Depreciation is a very important consideration in business accounting. Businesses with a heavy investment in non-current assets will record a large depreciation value in their accounts. Depreciation is also important because it is an allowable deduction for tax purposes and hence has a large impact on business cash flows. Depreciation is also important because it is a key component in asset valuation of a business. The causes of depreciation are many and include wear and tear, usage rights, inefficiency, obsolescence and impairment.
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What Is Depreciation?
Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy. Depreciation represents how much of an asset’s value has been used up. If you acquire an asset that is useful for 10 years your investment in it or it’s values declines by 10% per year. Each year the loss in value due to usage must be recognised as a cost of doing business. As we have already highlighted there are many causes which we can now get into with examples.
Wear And Tear
This depreciation cause is one which many people will be familiar with. Wear and tear refer to the damage that occurs to assets in the process of using them. While wear and tear apply to many assets it does not apply to all. It is most appropriately applied to assets with moving parts such as plant, machinery, vehicles and equipment. It can also be applied to fixtures and fittings in buildings. Wear and tear also tend to apply either the units produced method or the reducing balance methods of calculating depreciation as the straight-line method does not appropriately match the corresponding expenditure in repairs and maintenance.
Fixed assets are not always owned assets, in some cases under accounting conventions the rights to use of a property, real or intellectual, amounts to a non-current asset. An example of such an asset would the rights to use patented technology for say 5 years. The payment for such rights would be made to the owner of the patent upfront or at least the value agreed. The cause of depreciation is the movement of time; as time progresses the useful life of the rights diminishes. With this cause of depreciation, a lot depends on the nature of the agreement. If the agreement is time-based a straight-line method would be appropriate. If the agreement is tied to the number of units produced useful life depreciation accounting is more appropriate. With intangible assets such as intellectual property, depreciation is more often referred to as amortisation.
Natural Resource Usage
Where the fixed asset is a natural resource it is expected that resource has a limited capacity. The best example of this is extractive industries such as mining or oil drilling. In both these cases, field surveys are done to estimate the amount of resources that can be extracted from the field or claim. The claim comes at a cost so the amount expected to be extracted is measured against the cost. The cause of depreciation, in this case, is the depletion of resources within the claim. Now the surveys are rarely 100% accurate however they are used as reliable estimates. Given that we have a number of units the most appropriate approach to depreciating such an asset is the number of units method. An argument could be made for the straight-line method if it is expected to be used for the production of the same number of units every year for some years, this is very rare but plausible.
An asset is considered inefficient when it can no longer produce at an appropriate cost for the business to be viable. We can draw examples from two types of assets we have mentioned before. The motor vehicle example from the wear and tear depreciation cause is one. As a vehicle gets older it starts to experience break downs and requires repairs and more frequent maintenance work. It is considered inefficient when the cost of keeping it productive or lost earnings due to break downs are too great to the business compared to standards. Another example can be drawn from a gold claim in the natural resource usage depreciation cause. An expected standard of output is maintained for a certain amount of work, where the work no longer yields to the expected standard the claim is considered inefficient. In both cases, the type of depreciation is a revaluation or write down in the value of the asset.
Obsolescence refers to the depreciation of assets due to an inability to perform tasks as well as required. It is similar to the obsolescence depreciation cause in many aspects. Obsolescence can be easily understood through computers as a fixed asset. Technology is moving very fast and impacting the way business is done. Due to technological advancements and the Coronavirus pandemic video conferencing is on the rise. Consider a business that had bought employees computers that did not have this capability. These assets would be considered obsolete. The treatment of such assets would be to dispose of them and replace with new ones that are capable of the task. So the depreciation treatment would be a write-down in value.
Impairment is a depreciation cause that relates to a situation where there is a disparity between the book value of an asset and it’s fair market value. Similar to the aforementioned depreciation causes inefficiency and obsolescence however it is applied more commonly to assets whose productive capacity cannot be directly measured. An example is land and buildings, these assets play no part in the direct production of products for many businesses but remain fixed assets of the business. In such cases, the appropriate depreciation methods for regular depreciation are straight line or reducing balance. When there is a realisation that the book value of the asset does not match fair market value there is either a revaluation gain or loss. A revaluation loss is an impairment. This cause of depreciation can usually be traced to external factors. In our example, real estate market prices would be that factor.
It is important to remember that depreciation is an accounting estimate and as such it is rarely accurate in measuring the degree to which assets have lost value. Some methods of depreciating assets are more reflective of depreciation patterns than others. Multiple depreciation causes can be in action on a single asset at any point in time.