What is Depreciation of Fixed Assets?
Depreciation is the systematic reduction in the recorded cost of a fixed asset. Examples of fixed assets that can be depreciated are buildings, furniture, leasehold improvements, and office equipment. The only exception is land, which is not depreciated (since land is not depleted over time, with the exception of natural resources). The reason for using depreciation is to match a portion of the cost of a fixed asset to the revenue that it generates; this is mandated under the matching principle, where you record revenues with their associated expenses in the same reporting period in order to give a complete picture of the results of a revenue-generating transaction. The net effect of depreciation is a gradual decline in the reported carrying amount of fixed assets on the balance sheet.
Reasons for Depreciation of Fixed Assets
- Wear and tear. Any asset will gradually break down over a certain usage period, as parts wear out and need to be replaced. Eventually, the asset can no longer be repaired, and must be disposed of. This cause is most common for production equipment, which typically has a manufacturer’s recommended life span that is based on a certain number of units produced. Other assets, such as buildings, can be repaired and upgraded for long periods of time.
- Perishability. Some assets have an extremely short life span. This condition is most applicable to inventory, rather than fixed assets.
- Usage rights. A fixed asset may actually be a right to use something (such as software or a database) for a certain period of time. If so, its life span terminates when the usage rights expire, so depreciation must be completed by the end of the usage period.
- Natural resource usage. If an asset is natural resources, such as an oil reservoir, the depletion of the resource causes depreciation (in this case, it is called depletion, rather than depreciation). The pace of depletion may change if a company subsequently alters its estimate of reserves remaining.
- Inefficiency/obsolescence. Some equipment will be rendered obsolete by more efficient equipment, which reduces the usability of the original equipment.
Methods of Depreciation…
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