Depreciation is the reduction in the value of a fixed asset due to usage, wear and tear, the passage of time, or obsolescence.
The loss on an asset that arises from depreciation is a direct consequence of the services that the asset gives to its owner.
Therefore, a reasonable assumption is 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.
From an accounting perspective, depreciation is the process of converting fixed assets into expenses. Also, depreciation is the systematic allocation of the cost of noncurrent, nonmonetary, tangible assets (except for land) over their estimated useful life.
Depreciation is a systematic procedure for allocating the acquisition cost of a capital asset over its useful life.
Capital assets such as buildings, machinery, and equipment are useful 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 that 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., to offset the costs of the goods and services being consumed in an accounting period with the period’s revenue, thereby determining the profit or loss made by the business).
Depreciation accounting is a system of accounting that aims to distribute the cost (or other basic values) of tangible capital assets less its scrap value over the effective life of the asset. Thus, depreciation is a process of allocation and not valuation.
The expenditure on the purchase of machinery is not regarded as part of the cost of the period; instead, it is shown as an asset in the balance sheet.
The expenditure incurred on the purchase of a fixed asset is known as a capital expense. Capital expenditure is a fixed asset that is charged off as depreciation over a period of years.
The decisions that are made about how much depreciation to charge off are influenced by the accountant’s judgment.
To measure the depreciation of an asset, the following must be known:
- Cost of asset
- Estimated residual value
- Estimated useful life
The purchase price of an asset is its cost plus all other expenses paid to acquire and prepare the asset to ensure it is ready for use.
Estimated residual value is also known as the salvage value or scrap value. This is the expected value of the asset in cash at the end of its useful life.
When calculating depreciation, the estimated residual value is not depreciation because the business can expect 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 not to have residual value, the full cost of the asset is depreciated.
Estimated useful life is the number of years of service the business expects to receive from the asset.
Causes of Depreciation
The causes of depreciation include physical deterioration and obsolescence. An overview of the main causes is given below.
Assets decline in value due to use and wear and tear. All assets have a useful life and every machine eventually reaches a time when it must be decommissioned, irrespective of how effective the organization’s maintenance policy is.
An asset may become obsolete due to better designs, new inventions, or simply changing fashions. This may result in the asset being discarded even though it is still useful and in excellent physical condition.
An asset may be exhausted through work. This is the case for mineral mines, oil wells, and other similar assets. Due to the continuous extraction of minerals or oil, a point comes when the mine or well is completely exhausted—nothing is left.
Therefore, after a certain period, the value of the exhausted asset will be zero.
Efflux of Time
The value of certain assets falls with the passage of time. Leasehold properties, patents, and copyrights are examples of such assets.
Depreciation Is a Process of Cost Allocation
Depreciation is allocated over the useful life of an asset based on 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. Therefore, depreciation is a process of cost allocation—not of valuation.
Suppose that a company purchases a weighing machine for $1,000. After a year’s use, the value of the machine is assessed at $800.
In this example, we can say that the service given by the weighing machine in its first year of life was $200 ($1,000 – $800) to the company.
It is in this sense that depreciation is considered a normal business expense and, consequently, 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, and every day. It would, however, be impractical (and of no great benefit) to calculate and re-calculate the extent of this loss over short periods (e.g., every 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 ways to calculate depreciation. These are:
- Fixed installment method
- Reducing installment method
- Revaluation method