What is meant by Depreciation?

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Depreciation simply means a steady decrease in the value of asset. Often it is studied in relation to the time period over which such decrease in the value has occurred. Therefore, often it is also defined as the value lost by the asset over its useful life i.e. the time period for which it was subjected to use.

The following discussion is a bit detailed in technical in nature on depreciation. If you prefer simpler version of What is depreciation then click here

Important
Close to Depreciation, another concept is of Impairment.

Depreciation is a decrease that stays even over a period of time i.e. if observed at equal intervals, it will form a continuous rather predictable pattern as oppose to impairment which is abrupt, one off and not continuous in nature.

Straight-line method is one easy to understand example. Even under reducing balance method the rate of depreciation stays constant! Simply put, depreciation is a gradual decrease over a period of time instead of one-time decrease.

At very initial level of accounting, concept of depreciation is also taught in terms of difference between the cost incurred and residual value obtained. For example if an asset was acquired for Rs.10,000 and after few years sold for Rs. 3,000 then the decrease of Rs. 7,000 is called depreciation.

Assets loose their value not only because of deterioration as result of usage even though it is one of the biggest reasons for depreciation but there are other causes as well in which depreciation will occur.

Factors or causes of depreciation

The devaluation of asset or depreciation is caused by many factors such as:

  • Physical loss
    • Usage: wearing out of asset due to its intended use in business to obtain products or to support in service provision
    • Perishability, weathering, rusting: natural characteristics of the product making it impossible to store the asset or it loses its physical structure at chemical level due to certain factors.
    • Accident: A mishap causing assets to render lesser than original benefits.
  • Technological advancement
    • Extinction: no longer in fashion
    • Inappropriateness: with other options available, asset is no longer attractive.
  • Expiry: right to use has expired over time
  • Exhaustion: for example mines and wells where asset loses its value as a result of extraction of minerals

Depreciation in context of accounting and accounting standards

In accounting, the concept of depreciation is studied in context of non-current assets i.e. assets with useful life of more than one year. Under normal situations it is understood that almost every asset will loose its value over its life as a result of use and/or factors as discussed above therefore depreciation will be there. However, financial statements are prepared after a particular stretch of time which is mostly one year. Therefore, preparation of financial statements with complete information and to be relevant and reliable require an approach through which we can systematically ascertain the value which asset would have lost during a specific accounting period. This is where depreciation methods comes in which are basically systematic approaches of estimation and helps us in estimating the amount of depreciation from one accounting period to the other.

Depreciation in International Accounting Standard (IAS) 16 – Property, Plant and Equipment

According to IAS 16 the term depreciation has been defined as:

the systematic allocation of the depreciable amount of an asset over its useful life.

In financial accounting, or to be specific, in financial statements we have to use systematic basis for the computation of depreciation as Accounting standards like IFRSs, GAAPs and FRSs etc require it. Another reason is that use of systematic basis allows the user to understand how a particular asset will be reduced in the financial statements. This helps in them in making economic decisions regarding entity.

Remember
IAS 16 has defined depreciation in terms of systematic allocation is that in financial statements depreciation is the amount of expense which is recognized in financial statements. Therefore, a general definition of ‘decrease in value’ will leave the room of confusion. Thus it narrowed down the discussion of depreciation to depreciation methods and then restricting further only those methods which allow systematic allocation of cost or depreciable amount of asset. In other words you can say that IAS 16 describes the depreciation as process rather than as a concept.

Under International Accounting Standards IAS 16, only few depreciation methods has been named which are as follows:

  • Straight-line method
  • Reducing balance method
  • Units of production method

However, depreciation methods are not limited only to these three. Other examples include; sum of years digits method, machine hours method etc.

Even IAS 16 allows us to use any depreciation method which can or cannot be the one named under international accounting standards but IAS 16 para 60 requires that:

The depreciation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.

Fulfillment of the above condition will not make it more logical but also help in fulfilling matching principle which is another essential requirement under international accounting standards i.e. the depreciation charge should be made in the same period in which economic benefits from the asset have been obtained.

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