The lifetime of an asset to a business rests primarily on the purpose of its acquisition and, secondarily, on its nature. An item purchased for immediate consumption or sale is a short-lived asset and one intended for long-term use is a long-lived asset, although both produce income. While the first asset expires within a year of its acquisition, the last asset lasts longer. Therefore, almost all spending on a short-lived asset becomes an expense and is compared to the current year’s income.

But the position is different with a long-lived asset that wears out or depreciates over a long period. Consequently, the disbursement of a fixed asset is distributed over several years and only a fraction of it expires annually. Simply, this fraction, called past due cost or depreciation, is charged against current income and the rest, called past due cost, is carried over to future maturities.

“Depreciation can be defined as the permanent decrease in the value of an asset due to use and/or the passage of time.” – Terminology from the Institute of Management and Cost Accountants, England

“Depreciation is the permanent and continuing decline in the quality, quantity, or value of an asset.” -Pickles

“Depreciation can be defined as the measure of the exhaustion of the useful life of an asset for any reason during a given period.” -Spicer and Pegler

“Depreciation is ‘the gradual and permanent decline in value of an asset from whatever cause.” -Carter

Objects of the provision for depreciation

To achieve the following goals, depreciation accounting is a must for all businesses:

(1) Recovery of the cost incurred in fixed assets during their useful life to keep the owner’s capital intact;

(2) The provision is for replacement cost on retirement of the original assets;

(3) include depreciation in the cost of production to find the correct cost of production;

(4) to find out the correct profit for the year;

(5) to find out the correct financial position through the balance sheet.

Causes of Depreciation

Depreciation can be of two types:-

(1) Internal depreciation that occurs from certain inherent normal causes is known as internal depreciation. The causes of internal depreciation are:

(1.1) Wear and Tear – An asset decreases due to continued use, eg building, plant,
machinery etc. said decrease depends on the amount of use of an asset. If a factory works a double shift instead of a single shift, the depreciation on the plant and machinery will double. It is obvious that such a loss is inevitable. An asset can be maintained in proper working condition
through repairs for the time being, but it cannot be done permanently: at some point, the asset will become unfit for repairs, when it will no longer be suitable.

(1.2) Depletion: The value of some assets decreases proportionally to the amount of production, eg mines, quarries, etc. With the raising of coal, etc. from the coal mine, the total deposit is gradually reduced and after a while it will be completely depleted. Then its value will be null.

(2) External: Depreciation caused by some external reasons is called external.
depreciation.

The causes of external depreciation are:

(2.1) Obsolescence

Some assets, although working properly, can become obsolete. For example, the old machine becomes obsolete with the invention of a cheaper and more sophisticated machine, whose productive capacity is generally higher and the cost of production is lower. To survive in the competitive market, the manufacturer must install a new machine to replace the old one.

(2.2) Passage of time

Some assets lose value due to the mere passage of time, even if they are not used, for example, leased property, patent rights, copyrights, etc.

(2.3) Accidents

Assets may be destroyed due to abnormal reasons like fire, earthquake, flood, etc. In such a case, the destroyed asset can be written off as a loss and a new one purchased.

Need for Depreciation Provision

The need for provision for depreciation arises for the following reasons:

(1) Determination of true gain or loss: Depreciation is a loss. So unless it is considered like all other expenses and losses, the true profit/loss cannot be determined. In other words, depreciation must be considered to find out the true profit/loss of a business.

(2) Determination of the true cost of production: Goods are produced with the help of plants and machinery that incur depreciation in the production process. This depreciation must be considered as part of the production cost of the goods. Otherwise, the production cost would be shown below the actual cost. The selling price is normally set on the basis of the cost of production. Therefore, if the cost of production is shown to be lower by ignoring depreciation, the selling price will also be set low, resulting in a loss for the business;

(3) Real valuation of assets: the value of assets gradually decreases due to depreciation. If depreciation is not taken into account, the value of the asset will be shown in the books at a higher figure than its real value and, therefore, the true financial situation of the company will not be revealed through the Balance Sheet.

(4) Asset replacement: After a while, an asset will be completely depleted due to usage. Then a new asset will be purchased which will require a large sum of money. If the full amount of the profit is withdrawn from the business each year without considering the depreciation loss, the necessary amount may not be available. buying the new assets. In such a case, the required money must be raised by introducing fresh capital or by obtaining a loan through the sale of other assets. This is contrary to &0sound’s business policy.

(5) Keep capital intact: the capital invested in the purchase of an asset gradually decreases in
depreciation account. If the depreciation loss is not considered in determining the profit/loss at the end of the year, the profit will be shown more. If excess profits are withdrawn, working capital will be gradually reduced, the business will be weakened and its profit generation
capacity will also drop.

(6) Legal Restriction- Pursuant to Sec. 205 of the Companies Act of 1956, dividends may not be declared without charging depreciation of fixed assets. Thus, in the case of corporations, the collection of depreciation is mandatory.