The concept of depreciation is related to the fixed assets. Fixed assets like land, building, machines and equipment etc are acquired for their long term use in business operations rather the short term resale like current assets. The expenditure incurred for the acquisition of the fixed assets is treated as capital expenditure. The benefits of such expenditure are deferred over long life of such assets. The value of such assets diminishes with effluxion of time and their use in the business.
For the purpose of depreciation the fixed assets should be classified into two groups: (1) Tangible assets, and (2) Intangible assets
Tangible assets: Tangible assets are those fixed assets which are visible and enjoy physical existence e.g. land, building, machines, mines etc. Then tangible assets are further divided into groups:
1) Wasting assets: Wasting assets are the fixed asset consisting of natural resources like mines, oil wells, quarry etc. Like other tangible assets, they are recorded initially at the acquisition cost. Their value depletes according tot heir residual service potential.
2) Other tangible assets: These are the tangible fixed assets other than natural resources e.g. and, buildings, machines etc. They are recorded at the acquisition cost and are depreciated on the basis of the estimated useful life of the asset.
Intangible assets: Intangible assets are those assets which are characterized line existence e.g. patent, trademark, copyright, good will etc. The service potential of such assets is uncertain and difficult to measure. The cost of such assets is amortized over their useful life. Due to the high degree of uncertainty about their service potential it is considered as business prudence to write them off as early as possible.
On the basis of the aforesaid classification of fixed assets, the terms, depreciation depletion and amortization are used as under:
Depreciation is the cost of expired services of the tangible assets other than natural resources. Depletion is the estimated cost of natural resources that have been removed from their source. Amortization is the expired service cost of intangible assets. Thus, depreciation depletion and amortization are the systematic and rational apportionment of the acquisition costs of the fixed assets to future periods during which services or benefits out of them are received to the advantage of business.
Thus, the terms depreciation is made with reference to the tangible fixed assets like land, building, machines, furniture etc. The most scientific definition of the depreciation can be given as under:
Depreciation is the process of allocating the acquisition cost of tangible asset less salvage value, if any, in a systematic and a rational manner, over the estimated useful life of the asset; e.g. if one machine costs Rs 11,000 with a serviceable life of 5 years and the scrap value of the machine at the end of the 5th year is say Rs 1,000 then Rs 10,000 (i.e. Rs 11,000 less Rs 1,000) will be allocated over the 5 years on some rational basis. There are different methods for allocating such depreciable value over the life of the assets. Under the straight line method, the asset will be depreciated by Rs 2,000 (i.e Rs 10,000 / 5) very year. It should be noted that depreciation is a process of allocation and not valuation. The acquisition cost of the asset less the accumulated depreciation (i.e. total depreciation written off up to a given time) is referred as the book value or the written down value (WDV) of the asset. The book value does not necessarily show the realizable value of the asset at any given point of time.