Depreciation of Fixed Assets
A business may acquire fixed assets such as land, buildings, machinery, office equipment, delivery equipment and natural resources (e.g. a piece if mining land)to help in the process of its operations to earn revenue in order to make a profit. Such assets, by their very nature, provide benefits to the business for more than one financial year or period. In fact, when a business buys a fixed asset at a certain cost (say $10,000), it is actually buying a bundle of service benefits that will be provided by that fixed asset over a period of time in the future (say 10 years). Take, for example, when a wholesaler buys a delivery van, it is in effect buying transporting services for his goods that will be provided by the van over its useful life that will help him (the wholesaler) earn revenue. Note that all reasonable and necessary costs to get an asset in position and condition ready for use may be included as part of its cost. Thus, the lawyer's professional fees should be included in the cost of acquiring a building. Money spent to acquire fixed assets is called capital expenditure. The fixed asset is maintained in the books based on its cost. There is no need to revalue it even though its market price has changed. This is in line with the historical cost concept. As an asset is used over time, the bundle of future service benefits available from it becomes smaller and smaller. The whole cost of the fixed asset cannot be charged as an expense in the year it is bought. This is in line with the matching principle. Only a portion of the total cost representing the amount of service benefits that has been used up during an accounting period has to be charged as an expense for that period in the final accounts against the revenue earned. This amount is called the depreciation expense. Depreciation, therefore, means the allocation of the cost ($10,000 in the above example) of a fixed asset over its useful life (10 years, in the above example). Causes of Depreciation
The business has to make provisions for depreciation for its fixed assets in recognition of the fact that the availability of the service benefits from them grows less and less over time because of the reasons stated below. The fixed asset is then shown as a reduced value in the books after deduction the accumulated depreciation. It is in line with the concept of conservatism which anticipates all losses. 1. Physical deterioration caused mainly by physical wear-and-tear when the asset is used; erosion, rust, rot and decay when the asset is exposed to rain, sun, wind and other elements of nature. 2. Obsolescence, or the process of becoming obsolete or out of date. A good example of this is computers. You may buy a Pentium computer today, but with the speed at which information technology is developing nowadays, you can be sure it will be considered 'too slow', in other words, obsolete, in five years' time, even though the machine itself may still be mechanically fit to process information. 3. Depletion of an asset if it is one which is depleted over time, such as mining land or a quarry. Once the 'goodness; of the land has been extracted, and then sold, it cannot be replenished. Eventually, the asset would be totally depleted and it would be no longer economically viable for the owner to continue to extract more 'goodness' from it. 4. Passage of time which will shorten the life of assets such as copyrights, patent rights, and leases on hand. These assets confer upon their holder the exclusive right to enjoy certain privileges for a fixed period of time. Take, for example, the tenant (lessee) of a piece of land reserves the right to occupy the land for 10 years. During the period of the lease, the rightful owner (lessor) has no right to repossess it, as long as the tenant fulfils all the terms of the lease. However, at the end of the 10 years, the tenant no longer has any right to continue to...
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