Definition and Explanation
Depreciation applies to fixed assets on your Balance sheet and is credited directly or indirectly to net profit or loss. This group of assets is also called Property, Plant, and Equipment or PPE. They are items that you buy to use in your business to help generate income over an extended period (12 months and more). Do not let the word fixed confuse you. It does not mean that they are not physically movable. It means that they are part of your long-term business assets.
For fixed assets to be considered depreciable, they should also have a limited useful life. Useful life the length of time the depreciated assets will be productively used in the operations of a business. Moreover, these assets should be used by an organization in the production or supply of goods and services, for renting to other organizations, or for administrative purposes.
In accounting records, total depreciation cost is reflected as net of the acquisition price and estimated residual value. It must be accounted for using one of the depreciation methods each reporting period during the useful life of the asset, regardless of any increase in its value.
The reason for spreading the fixed asset’s cost is to match expense with income. For example, a car or a computer or a building will be used in a company to generate income for more than one year. In other words, the cost is an expense that is related to future income in your organization. Thus, it should not be expensed only in the month you acquire it. This is especially true for large, expensive fixed asset purchases that will otherwise greatly distort the financial statements of your organization.
Useful life of depreciable assets
The useful life of depreciable assets is determined taking into account the expected physical wear and tear, obsolescence, legal and other restrictions on the use of the asset. The useful life of depreciable assets for an entity can be less than its physical life. Therefore, in addition to physical wear and tear, one should take into account the obsolescence caused by technological changes, improvement in production, changes in market demand, and other factors.
The useful lives of major depreciable assets or groups should be reviewed periodically. If necessary, the depreciation rates for the current and future periods are adjusted. Such changes are made in the accounting period in which they took place. There might not be enough experience using some depreciable assets in the production of a new product or a new type of service, which makes it much more difficult to calculate the useful life, but it still should be done to the best of one’s ability and adjusted later as necessary.