Depreciation can be described as a means of spreading the cost of a fixed asset over its useful life, and so matching the cost against the full period during which it earns profits for the business. Depreciation charges are an example of the application of the matching concept to calculate profits.
Depreciation has two important aspects.
- Depreciation is a measure of the wearing out or depletion of a fixed asset through use, time or obsolescence.
- Depreciation charges should be spread fairly over a fixed asset’s life, and so allocated to the accounting periods which are expected to benefit from the asset’s use.
A fixed asset is acquired for use within a business with a view to earning profits. Its life extends over more than one accounting period, and so it earns profits over more than one period. In contrast, a current asset is used and replaced many times within the period. Foe example stock is sold and replaced, debtors increase with sales and decrease with payment received.
When a business acquires a fixed asset, it will have some idea about how long its useful life will be and might decide,
- To keep on using the fixed asset until it becomes completely worn out, useless and worthless.
- To sell off the fixed asset at the end of its useful life, either by selling it as a second hand item or as scraps.
Since a fixed asset has a cost, and a limited useful life, and its value eventually declines, it follows that a charge should be made in the trading, profit and loss account to reflect the use that is made of the asset by the business. This charge is called depreciation.