of years. The entire cost of a capital asset is not charged to any one year as an expense; rather the cost is spread over the useful life of the asset. Thus, the cost of the asset is charged as an expense to the periods that benefit from the use of the asset.

The part of the cost which is charged to operation during an accounting period is known as depreciation. Hence, the objective of depreciation is to achieve the matching principle i.e, offset the costs of the goods and services being consumed in an accounting period with the revenue of the same period so as to arrive at the profit or loss made by the business.

Depreciation Accounting


Depreciation Accounting is a system of accounting which aims to distribute the cost or other basic values of tangible capital assets less its scrap value over the effective life of the asset. The expenditure on the purchase of machinery will not be considered as part of cost of the period but will be shown as an asset in the Balance Sheet.

The expenditure incurred on the purchase of fixed asset is known as capital expenditure. The capital expenditure is a fixed asset which is charged off over a period of years as depreciation. The decision of how much depreciation is changed off as depreciation is influenced by the accountant’s judgment.

The depreciation accounting is a system of accounting which aims to distribute the cost or other basic value of tengible capital asset, less scrap if any over its effective life. Thus depreciation is a process of allocation and not of valuation.

Measuring Depreciation

To measure the depreciation of an asset, we must know its cost, its estimated residual value and its estimated useful life.

Cost of an Asset

The purchase price of the asset is its cost plus all other expenses paid to acquire and include the asset so that it is ready for use estimated residual value is also known as the salvage value or scrap value. This is the expected cash value of the asset at the end of its useful life.

In calculating depreciation, the estimated residual value is not depreciation because the business expects to receive this amount from selling off the asset. The cost of the asset minus its residual value is called the depreciable cost of the asset. The depreciable cost is allocated over the useful life of the asset. However, if the asset is expected to have not residual value. The full cost of the asset is depreciated. Estimated useful life is the number of years of service the business expects to get from the asset.

Causes of Depreciation

The cause of depreciation is physical deterioration and obsolescence.

Physical deterioration

Assets decrease in their value due to constant use and wear and tear. All assets have a useful life and every machine eventually reaches a point when it must be discarded, however good the repair policy of the organization is.

Obsolescence

An asset may become obsolete because of better designs, new inventions simply changed fashions. This may result in the asset being discarded even though it is still useful and in excellent physical condition.

Exhaustion

An asset may get exhausted through working. This is the case with minerals mines, oil wells, etc. On account of, continuous extraction of minerals or oil, a stage comes when the mine or well gets completely exhausted and nothing is left. Thus, after a specific period, the value of washing asset will be zero.

Efflux of time

Certain asset’s value goes down with the passage of time. The following are the assets where it is applied: leasehold properties, patents or copyrights.

Depreciation is a process of cost allocation

Depreciation is allocated over the useful life of the asset on the basis of the book value of the asset originally entered in the books of accounts. The market value of the asset may increase or decrease during the useful life of the asset. However, the allocation of depreciation in each accounting period continues on the basis of the book value without regard to such temporary changes. Also, depreciation expense is merely a book entry and represents a “non-cash” expense. thus, depreciation is a process of cost allocation, not of valuation.

Example

For example, if a company buys a weighing machine for $1,000 and after a year’s use its value is assessed at $800, it can be said that the service given by this machine in its first year of life was $200 ($1,000 – $800) to the company.

It is in this sense that the depreciation is considered a normal business expense and treated in the books of account in more or less the same way as any other expense.

Fixed assets lose value throughout their useful life, every minute, every hour, every day of it. It would, however, be impractical and of no great benefit ascertain the extent of this loss in value over short periods like a day, or a weak, or even a month. As business accounts are usually prepared on an annual basis, it is common to calculate depreciation only once at the end of each financial year.

Methods of calculating depreciation

There are three popular methods of calculating depreciation. These are:

  1. Fixed installment method
  2. Reducing installment method
  3. Revaluation method

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