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Depreciation of an Asset: Meaning, Purpose and Types

After reading this article you will learn about:- 1. Meaning of Depreciation 2. Purpose of Calculating Depreciation 3. Types

Meaning of Depreciation:

“The term Depreciations means a fall in the value of an asset with use and passage of time for the fixed assets like plant, machinery, building, furniture fixtures etc. there is a decline in the value due to use and it is termed as Depreciation.”

Most of the fixed assets are worn out while in use over a period of time. This wear and tear is bound to occur but it can be minimized up-to some extent by proper care and maintenance.

The efficiency of these assets also reduces with the passage of time and at one time it becomes uneconomical to be used further and requires replacement conventionally, this money required for replacement is charged as depreciation.

The term depreciation means a fall in the value of an asset i.e., with the use over a period of time, there is a decline in the fixed assets. These fixed assets include plant and machinery, building furniture fixtures and tools accessories etc. Their value falls due to use. From the accounting point of view, the concept of depreciation is that of sluggish or amortized cost.

Some of the important reasons for decline in the value of the assets may be:

(i)) Lapse of time

(ii) Wear and tear due to use over a period of time

(iii) Lack of proper repair and maintenance

(iv) Mishandling and accidents and

(v) Introduction of new improved equipment in the market (obsolescence).

Purpose of Calculating Depreciation:

In the light of above discussion some money must be set aside yearly from the profits, so that when equipment goes uneconomical, it can be replaced by the new machines. Therefore, we want a system of accounting in which we distribute the initial cost of the equipment machines or assets plus installation charges less the salvage value (if any) over the estimated useful life of the assets.

In the absence of provision for any depreciation, the assets may be worn out in parts every year and thus it may swallow the profits unnecessarily. Thus for this purpose depreciation accounts for the complete plant or individual machines/equipment is opened in the organization’s account books known as “Depreciation Fund”.

In this way the depreciation amount is distributed scientifically over the useful life of the asset and is deducted yearly from the profits chargeable to overheads. The money so collected in Depreciation Fund is utilized for replacement of the assets at the end of useful life.

Thus the main objectives providing depreciation accounting may be as follows:

(i) To keep annual depreciation of various assets in operation.

(ii) To provide reserve fund for the proper repair and maintenance of plant and equipment.

(iii) To provide depreciation data for policy formulation.

(iv) To provide depreciation cost to get

(a) Estimated life of the equipment/asset in years.

(b) Estimated scrap value of the asset.

(c) Cost the equipment required for replacement.

Types of Depreciation:

Depreciation may be classified under the following types:

(1) Physical depreciation.

(2) Functional depreciation.

(3) Accidental depreciation.

(1) Physical Depreciation:

Depreciation resulting from physical impairment of an equipment or assets is called physical depreciation. It manifests itself in such clear and definite ways as the wearing of metal particles from the bearing surfaces, corrosion of tubes in boilers or heat exchangers, chemical decomposition etc.

The primary causes of physical depreciation may be due to three main classes of causes as follows:

Depreciation Due to Wear and Tear:

Wearing of the equipment/machine or asset due to abrasion, shock, vibration or impact etc., which are caused due to use over a period of time. So the cost of replacement due to this cause is the value of depreciation due to wear and tear.

Depreciation Due to “Physical Decay”:

Wearing of assets/items by such ways which are independent of use e.g. rotting of wood, corrosion of pipes, decay of electric cables, chemicals etc. This reduction is depreciation due to physical decay.

Depreciation Due to Deferred Maintenance and Neglect:

If the instructions of maintenance recommended by the manufacturer are not followed properly by the user the value of asset may be reduced and depreciation in value because of this reduction is known as depreciation due to deferred maintenance and neglect.

(2) Functional Depreciation:

This type of depreciation results not from a deterioration in the assets ability to perform duties of its intended purpose but from a change in demand for the services it can render.

Such a change may occur because of the fact that the asset is no more profitable to use. Depreciation resulting from a change in the need for the service of an asset/equipment may be result of technological developments these developments cause obsolescence of the existing assets.

The two reasons are:

(i) Obsolescence owing to the development of superior units and existing unit cannot serve the desired goal (service).

(ii) Inability to meet the desired demand so change of existing asset by superior unit available.

(3) Accidental Depreciation:

Accidents incur a very rapid loss of value of the equipment/asset and are unpredictable. Nowadays the practice is to insure against accidental losses. These insurable losses may be of huge magnitude and are not treated as depreciation. However the premium paid may be charged from depreciation fund.

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About the author

Salman Qureshi

Salman Qureshi is an Accountant by profession & he loves to write on Commerce & Management Sciences Subject to assist Students. Hope you guys will like his effort.