The word “depreciation” has been derived from the Latin word ‘depretium’ in which 'De' means to decrease and 'premium' refers to the price or value. Depreciation may be defined as the loss or diminution of the value of assets due to wear, tear, natural causes, obsolescence, and expiry of time, depletion and decrease in market value. It must be accounted on the firm’s books of account. Depreciation is usually practiced in case of fixed assets. Decrease in the value of assets due to its continuous use is called depreciation.
Depreciation is a non-cash expense and must be charged as revenue expenditure to ascertain the true income of a business organization. Only in a few cases, fixed assets may appreciate. The most suitable example of appreciation is an land.
“Depreciation is gradual and permanent decrease in the value of an asset from any cause.”- R.N. Carter
Features of depreciation
Depreciation is decreased in the value of assets.
Depreciation is the exhaustion of the effective life of business.
Maintenance of assets is not depreciation.
Decrease in value should be gradual and continuous.
Depreciation is non-cash expenses.
Depreciation is allowable expenses for tax purpose.
Causes of depreciation
The main reasons for depreciating fixed assets are as follows:
Physical wear and tear: When the assets are continuously used, the value of assets decreases. Such decrease in the value of assets is said to be due to physical wear and tear.
Expiry of time: The value of assets may decrease even if they are not in use. Such assets are decreased when they are exposed to the force of nature like weather, winds, rains and so on.
Exhaustion: The value of natural resources like mines, minerals, oil field, etc. decreases due to a continuous extraction of mineral and oil. This type of reduction in value of assets is also called depreciation.
Obsolescence:The obsolescence of assets is the decline in usefulness. Due to new inventions and technological change, old assets may have to disposed of even though they are capable of operation.
Change in an economic environment: Decrease in the demand for assets may decrease the value of assets.
Other: Accident, permanent fall in the market price, legal requirement, regular use of the assets are some other causes of depreciation.
Factors affecting depreciation
The factors affecting depreciation are as follows:
The cost of the assets:It includes the purchase price, carriage expenses, customs duty, installation expenses which are incurred till the assets become operational. So, these expenses should be taken while calculating depreciation of assets which is known as original cost.
Expected usefulness of assets: Expected usefulness of assets affects the amount of depreciation. It is the estimated working life of the assets. If the assets are useful for short, the amount of depreciation will be more and vice-versa.
Scrap value: It is also called salvage value or breakup value. Scrap value is the value of the assets at the end of its useful life at which the assets will be disposed off for some amount.
Legal provision: Legal provision affects the amount of depreciation. There are various rules, rate and methods of charging depreciation in Company Act and Income Tax Act.
Advantage for providing depreciation
The various advantages for providing depreciation are as follows:
It is compulsory to charge the amount of depreciation to determine the actual profit and loss of the business during the particular period.
Depreciation helps to show the real value of the assets for a correct financial position of the business.
Depreciation helps to generate sufficient fund to replace the old assets.
According to the Company Act 2063, the depreciation is charged to fulfill the legal requirement of the business organization.
Methods of allocating depreciation
The following are the methods of allocating the depreciation of fixed assets: