On the basis of the Fundamental Accounting Assumption of Going Concern, assets are classified as Fixed Assets and Current Assets. Fixed assets are used in the business to drive benefits for more than one accounting period. Periodic profit is measured by charging cost against periodic revenue.
Since fixed assets are used to generate periodic revenue, an appropriate proportion of the cost of fixed assets, which is believed to be used or expired for the generation of periodic revenue, needs to be charged as a cost. Such an appropriate proportion of the cost of fixed assets is termed as Depreciation.
Generally, the term ‘depreciation’ is used to denote a decrease in value but in accounting, this term is used to denote a decrease in the book value of a fixed asset.
Depreciation is the permanent and continuous decrease in the book value of a fixed asset due to use, effluxion of time, obsolescence, expiration of legal rights or any other cause.
According to the Institute of Chartered Accountants in England and Wales, ‘Depreciation represents that part of the cost of a fixed asset to its owner which is not recoverable when the asset is finally out of use by him. Provision against this loss of capital is an integral cost of conducting the business during the effective commercial life of the asset and is not dependent on the amount of profit earned.’
Depreciation is not the result of fluctuations in the value of fixed assets since the fluctuation is concerned with the market price of the fixed asset whereas the depreciation is concerned with the historical cost.
An analysis of the definition given above highlights the characteristics of depreciation as follows:
- It is related to Depreciable fixed assets only.
- It is a fall in the book value of a depreciable fixed asset.
- The fall in the book value of an asset is due to the use of the asset in business operations, effluxion of time, obsolescence, expiration of legal rights or any other cause.
- It is a permanent decrease in the book value of an asset.
- It is a continuous decrease in the book value of an asset.
Comprehensively, the term ‘Depreciation’ covers Depletion, Amortization and Obsolescence.
The term ‘Depletion’ refers to the physical deterioration by the exhaustion of natural resources (ore-deposits in mines, oil wells, quarries, timber stands etc.).
The term ‘Amortisation’ refers to the economic deterioration by the expiration of intangible assets (patents, copyrights, goodwill etc.).
The term ‘Obsolescence’ refers to the economic deterioration by
(a) invention of improved technique or equipment
(b) market decline due to change in taste and fashion etc.
(c) inadequacy of existing plant to meet the increased business.