Definition of depreciation, facts and causes

The word ‘Depreciation’ has been derived from the Latin word ‘Depretium’ which means ‘decline in price’ or ‘value’. Depreciation relates to fixed assets which loose value on account of usage. Therefore ‘Depreciation’ means decline in value of fixed assets on account of usage.

Definitions:

Depreciation may be defined as the permanent and continuing diminution in the quality, quantity or the value of an asset.William Pickles

Depreciation in the shrinkage in the value of an asset at a given date as compared with its value at a previous date.J.H. Burton

Facts about depreciation;

1.Depreciation is part of the operating cost

2.It is a reduction in the value of an asset

3.The decrease in the value of an asset is due to its use, caused by wear and tear or any other reason

4.The decrease in the value of an asset is gradual and continuous.

Causes of Depreciation:

1.Physical wear and tear

The most important fact that contributes to depreciation of an asset is the physical wear and tear resulting from its use. It reduces the future capacity of the asset to serve and its earning power. As a result, it reduces the value of an asset. A tangible asset physically deteriorates by wear and tear caused from vibration, friction, movement, strain, erosion etc.

2.Physical deterioration

In case of majority assets, the deterioration takes place with sheer passage of time. The assets are exposed to elemental forces of nature such as winds, weather etc.

3.Expiry of legal rights

Certain assets like patents, lease and licences, depreciate with the passage of time.

4.Fall in value due to demand fluctuations.

Sometimes, the demand for services provided by the assets may fluctuate which causes a fall in the value of an asset.

5.Obsolescence

Depreciation may be caused on account of obsolescence. It may be due to technological development in asset, technique of production or product.

Objects of Depreciation:

1.To ascertain true profit or loss

Ascertainment of true profit or loss is not possible without providing for depreciation as the loss in the value of assets also goes towards earning of the income. Therefore, depreciation should be considered as an expenditure to earn the revenue and charged to profit and loss account. Only then, true profit or loss can be ascertained.

2.To present a true financial position.

A balance sheet is supposed to exhibit a true and fair financial position of the concern. That means the fixed assets must be shown at their proper value to the business as a going concern. True value would be the cost less the amount that is lost by the way of wear and tear ie. Depreciation on account of use of assets in the period. This reduction in the value is estimated and is charged as a loss to the profit and loss account every year.

3.Replacement of asset

The gradual reduction or decline in the value of asset lead to a point of time when the asset has no value. It cannot be used. It needs to be scrapped and replaced by another asset of similar type. At such time, it becomes essential to purchase another asset or of similar type or right in such asset and pay for the same.

Depreciation aims to provide for such contingency too.

a.Charging a fixed amount to profit and loss account as depreciation each year

b.To invest such amount in security or policy every year, and the interest received is also invested in securities.

c.At the time of replacement, investments are disposed off, amount is realized and utilized to pay for new asset.

4.Assessment and allocation of Depreciation

Assessment and allocation of periodic depreciation usually rest on the depreciable asset’s a) Original cost, b) estimated residual value, c) expected useful life.

a.Original cost

It represents the historical cost as well as additions and improvements if any.

b.Estimated residual value

It is the amount likely to be realized on the disposition of asset as a scrap.

c.Useful life

It refers to depreciable asset’s effective service, expressed in periods to the organization.