Depreciation – What is depreciation?
Definition: Depreciation is permanent and continuing diminution in the quality, quantity or value of an asset.
Depreciation is calculated as the estimate of this measure of wearing out and is charged to the Profit & Loss account either on a monthly or annual basis. The cost of the asset less the total depreciation will give you the Net Book Value of the asset.
Cost of an asset spread over the span of several years
The idea of depreciation is to spread the cost of that capital asset over the period of its "useful life to the entity" that currently owns it.
If the full cost of the asset were to be borne in the year that it was purchased, then that year's expenditure would be unfairly penalised whilst expenditure during the remaining years, which were still receiving the benefit from the asset, would not be affected.
How do assets depreciate?
Assets depreciate for two reasons:
- Wear and tear. For example, a car will decrease in value because of the mileage, wear on tyres, and other factors related to the use of the vehicle.
- Obsolescence. Assets also decrease in value as they are replaced by newer models. Last year's car model is less valuable because there is a newer model in the marketplace.
Depreciation is calculated as follows: The original cost of the asset, minus the salvage value (the "scrap" value) then divided over the years of useful life of the asset.