What is the Meaning and Definition of Depreciation?

Meaning and Definition of Depreciation

Depreciation is the systematic and rational allocation of the cost of an asset over its useful life. It is a method of accounting that is used to account for the decline in value of an asset over time, as a result of wear and tear, obsolescence or other factors. It is an expense that is recorded on the income statement, which reduces the value of an asset on the balance sheet over time. Depreciation is a non-cash expense, which means that it does not involve any cash outflow, but it reduces the value of the asset and it is used to match the expense of the asset to the income it generates, in order to produce accurate financial statements.

Causes of Depreciation

There are several causes of depreciation, including:

1. Physical wear and tear: Over time, assets such as machinery, equipment, and vehicles will experience physical wear and tear, which reduces their value.
2. Obsolescence: Advances in technology can make an asset obsolete, reducing its value and usefulness.
3. Economic factors: Economic conditions, such as inflation, can cause an asset to depreciate in value.
4. Changes in market conditions: A change in market conditions, such as a decrease in demand for a product or service, can cause an asset’s value to depreciate.
5. Environmental factors: Natural disasters, such as floods and earthquakes, can cause an asset to depreciate in value.
6. Depletion: Certain assets like mines and oil wells are depleted over time, reducing its value.
7. Legal and regulatory factors: Changes in laws or regulations can cause an asset to depreciate in value.

It’s worth noting that in accounting, Depreciation is an estimate, and the actual depreciation might be different from the estimated one. Depreciation methods are chosen based on how well they align with the expected economic use of the assets.

Need of Providing for Depreciation

The need for providing for depreciation arises from the fact that assets used in a business generally decline in value over time due to various factors such as wear and tear, obsolescence, and changes in market conditions. The decline in value of these assets is a cost that should be reflected in the financial statements of the business.

Providing for depreciation allows a business to match the expense of an asset with the income it generates over its useful life. This is important for producing accurate financial statements, as it allows a business to report its true financial position and performance. It also allows the business to maintain an accurate record of the value of its assets, which is important for tax, financial, and other purposes.

In addition, providing for depreciation is important for budgeting and forecasting, as it allows a business to plan for the replacement of assets as they reach the end of their useful lives. It also helps in making important decisions about the purchase, maintenance and disposition of assets.

Furthermore, providing for depreciation helps to maintain the liquidity of the business as it allows for spreading out the cost of an asset over its useful life, rather than incurring the entire cost in one year.

Accounting for Depreciation

Accounting for depreciation involves the process of allocating the cost of a tangible asset over its useful life and recognizing the decline in value of the asset in the financial statements. The cost of an asset is typically allocated through a systematic and rational method, such as the straight-line method or the declining balance method.

The process of accounting for depreciation typically involves the following steps:

1. Determining the cost of the asset: The cost of an asset includes the purchase price, as well as any additional costs incurred in acquiring the asset, such as freight and installation costs.
2. Estimating the useful life of the asset: The useful life of an asset is the period over which it is expected to be used by the business. This is typically estimated based on industry standards, or by considering the expected physical wear and tear, technological obsolescence, or other factors.
3. Choosing a method of depreciation: There are several methods of depreciation, such as straight-line, declining balance, units of production, sum of years digits, etc. The choice of method will depend on the nature of the asset and the company’s accounting policies.
4. Recording the depreciation expense: The depreciation expense is recorded in the income statement, and the corresponding reduction in the asset’s value is recorded in the balance sheet.
5. Reviewing the asset’s value: The value of an asset is reviewed periodically and any adjustments to the estimated useful life or residual value are made accordingly.

It’s worth noting that under the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) Depreciation is a systematic and rational allocation of the cost of an asset over its useful life, but the actual depreciation might be different from the estimated one. Depreciation methods are chosen based on how well they align with the expected economic use of the assets.

Various Methods of Deprecation with Example

There are several methods of accounting for depreciation, each of which has its own advantages and disadvantages. The most common methods include:

1. Straight-Line Method: The straight-line method involves dividing the cost of an asset by its estimated useful life to determine the annual depreciation expense. For example, a company purchases a piece of equipment for ₹ 100,000 with an estimated useful life of 10 years, the annual depreciation expense would be ₹ 10,000 (₹ 100,000 / 10 years).
2. Declining Balance Method: The declining balance method involves calculating depreciation at a fixed rate on the asset’s book value (cost minus accumulated depreciation). This method results in higher depreciation expense in the early years of an assets useful life. For example, a company purchases a piece of equipment for ₹ 100,000 with an estimated useful life of 10 years and a depreciation rate of 20%. In the first year, the depreciation expense would be ₹ 20,000 (₹ 100,000 x 20%).
3. Sum-of-the-Years-Digits (SYD) Method: The SYD method involves calculating depreciation as a percentage of the remaining life of the asset. The percentage is calculated by taking the sum of the digits of the estimated useful life and multiplying it by the cost of the asset, then dividing by the sum of the digits. For example, if a company purchases a piece of equipment for ₹ 100,000 with an estimated useful life of 10 years, the annual depreciation expense would be ₹ 9,000.
4. Units of Production Method: This method is used for assets that are used in production and are measured by the number of units produced. Depreciation is calculated by taking the total cost of the asset and dividing it by the total number of units expected to be produced over its useful life. For example, a machine that produces 10,000 units per year, and has a total cost of ₹ 100,000 with an estimated useful life of 10 years, the depreciation expense per unit is ₹ 0.01.

It’s worth noting that the choice of method will depend on the nature of the asset and the company’s accounting policies. Under the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) Depreciation is a systematic and rational allocation of the cost of an asset over its useful life, but the actual depreciation might be different from the estimated one. Depreciation methods are chosen based on how well they align with the expected economic use of the assets.