1. What is depreciation? 2. What factors determine depreciation charges? 3. Reasons for providing depreciation

Answer Details

1. What is depreciation?

Depreciation is the gradual and permanent reduction in the value of a fixed asset due to use (wear and tear), the passage of time, obsolescence, or depletion. It represents the part of the asset's cost that is charged as an expense over its useful life.

2. Factors that determine the depreciation charge

• Cost of the asset - the purchase price plus all costs of bringing it into use.
• Estimated useful (economic) life - how long the asset is expected to serve the business.
• Estimated residual (scrap/salvage) value - the amount expected on disposal at the end of its life.
• Method of depreciation adopted - e.g. straight-line or reducing-balance.
• Legal or usage limits where the asset's life is fixed by law or output.

3. Reasons for providing depreciation

• To ascertain the true profit by matching the cost of the asset against the revenue it helps to earn.
• To show the asset at its true (net book) value in the balance sheet.
• To set aside/retain funds within the business for the eventual replacement of the asset.
• To comply with the matching and prudence concepts.
• To avoid overstating profit and the value of assets.