Definition of Depreciation:

Depreciation refers to the reduction in the value of an asset over time due to wear and tear, obsolescence, or other factors. It is a systematic allocation of the cost of an asset throughout its useful life. Depreciation helps businesses account for the gradual decrease in value of their assets over time.

Causes of Depreciation:

  • Physical Deterioration: Assets are subject to wear and tear from regular use, such as machinery rusting, vehicles losing efficiency, or buildings falling into disrepair.
  • Functional Obsolescence: Assets may become outdated or less efficient due to technological advancements, making them less valuable or useful in the market.
  • Economic Obsolescence: Factors outside the asset itself, like changes in consumer demand, market conditions, or government regulations, can render an asset less valuable.

Methods of Depreciation:

There are various methods used to calculate and record depreciation:

  1. Straight-line Method: Calculates depreciation by dividing the cost of the asset by its estimated useful life. It allocates the same amount of depreciation expense evenly over each period.
  2. Declining Balance Method: Calculates depreciation by applying a fixed percentage to the asset’s carrying value. It results in higher depreciation expenses in the early years and lower expenses as the asset ages.
  3. Units of Production Method: Calculates depreciation based on the actual usage or production level of the asset. It allocates a higher amount of depreciation when the asset is utilized more and vice versa.
  4. Sum-of-the-Years’-Digits Method: Calculates depreciation by multiplying the cost of the asset by a fraction based on the sum of the digits of its useful life.

Importance of Depreciation:

Depreciation plays a crucial role in financial reporting and the determination of accurate asset values. It aids in matching the expenses associated with an asset to the revenue it generates over its useful life. Depreciation also facilitates assessment of an asset’s replacement or repair costs, as well as determining its fair market value for resale.