Accountancy · Ch 2 — Depreciation
Meaning, Need and Causes of Depreciation
Meaning, Need and Causes of Depreciation
Every fixed asset a business buys to use in its operations — a machine, a delivery vehicle, office furniture, a computer, a factory building — is expected to serve the business for several years, but none of these assets lasts forever at the same value. As an asset is used year after year, part of its cost is genuinely "consumed" in earning that year's revenue, well before the asset is finally scrapped or replaced. Depreciation is the accounting term for this gradual, permanent fall in the book value of a fixed asset, arising from use, the passage of time, or obsolescence, and it is charged as an expense in the Profit and Loss Account so that each accounting period bears a fair share of the cost of the asset it actually used.
For students preparing for the Andhra Pradesh Board of Intermediate Education (BIEAP) second-year Commerce examination, depreciation is one of the most consistently tested chapters in AP Intermediate Accountancy questions and answers, because it combines a conceptual "why" with genuinely worked computations that examiners like to test both together.
Depreciation must not be confused with a mere fall in an asset's market or resale price — a machine's SECOND-HAND SALE VALUE might fall for entirely different reasons (a slump in demand, a competitor launching something newer) that have nothing to do with how the business itself accounts for using up that asset's cost. Depreciation is purely an internal accounting allocation of COST over USEFUL LIFE, independent of what the asset might actually fetch if sold today.
The main causes of depreciation are:
| Cause | What it means |
|---|---|
| Wear and tear | Ordinary physical deterioration from regular use — moving parts loosen, surfaces wear thin |
| Efflux of time | Some assets (a leasehold right, a patent) simply run down and expire with the passage of time, whether used heavily or not at all |
| Obsolescence | A newer invention, technology or method makes the existing asset outdated and uneconomical to keep using, even though it may still work perfectly |
| Depletion | Wasting natural resources — a mine, a quarry, an oil well — are physically exhausted as the resource is extracted |
| Accidents | A fire, an accident or a natural calamity can suddenly and permanently reduce an asset's usefulness |
Depreciation is charged for several closely connected reasons: (a) to ascertain the TRUE profit or loss of the business for the period — ignoring the cost of using up fixed assets would overstate profit; (b) to show the asset at a fair, TRUE value in the Balance Sheet, rather than at its full original cost indefinitely; (c) to accumulate funds, over the asset's life, toward its eventual REPLACEMENT; (d) to arrive at the correct COST of production or services, where an asset is used directly in making goods; and (e) because certain laws (including the Income Tax Act and the Companies Act) require depreciation to be provided before profits are distributed.
The gradual, permanent reduction in the book value of a fixed asset caused by use, the passage of time, or obsolescence, charged as an expense so that each accounting period bears a fair share of the cost of the asset it used.
A fall in an asset's usefulness because a newer technology, design or method has made it outdated and uneconomical to keep using, regardless of the asset's own physical condition.
The physical exhaustion of a wasting natural resource (a mine, quarry or oil well) through extraction — the depreciation-equivalent term used specifically for such resources.