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Home Depreciation, Provisions and Reserves Definition, Explanation and Causes of Depreciation

Definition, Explanation and Causes of Depreciation:

Definition and Explanation:

Depreciation is that part of the original cost of a fixed asset that is consumed during period of use by the business. The annual charge to profit and loss account/income statement for depreciation is based upon an estimate of how much of the overall economic usefulness of a fixed asset has been used up in that accounting period. It is an expense for services consumed in the same way as expenses are incurred for items such as wages, rent or electricity. Because it is charged as an expenses to the profit and loss account/income statement, depreciation reduces net profit.

For example, if a PC cost $600 and was expected to be used for three years, it might be estimated at the end of the first year that a third of its overall usefulness had been consumed. Depreciation would then be charged at an amount equal to one third of the cost of the PC, i.e. $200. Profit would be reduced by $200 and the value of the PC in the balance sheet would be reduced from $600 to $400.

Using an example of a van and the petrol it consumes, you can see that the only real difference between the expense of depreciation for the van and the expense of petrol incurred in order to use the van, is that the petrol expense is used up in a day or two, whereas the expense for use of the van is spread over several years. Both are expenses of the business.

Causes of Depreciation:

The causes of depreciation can be divided up between physical deterioration, economic factors, the time factor, and depletion. These are briefly explained below:

Physical Deterioration:

Wear and Tear:
When a motor vehicle or machinery or fixtures and fittings are used they eventually wear out. Some last many years, others last only a few year. This is also true of buildings, although some may last for a long time.

Erosion, Rust, Rot and Decay:
Land may be eroded or wasted away by the action of wind, rain, sun and other elements of nature. Similarly, the metals in motor vehicles or machinery will rust away. Wood will not eventually. Decay is a process which will also be present due to the elements of nature and the lack of proper attention.

Economic Factors:

These may be said to be the reasons for an asset being put out of use even though it is in good physical condition. The two main factors are usually obsolescence and inadequacy.

This is the process of becoming out of date. For example, over the years there have been great progress in the development of synthesizers and electronic devices used by leading commercial musicians. The old equipment will therefore have become obsolete, and much of it will have been taken out of use by such musicians.

This does not mean that the equipment is worn out. Other people may buy the old equipment and use it, possibly because they cannot afford to buy new up-to-date equipment.

This arises when an asset is no longer used because of the growth and changes in the size of the business. For example, a small ferryboat that is operated by a business at a coastal resort will become entirely inadequate when the resort becomes more popular. Then it will be found that it would be more efficient and economical to operate a large ferryboat, and so the smaller boat will be put out of use by the business. In this case also it does not mean that the ferryboat is no longer in good working order, nor that it is obsolete. It may be sold to a business at a smaller resort.

The Time Factor:

obviously time is needed for wear and tear, erosion, etc., and for obsolescence and inadequacy to take place. However, there are fixed assets to which the time factor is connected a different way. These assents which have a legal life fixed in terms of years. For instance, you may agree to rent some buildings for ten years. This is normally called a lease. When the years have passed, the lease is worth nothing to you, us it has finished. Whatever you paid for the lease is now of no value.

A similar assert is where you buy a patent so that only you are able to produce something when the patent's time has finished it then has no value.

Instead of using the term depreciation, the term amortization is often used for these assents.


Other assets are of wasting character, perhaps due to the extraction of the raw materials from them. These materials are then either used by the business to make something else, or are sold in their raw state to other businesses. Natural resources such as mines, quarries and oil wells come under this heading. To provide for the this consumption for an asset of a wasting character is called provision for depletion.  


More study material from this topic:

Definition, explanation and causes of depreciation
Depreciation is not a matter of valuation but a means of cost allocation
Activity method of depreciation
Straight line method of depreciation
Sum of the years' digits method of depreciation
Reducing balance method
Annuity method
Depreciation fund method or sinking fund method
Insurance policy method
Revaluation method
Depletion method
Machine hour rate, mileage, and global method
Methods of recording depreciation
Difference between general reserve and specific reserve
Difference between capital reserve and general reserve
Difference between reserve and reserve fund
Difference between provision and reserve



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