Meaning of Depreciation and Factors that Affect the Computation of Depreciation
Depreciation is the process of allocating the cost of a plant asset over its useful life. It is a way of accounting for the gradual decline in the value of an asset as it is used in a business. Depreciation does not refer to the physical deterioration of an asset or the decrease in its market value over time. Instead, it is a way of dividing the cost of the asset among the periods that benefit from its use.
There are several factors that affect the calculation of depreciation, including
- the cost of the asset,
- its residual value (also known as salvage value),
- its depreciable cost, and
- its estimated economic (useful) life.
The cost of the asset is the net purchase price plus any reasonable and necessary expenses to get it ready for use.
The residual value is the estimated market value of the asset at the time it is retired.
The depreciable cost is the difference between the asset's cost and its residual value.
The estimated economic life of an asset is the total number of expected service units, which may be measured in terms of years, units produced, miles driven, or other similar measures.
To determine the estimated useful life of an asset, an accountant should consider
- past experience with similar assets,
- the asset's current condition,
- the company's repair and maintenance policy,
- technological and industry trends, and
- local conditions.