Definition and Explanation:
Depreciation is that part of the
original cost of a fixed asset that is consumed
during period of use by the business. The annual
charge to profit and loss account/income statement
for depreciation is based upon an estimate of how
much of the overall economic usefulness of a fixed
asset has been used up in that accounting period. It
is an expense for services consumed in the same way
as expenses are incurred for items such as wages,
rent or electricity. Because it is charged as an
expenses to the profit and loss account/income
statement, depreciation reduces net profit.
For example, if a PC cost $600 and
was expected to be used for three years, it might be
estimated at the end of the first year that a third
of its overall usefulness had been consumed.
Depreciation would then be charged at an amount
equal to one third of the cost of the PC, i.e. $200.
Profit would be reduced by $200 and the value of the
PC in the balance sheet would be reduced from $600
Using an example of a van and the
petrol it consumes, you can see that the only real
difference between the expense of depreciation for
the van and the expense of petrol incurred in order
to use the van, is that the petrol expense is used
up in a day or two, whereas the expense for use of
the van is spread over several years. Both are
expenses of the business.
Causes of Depreciation:
The causes of depreciation
can be divided up between physical deterioration,
economic factors, the time factor, and depletion.
These are briefly explained below:
Wear and Tear:
When a motor vehicle or machinery or fixtures and
fittings are used they eventually wear out. Some
last many years, others last only a few year. This
is also true of buildings, although some may last
for a long time.
Erosion, Rust, Rot and Decay:
Land may be eroded or wasted away by the action of
wind, rain, sun and other elements of nature.
Similarly, the metals in motor vehicles or machinery
will rust away. Wood will not eventually. Decay is a
process which will also be present due to the
elements of nature and the lack of proper attention.
These may be said to be the reasons
for an asset being put out of use even though it is
in good physical condition. The two main factors are
usually obsolescence and inadequacy.
This is the process of becoming out of date. For
example, over the years there have been great
progress in the development of synthesizers and
electronic devices used by leading commercial
musicians. The old equipment will therefore have
become obsolete, and much of it will have been taken
out of use by such musicians.
This does not mean that the
equipment is worn out. Other people may buy the old
equipment and use it, possibly because they cannot
afford to buy new up-to-date equipment.
This arises when an asset is no longer used because
of the growth and changes in the size of the
business. For example, a small ferryboat that is
operated by a business at a coastal resort will
become entirely inadequate when the resort becomes
more popular. Then it will be found that it would be
more efficient and economical to operate a large
ferryboat, and so the smaller boat will be put out
of use by the business. In this case also it does
not mean that the ferryboat is no longer in good
working order, nor that it is obsolete. It may be
sold to a business at a smaller resort.
The Time Factor:
obviously time is needed for wear
and tear, erosion, etc., and for obsolescence and
inadequacy to take place. However, there are fixed
assets to which the time factor is connected a
different way. These assents which have a legal life
fixed in terms of years. For instance, you may agree
to rent some buildings for ten years. This is
normally called a lease. When the years have passed,
the lease is worth nothing to you, us it has
finished. Whatever you paid for the lease is now of
A similar assert is where you buy a
patent so that only you are able to produce
something when the patent's time has finished it
then has no value.
Instead of using the term
depreciation, the term amortization is
often used for these assents.
Other assets are of wasting
character, perhaps due to the extraction of the raw
materials from them. These materials are then either
used by the business to make something else, or are
sold in their raw state to other businesses. Natural
resources such as mines, quarries and oil wells come
under this heading. To provide for the this
consumption for an asset of a wasting character is
called provision for depletion.