Cambridge IGCSE Accounting(0452)/O Level Principles of Accounts(7110) Notes: Introduction to depreciation

  • We have already explained that depreciation is the wasting away of fixed assets
  • We have also explained that it is treated as an expense in the Income Statement where it should appear at least once a year
  • Now we will look at the causes of depreciation
  • It is caused primarily by the following factors:
    1. physical factors
    2. economic factors
    3. time
    4. depletion

Physical factors

  • These can be broadly divided into 2:
  • Wear and tear– for example machines with parts that grind together and wear away e.g. motor vehicles
  • Rust,erosion,rot and decay-for example machines made up of iron, wood or organic materials

Economic factors

  • An asset may still lose its value and put out of use if though it may still be physically sound
  • This is usually due to two economic factors:
  • Obsolescence– the asset may now be out of date. A popular example is that of typewriters which have been replaced by computers. Computers themselves quickly become of date and need to be replaced by newer models
  • Inadequacy-arises due to the growth of the business for example as a business increases in size it might need to buyer a larger machine with more capacity essentially eliminating the need for the smaller machine

Time

  • Common sense dictates that time is required for an asset to wear, tear or rust
  • Time has a greater impact on assets that are of a legal nature
  • For example a lease, a rental contract has a fixed term, as time passes that term is reduced which must mean that the lease’s value/net worth decreases with the passage of time
  • This decrease in value is called ammortisation
  • Usually it relates to intangible fixed assets of a legal nature
  • While on the issue it must be emphasized that while Goodwill is treated as an intangible asset, it should never be amortized (depreciated)
  • This is something we will continue to speak about in the relevant topics

Depletion

  • Other assets are of a wasting nature usually due to the extraction of non renewable raw materials from them
  • These raw materials may be processed by the business or sold as is to customers
  • Examples are mines, oil wells, sand pits and quarries
  • As the asset is consumed its value falls
  • We have therefore to provide for this depletion

NB

  • Land does not normally suffer depreciation but if it does that depreciation needs to be calculated
  • Buildings depreciate and their value must be separated from the land upon which they stand

To access more topics go to the Principles of Accounting Notes.