The Institute of Chartered Accountants of India defines depreciation as below
“Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes. Depreciation is allocated as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset.” In short, depreciation is the allocation of the depreciable amount of an asset over its estimated useful life. It includes amortisation of assets whose useful life is predetermined and depletion of wasting assets.
(b) Causes of Depreciation
Depreciation may arise from two causes : internal and external. Internal depreciation may arise from the operation of any cause natural to itself, while external depreciation is that which arises from the operation of forces outside the asset itself.
Internal causes of depreciation are as follows
(1) Wear and Tear. The value of fixed assets such as plant, machinery or furniture and fittings may decrease due to constant use. The utility value of such an asset when it was purchased gradually decreases as it is constantly used. Hence its value decreases after some period. The difference between its utility value at the time of purchase and its utility value after using it for some time is called depreciation.
(2) Exhaustion. Exhaustion or depletion occurs when the minerals are exhausted from a mine, its value decreases. As the whole mine is exhausted, the mine loses its value. External depreciation occurs on account of the following :
(1) Effluxion of Time. The value of an asset may decrease by the effluxion of time as in the case of a lease, copyright or patent. In case of a lease, at the end of the period, it terminates and becomes valueless.
(2) Obsolescence. Decrease in the value of an asset may occur on account of new inventions, say of a new machinery, the use of which will make the goods cheaper, better and the larger quantity. The manufacturer will therefoie discard the old machinery and buy the new model.
(c) Factors to be considered for Assessment of Depreciation
The following three factors are usually taken into consideration for assessment of depreciation and the amount to be charged in respect thereof in the accounting period.
1. historical cost or other amount substituted for ‘the historical cost of the depreciable asset when the asset has been revalued.
2. expected useful life of the depreciable asset;
3. estimated residual value of the depreciable asset.
(1) Historical cost of a depreciable asset includes all expenditure incurred in connection with its acquisition, installation and commissioning as well as additions to or improvement thereof.
(2) The useful life of a depreciable asset, i.e. the time during which the asset will be commercially useful to the undertaking, is shorter than physical life. It cannot be precisely calculated. Determination of the probable effective life of an asset is a matter of estimation and is normally based on various factors including experience with similar types of assets. Such estimation is more difficult for an asset using new technology or used in the production of a new product or in the provision of a new service. Nevertheless estimation is made on some reasonable basis.
(3) Determination of residual value (scrap value) of an asset is normally a difficult matter. If such value is considered insignificant, it is normally regarded as nil. On the contrary, if it is likely to be significant, the residual value is estimated at the time of acquisition/ installation or at the time of subsequent revaluation of the asset. One of the bases for determining the residual value would be the realisable value of similar assets which have reached the end of their useful lives and have operated under conditions similar to those in which the asset will be used.