Definition: Depreciation

Depreciation is the loss of economic or monetary value of an asset on use. When an asset is acquired, it is first recorded at its cost and not the market net realizable monetary value. This is in compliance to going concern concept which advocates that the business entity will continue to operate for a long time in the future unless there is good evidence to the contrary. The enterprise is viewed as a going concern, that is, as continuing in operations, at least in the unforeseeable future. Because of this assumption, the accountant while valuing the assets does not take into account forced sale value of them (or market value).. In fact, the assumption that the business is not expected to be liquidated in the foreseeable future establishes the basis for many of the valuations and allocations in accounting. In addition, the aforementioned Accounting concept go together with Historical Cost Principle which advocate that business transactions are always recorded at the actual cost at which they are actually carry out. That is, whenever an asset is acquired, it should be recorded at its actual cost and the same is used as the basis for all subsequent accounting purposes such as charging depreciation on the use of asset. Therefore, an accountant charges depreciation on fixed assets. Depreciation is a general term that cuts across various assets hence this aspect is categorized into diverse classes, namely;

1.Wear and Tear

2.Depletion

3.Obsolescence

4.Amortization

Wear and Tear is loss of economic value of a physical asset due to its normal utilization or it can be caused by unexpected perils such as accidents, natural disaster such as earthquakes, floods and fire just to mention but a few. Examples of assets which undergo wear and tear process are fixtures and fittings, machinery, office equipment, motor vehicles and farm implements. These assets are commonly referred to as fixed assets and their life span in the business is more than one calendar years. The learner should note that although buildings and land are classified as fixed assets when preparing the balance sheet, this is not true for they appreciate in value as they are being used. Therefore, they are referred to as real estate.

Depletion is loss of economic value of an asset due to the process of mineral extraction. The process of extraction is common in mining of precious minerals such as petroleum products, fluorspar, diamond and gold. So as extraction is being undertaken, the economic value of that mineral deposit declines.

Obsolescence on the other hand, is loss of economic value of a fixed asset due to change in technology. When a new technology is launched in a country, the old technical knowhow is forsaken and this renders the old machinery and equipment redundant. Hence their monetary value reduce.

Amortization is loss of economic value of intangible assets due to lapse of time. This aspect of depreciation is based on rights of usage whereby the rightful owner of the intellectual property losses the rights to utilize the asset once the set time lapses. Examples of such assets which undergo amortization are; copy rights, franchise, trademarks and patents.

Background

In the previous lesson , it was established that incomes and expenses, be it of trading or operational nature, require adjustments before they are incorporated in the respective financial statements. It is also the same with provisions which need to be considered with the same weight for they are allowances that can materially influence the true and fair representation of financial status of an organization. A provision is an allowance created by the management so as to avoid cases of either under or overstating the net profit of the business. Therefore, it is not a business expense for it does not involve actual cash inflow or cash outflow. A provision can either be of expense or income nature. In this level two tutorial series, the focus will be on depreciation and bad debts.

 Lesson One: End of Year Adjustments: Provision for Depreciation

In this lesson, we will focus on matching principle which require a business to consider incomes and expenses of a particular period of time whenever profits or losses are being computed. The Matching Principle advocates matching of expenses against incomes. As it was the case of incomes and expenses in part four, in this lesson, we will consider the matching principle and other relevant ones when making provisions. This means that all provisions relating to the financial period to which the accounts relate to should be taken in to account. The following scenarios will portray the suggestions of the matching principle pertaining depreciation and bad debts. For a start we will discuss depreciation.

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