Depreciation is defined as the monetary value of an asset decreases over time due to use, wear and tear or obsolescence. It can also be described as a non-cash expense that reduces the value of an asset as a result of wear and tear, age, or obsolescence. Describing depreciation as ‘non-cash’, it means that depreciation is taken as an accounting entry and that the amount of cash held by the business is not affected. The opposite of depreciation is appreciation, which is increase in the value of an asset over a period of time. Business assets that can be depreciated include equipment, machinery, technology and computers, office furniture, buildings and improvements to buildings, leasehold improvements to rented property, and business vehicles. Land cannot be depreciated because it appreciates instead of depreciating.
Some of the different perspectives of depreciation are:
- In accounting, depreciation is the gradual conversion of the cost of a tangible capital asset or fixed asset into an operational expense (called depreciation expense) over the asset’s estimated useful life.
- In commerce, it is the decline in the market value of an asset.
- In economics, it is the decrease in the economic potential of an asset over its productive or useful life.
- In foreign exchange, it is the reduction in the exchange value of a currency, either by a government or due to weakening of the underlying economy in a floating exchange rate system; or simply put, a declinein the value of a given currency in comparison with other
Depreciation in an asset’s value may be caused by a number of other factors as well such as unfavourable market conditions, etc. Machinery, equipment, currency are some examples of assets that are likely to depreciate over a specific period of time. Depreciation is taken on business assets to recognise the change in value of these assets as they age. Assets depreciate for two reasons:
- Wear and tear.For example, an auto will decrease in value because of the mileage, wear on tires, and other factors related to the use of the vehicle.
- Obsolescence.Assets also decrease in value as they are replaced by newer models. Last year’s car model is less valuable because there is a newer model in the marketplace.
Most assets lose their value over time (in other words, they depreciate), and must be replaced once the end of their useful life is reached. There are several accounting methods that are used in order to write off an asset’s depreciation cost over the period of its useful life. Because it is a non-cash expense, depreciation lowers the company’s reported earnings while increasing free cash flow. According to Business Victoria (2008), fixed assets such as plant and machinery, computer hardware, tools of trade and motor vehicles are recognised as having a useful working life before becoming worn out or obsolete. The limited life of these assets is recognised by depreciating them over the estimated period of time they will be used productively. This means that the original cost is expensed or amortised over the number of years that it is earning income, instead of writing it off as a single cost at the time of purchase.
How depreciation is calculated
Depreciation is computed at the end of an accounting period (usually a year), using a method best suited to the particular asset. When applied to intangible assets, the preferred term is amortization. The objectives of computing depreciation are to:
- reflect reduction in the book value of the asset due to obsolescence or wear and tear;
- spread a large expenditure (purchase price of the asset) proportionately over a fixed period to match revenue received from it; and
- reduce the taxable income by charging the amount of depreciation against the company’s total income. In effect, charging of depreciation means the recovery of invested capital, by gradual sale of the asset over the years during which output or services are received from it.
Depreciation is calculated in various ways, but in general the process of calculating depreciation includes:
- The original cost of the asset, including costs of acquiring the asset, transporting it and setting it up
- Less the salvage value (the “scrap” value)
- Divided over the years of useful life (or working life expectancies) of the asset.
Different types of assets will have different working life expectancies. For example:
- a computer may become superseded in three years even though it is in perfect working order
- a motor vehicle may need to be changed over at three or five year intervals
- a manufacturing plant may work consistently for 10 or 20 years, if maintained correctly
In the balance sheet, these assets would be recorded at their historical cost, less a provision for depreciation, this figure being their current or written down value. Accounting depreciation is based on useful life, whereas tax depreciation is that specified in the depreciation schedule; the schedule may or may not be based on useful life. These schedules may vary from time to time depending on government economic policy. The underlying assumption of valuation is that a business is regarded as a going concern and assets reflect the current market value of the used asset. It does not reflect the realisation value that would be obtained if a forced sale of assets took place.
References
Economictimes (2017). Definition of depreciation. http://economictimes.indiatimes.com/definition/ depreciation
Murray, J. (2016). Depreciation and business taxes. https://www.thebalance.com/depreciation-and-business-taxes-updated-398220
WebFinance, Inc. (2017). Depreciation. http://www.businessdictionary.com/definition/depreciation .html
WebFinance, Inc. (2017). Depreciation. http://www.investorwords.com/1416/depreciation.html
