Concept of Depreciation

What is Depreciation?

Depreciation is the systematic allocation of the Depreciable cost, Cost less salvage value, of property plant and equipment items over its estimated useful life. Its objective of computing the depreciation is to match the benefits received from using the asset to the expense associated from the use of such asset. In other words, any benefits we get has a corresponding expense incurred from gaining the benefit.

Kinds of depreciation

There basically two kinds of depreciation. Physical Depreciation and Economic Depreciation. The only difference on the two lies on the way how they are arrived.

Physical Depreciation

This type of depreciation is related to the wear and tear of the asset or its deterioration over a particular period of time. It includes:

1. Wear and tear due to frequent use
2. Passage of time due to non-usage
3. Accident such as flood, fire, and etc.

Economic Depreciation

Economic Depreciation, on the other hand, relates to the assets technical obsolescence and inadequacy to perform efficiently.

Obsolescence may arise from the following:

• When there is no future demand for the product being produced by the asset.
• When new and better asset becomes available in the market.

Inadequacy arises when the asset can no longer meat the demand for the product's production. For example, ABC Company is using an old machine that manufactures 5,000 bottles of soft drinks. The old machine is in its maximum production capacity. However, because of increasing market size, the demand for the soft drinks have increase by 45% of the normal production. Because of this increase, the old machine can no longer supply the demand of the market. Therefore, the company needs to buy a new machine with a bigger manufacturing capacity. 

Methods of computing depreciation

1. Straight Line
2. Declining Balance Method
3. Sum of the Years Digits
4. Output Method

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