Depreciation


Non-Current Assets and Depreciation – Definition, Concept and Explanation:

Non-current assets are purchased by a business not for resale but to be used within the business in producing revenue. Non-current assets usually help to earn revenues for a number of accounting years, i.e., over their useful lives. Instead of charging their full costs in the years of purchase, these costs are spread over their useful lives on account of depreciation.

Depreciation:

“Depreciation is the enduring and continuing reduction in the estimated useful life of a non-current asset. It recognizes that assets with finite lives lose their value, efficiency or effectiveness with the passage of time”.

Depreciation is recorded as an expense in the income statement to spread the original cost of a non-current asset over its useful life to match the revenue, it is generating.

The amount spent on purchase of a non-current asset is in fact an advance payment for its ability to increase earning capacity of the business for a long period of time. As with the passage of time, the purchased assets become useless or unable to generate the necessary earnings. As a result depreciation is recorded as an expense to reflect the continuing diminution in the value of the asset.

Depreciation in Prudence Concept of Accounting:

According to “prudence concept” the value of asset should not be overstated and therefor depreciation is the method by which we show a more realistic (not market) value for the asset. However, the depreciation of assets is not undertaken purely to show market value for non-current assets.

Depreciation in Matching Concept of Accounting:

The main reason for charging depreciation is concerned with the “matching concept” which states that while preparing the income statement, revenues of the business are matched with the related expenses incurred in earning these revenues. This implies that the cost of a non-current asset is not written off all in the income statement at once. Instead, depreciation is charged in the income statement over the asset’s estimated useful life to “match” its cost with the benefits, it produces.

Depreciation in Historical Cost Concept of Accounting:

Charging depreciation goes to some extent against the “historical cost concept” which states that all non-current assets should be shown at cost value, whereas; all non-current assets, with the exception of land, should be subject to depreciation. However, balances in non-current assets accounts still show their costs as depreciation is recorded in separate accounts.

Depreciation in Consistency Concept of Accounting:

Once a depreciation method is chosen, it should not be changed. This is in accordance with the “consistency concept”. Under this concept different accounting methods are used the same way from one year to another. This way, accounting users may have more useful comparisons of financial statements from year to year.

Amortization and Depletion:

Amortization is allocation of the costs of intangible assets e.g., goodwill, brands, trademarks. etc., over their useful lives.

Effects of Depreciation on Cash Flow:

Depreciation is a non-cash expense as does not involve any new cash outlay. Moreover, it has nothing to do with the retention of cash or funds for the replacement of non-current assets.

Depreciation Relationship with Market Value:

The process of charging depreciation has no direct relationship to the market value. or current realizable value of the assets. In fact, depreciation can still be charged even if the market value of an asset is increasing as depreciation simply spreads cost of a non-current asset over its useful life.

Causes for Depreciation:

(i) Wear and tear (physical deterioration due to erosion, rust and decay)

(ii) Passage of time (applicable to intangible non-current assets which do not exist in a physical sense)

(iii) Obsolescence (change of custom or availability of new substitutes or advancement in technology)

(iv) Inadequacy (due to increase in business operation or capacity)

(v) Natural calamity (natural disasters like flood, earthquakes, etc.)

(vi) Fall in market price

(vii) Depletion (applies on natural resources like mineral resources)