DEPRECIATION — MEANING, CAUSES AND TERMINOLOGIES

Generally, fixed assets over time lose their ability to provide services due to various factors such as wear and tear.

This is the reason why they are depreciated.

Depreciation is defined as the value of an asset that is lost during a specific period.

Depreciation is the systematic allocation of the depreciable value of an asset over its useful life.

It's the process of allocating the cost of a fixed asset to the accounting periods in which it'll be used.

Depreciation can also be defined as the portion of a fixed asset that is consumed during its period of use by a company.

Depreciation is defined as the continuous diminution in the quality, quantity or value of an asset from any cause whatsoever.

Depreciation of a tangible asset is defined by the International Accounting Standard (IAS) 16 as "the systematic allocation of the depreciable amount of an asset over its life."

Causes Of Depreciation Of Assets

Depreciation of most assets is caused by one or all of the following:

1. Wear and tear of the asset: This is one of the commonest forms of depreciation of the asset. 

Generally, the more assets are employed in the production of goods and services, the less productive and effective they become.

With every use of the asset for production, the technical capacity of the asset decreases resulting in a decrease in the value of the asset.

It may even get to the point where the asset must be sold (scrap value).

2. Time factor: Even if an asset isn't being used in production, it will depreciate with time.

For example, the wood of the furniture of a company will eventually be decayed, even if it is left without use for a long period.

As another example, the metal in a motor vehicle will rust eventually even if it is abandoned.

It does not matter the condition of the asset. It does not matter if the asset is moderately or intensely used in production. Age and time factors will always cause the asset to depreciate.

However, it is important to note that the extent to which an asset is affected by the passage of time is highly dependent on its exposure to natural conditions such as rain, wind, and fire.

Furniture that is not exposed to a lot of rain, for example, will last longer than furniture that is constantly exposed to rain.

3. Expiration of lease period: Some assets are controlled by a company but not necessarily owned by the company.

An example is leased equipment which is expected to last for 5 years.

In this instance, the company is legally permitted to use the equipment for five years before returning it to the original owner or lessor.

However, each year, the leased equipment will be depreciated one-fifth of the leased amount. 

This means that at the end of the fifth year, the value of the leased equipment will be zero.

4. Obsolescence: Depreciation can also occur as a result of an asset becoming obsolete.

Obsolescence means an asset has gone out of fashion or is outdated

Obsolescence of assets may be caused by the emergence of a new and improved form of asset that can perform the job better.

For example, the emergence of computers has largely replaced the use of typewriters in most organizations, thus rendering typewriters obsolescence.

5. Maintenance: The level of maintenance can also affect the depreciation of an asset.

In general, equipment that is serviced and maintained regularly will live longer than equipment that is not serviced at all.

Also, there is more depreciable value when there is less maintenance, and less depreciable value when there is more maintenance.

6. Superfluity: This occurs when an asset is no longer needed due to changes in an organization's size or plans.

For example, some plants may become superfluous to production requirements if production plans change.

As a result, the value of the plant may reduce

7. Depletion: This is mostly applicable to natural assets.

Natural assets are those that are derived from the natural environment.

When a firm has the right to access the sources of natural resources, such as mines, quarries, forests, and oil wells, it has natural assets.

The natural asset may be used by the business to make its product, or it could be sold in its raw state to other businesses who needed such resources to make their goods.

However, the continuous usage of the resources may lead to depletion, which is a situation where a resource is being consumed faster than it is replaced.

Resource depletion is exemplified by deforestation, which is rampant in today's world.

READ ALSO: TRADITIONAL CLASSIFICATION OF ACCOUNTS

5 Terminologies Commonly Associated With Depreciation

1. Original value: This refers to the cost price of the asset.

In a situation where the asset was not bought or the asset is a gift from another company, the original value of the asset will be the market value of the asset at the beginning of its life span.

2. Residual value: This is the amount expected to be realized from the sales of an asset at the end of its useful life.

It is the estimated worth of an asset after it's fully depreciated or when it is retired from use.

Residual value is also known as scrap value or salvage value.

It is calculated as the difference between the original value and the depreciable value.

3. Life span: This is the estimated useful life of the asset.

In other words, the life span of an asset is the number of years an asset is expected to remain in use before it is scrapped or disposed

4. Net book value of an asset: This is the value of an asset that a company records in its statement of financial position (balance sheet).

It is the original value of an asset less accumulated depreciation. 

Net book value can be thought of as the remaining unallocated cost of an asset.

5. Depreciated value: The depreciable value of an asset is the difference between the cost of the asset and its scrape value. 

For example, if an equipment costs €10,000 and it is expected to be sold for €1000 at the end of its useful years, it follows that the depreciable value of the asset is €10,000-€1000 or €9000

READ ALSO: MEANING, IMPORTANCE AND TYPES OF SUBSIDIARY BOOKS

Conclusion

We just discussed the meaning, causes and terminologies of depreciation.

To recap, depreciation can be defined as the reduction in the value of company fixed assets over a particular period.

Depreciation is caused by various factors including wear and tear, time, depletion, and superfluity.

Lastly, we also discussed five terminologies commonly associated with depreciation, namely; original value, residual value, life span, net book value and depreciable value.

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