Depreciation (Accounting)

By:

James Knight

James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the… read more.

Updated: Aug 20, 2021

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The reduction in value of an asset through wear and tear. An allowance for the depreciation on a company’s assets is always made before the calculation of profit on the grounds that the consumption of capital assets is one of the cost of earning the revenues of the business and is allowed assuch, according to special rules, by the tax authorities. Since depreciation can only be accurately measured at the end of life of an asset (i.e. ex post), depreciation provisions in company accounts require an estimate both of the total amount of depreciation and the asset life. Annual depreciation provisions are normall calculated according to two methods:

The straight-line metohod where the estimated residual (e.g. scrap) value of an asset is deducted from its original cost snf the balance divided by the number of years of estimated life to arrive at an annual depreciation expense to set against revenue; and The reducing-balance metod. In this case the actual depreciation expense is set at a constant proportion of the cost of the asset, i.e. a diminishing annual absolute amount. There are other methods of calculating depreciation and also of dealing with the fact that, in periods of rising prices, the replacement cost of an asset may be very much greater than its original cost. The latter problem is dealt with by revaluing assets at intervals, or even annually, using special capital cost indices and adjusting depreciation charges accordingly.This is called replacement-cost depreciation as opposed to historic-cost depreciation when the original cost of purchase is retained throughout the period. It should be noted that obsolescence is distinct from depreciation, in that the former is an unforseen change in the value of an asset for technical or economic reasons. If an asset becomes obsolescent its undepreciated value is usually written off (depreciated) completely in the year of replacement. In some cases the life of an asset may be very difficult to determine because it is specific to the production of a product the deman for which is subject to rapid changes in tasteor fashion, i.e. there is a high risk of product obsolescence. In these cases the life of the asset is written off over a very short period.

The purpose of depreciation provisions in accounting is to ensure that the cost of the flow of services provided by capital assets is met in the price of the company’s products; it is not to build up funds for the replacement of these assets to be available at at certain date. In practise, depreciation provisions are treated aspart of the net cash flow of a business and are used to repay loans, to purchase other fixed assets or to invest in other businesses; that is, they are put to the use that will give the highest possible return. Much confusion is caused by this point, since what happens to depreciation provisions – which are, in effect, transfers of funds from fixedassets to current assets and sometimes back again – is not often clear from the balance sheet.

Depreciation is accepted for tac purposes as a charge against profits, but this depreciation has to be calculated according to certain rules and does not necessarily bear any realtion to the depreciation actually charged by the business in its accounts.

Reference: The Penguin Dictionary of Economics, 3rd edt.