This article provides notes on the concept of depreciation in accounting.
Apportionment of depreciable amount of depreciable asset and charging the same to revenue during the useful life of that asset is known as depreciation. Apart from other factors which distinguish an accrual base accounting from cash base accounting is the depreciation. If an enterprise acquires some fixed assets, cash basis accounting would treat the whole amount for purchasing the asset as an expense for the year in which the assets have been purchased.
However, the accrual base accounting first capitalize the whole cost of assets and then apportion or allocate the depreciable amount over the accounting years during which the asset has been gainfully used. The apportionment of depreciable amount of the asset and charging the same into revenue during the useful life of the asset is known as depreciation. Through this process depreciation expenses can be matched with the revenue generated from the use of asset.
Every fixed asset, such as machines, motor cars, furniture etc. normally depreciates in value over a period of time, irrespective of regular repairs and efficient management. A possible exception is made in respect of land because it has an indefinite useful life and its value tends to increase over a period of time.
Depreciation is nothing more than the written off value of the cost of an asset over its useful life. In general life, we often say that a car has been depreciated in value because value of such a car has declined as compared to the value of other cars available with the latest technology in the current market.
However, from accounting point of view depreciation is not a method of valuation and approximating current values such as replacement cost or resale values but a process of allocation of cost over the period of useful life of an asset.
For ascertaining the true cost in any business operation, depreciable amount of the depreciable asset is to be allocated over its useful life in such a manner that only true and fair values of the asset is shown in the balance sheet of the business enterprise. Here, we have used three important terms such as ‘depreciable asset, ‘depreciable amount’ and ‘useful life’.
Now we shall move to discuss these terms in detail:
Depreciable amount is the allocated value of the acquisition cost of the depreciable asset over its useful life. In real sense, it is an excess of total acquisition cost of the depreciable asset over the estimated residual value of the asset.
Depreciable assets are those assets which are expected to be utilised by the enterprise for more than one accounting period. These assets have a limited useful life and held by the enterprise for use in the enterprise for production or supply of goods and services, giving assets to others on rent basis and/or for administrative purposes but not for the purpose of sale in the ordinary course by the business enterprise.
Useful Life of the asset is either:
(i) The period over which a depreciable asset is expected to be used by the enterprise or
(ii) The number of production or similar units expected to be obtained from the use of the asset by the enterprise.
It is worth mentioning that the useful life should not be confused with the physical life of the asset because may be an asset is physically available with the enterprise but it can not be used any more. So what is important is the useful life and not the physical life.
In other words, we can say that useful life is the economic life of an asset which is either the physical life of the asset before it wears out or the economic life of the asset before it becomes obsolete, whichever is shorter, because, due to rapid enhancement in software technology and decrease in cost of computers, many enterprises replace them much before they wear out physically.
In a nutshell the basic aim of providing the depreciation is to apply the matching principle. The matching principle offsets the revenue generated in an accounting period against the cost of goods and services which have been consumed for generating that revenue.
Other Related Concepts:
The term depreciation should not be confused with the terms ‘Depletion’ and ‘Amortization’. In this connection American Institute of Certified and Public Accountants (AICPA) states that “Depreciation can be distinguished from other terms with specialized meanings used by accountants to describe assets costs allocation procedures.
Depreciation is concerned with charging the cost of man-made fixed assets to operations (and not determination of asset values for the balance sheet). Depletion refers to cost allocation for natural resources such as oil and mineral deposits. Amortization relates to cost allocation for intangible assets such as patents and leaseholds.
Depletion is used in respect of natural resources such as oil, coal, timber and minerals etc. It is well known that these resources are limited in quantity and we cannot extract them up to infinite time. Value of these resources gets reduced or exhausted as we extract or remove these resources from their sources. In this context, a systematic apportionment and allocation of total acquisition cost of the natural resources over the periods in which revenue is contributed by such resources is called depletion.
Amortization is used in respect of intangible assets such as goodwill, trademarks, patents, copyrights and other intellectual property rights. These intangible assets have a limited useful life. So total acquisition cost of the asset should be allocated and apportioned over the periods during which the benefit is derived from them. In this context, a systematic apportionment of total acquisition cost is called amortization.