Cambrige Notes: Principles of Accounting: Causes of 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• Obsolescence– the asset may now be out of date. A popular example is that of typewriters which have been replaced by computers.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.