Depreciation occurs because a tangible asset loses its value or economic usefulness over its useful life. Long-term assets such as equipment are used in business activities for several accounting periods. As these assets are used, their value may gradually decrease. The cost of the asset is therefore allocated over the periods in which the business receives benefits from its use.
Wear and Tear
One of the main causes of depreciation is wear and tear arising from the regular use of an asset. When machinery, equipment, or other tangible assets are continuously used in business operations, their physical condition gradually deteriorates.
For example, factory equipment may lose value every year because it is used in production and its parts gradually wear out. As the asset continues to be used, its remaining useful life and economic usefulness decrease. This reduction in value results in depreciation.
Use of the Asset
The continuous use of an asset in business activities is another important cause of depreciation. A depreciable asset provides economic benefits to the business over several accounting periods. As these benefits are obtained, a part of the cost of the asset is considered to have been consumed.
Therefore, the original cost of the asset is systematically allocated to the accounting periods in which the asset is used. The amount allocated to a particular period is recognised as depreciation expense.
Passage of Useful Life
Assets generally have an estimated useful life, which represents the period during which the asset is expected to provide economic benefits to the business. As time passes, the remaining useful life of the asset decreases.
For example, if equipment has an estimated useful life of five years, each year of use reduces the remaining period during which the equipment is expected to provide benefits. The cost of the equipment is therefore allocated over its useful life through depreciation.
Reduction in Fair Value
Depreciation may also reflect an actual reduction in the fair value of an asset. The value of an asset may decrease as it is used and becomes older.
For example, factory equipment may have a higher value when it is newly acquired. After several years of use, its value may decline because of its age and physical condition. This decrease in the value of the asset is one aspect of depreciation.
Partial Obsolescence
An asset may also suffer from partial obsolescence, which can reduce its economic usefulness. Property, plant, and equipment may become less useful because their ability to provide economic benefits has declined.
Where the decline in the value or recoverability of an asset is unexpected, accounting rules may require the recognition of an impairment charge. Impairment is different from normal depreciation because depreciation is a systematic allocation of cost, while impairment generally arises from an unexpected decline in asset value.
Change in the Manner of Using an Asset
A change in the manner in which an asset is used may affect its value and economic usefulness. If an asset is no longer used in the same way as originally expected, its ability to provide future benefits may decline.
Such a change may indicate a reduction in the recoverability of the asset and may require the business to examine whether the asset has suffered impairment.
Expected Consumption of Economic Benefits
A tangible asset is purchased because the business expects to receive future economic benefits from its use. As the asset is used in business operations, these economic benefits are gradually consumed.
Depreciation represents the allocation of the asset’s cost according to the periods in which these benefits are obtained. Therefore, the gradual consumption of future economic benefits is an important accounting reason for recognising depreciation.
Exam Focus
The main causes of depreciation are wear and tear, continuous use of an asset, passage of its useful life, reduction in fair value, and gradual consumption of economic benefits from the asset.
Assets such as factory equipment lose value as they are used and physically wear out. As the remaining useful life of an asset decreases, its cost is systematically allocated to the accounting periods benefiting from its use.
Depreciation is a systematic allocation of asset cost, whereas an unexpected decline in the value or recoverability of an asset may result in impairment.