Depreciation is the decrease in the value of an asset over a period of time.
When a business acquires fixed assets they are generally used to increase business trading activities and revenue earning capacity. Fixed assets are primarily purchased for the business with the intention of permanent use and are not intended for resale. With the exception of land, all fixed assets decrease in value over time. This gradual reduction or decrease in the value of a fixed asset is called depreciation.
In accounting, depreciation is calculated for all assets that have a useful life which is generally greater than one accounting period. Depreciation is the accounting mechanism used to describe the method of progressively reducing the value of an asset over a period of time due to usage, wear and tear, decay, obsolescence, or other factors.
Depreciation includes such features as
- It is the decline in the book value of fixed assets
- It included the loss of value due to the passage of time, usage or obsolescence
- Is a non-cash expense that has no effect on cash flow
There are two main methods of calculating depreciation
- “Prime cost,” straight line or fixed instalment method.
- “Diminishing value or” reducing balance method.
There is no right or wrong answer as to which method of depreciation is adopted. This is a matter of choice. In either case an agreed percentage is deducted from the value of the asset each year.