Depreciation is a ratable reduction in the carrying amount of a fixed asset. Depreciation is intended to roughly reflect the actual consumption of the underlying asset, so that the carrying amount of the asset has been greatly reduced to its salvage value by the time its useful life is over.
But why do we need depreciation at all? The causes of depreciation are:
- Wear and tear. Any asset will gradually break down over a certain usage period, as parts wear out and need to be replaced. Eventually, the asset can no longer be repaired, and must be disposed of. This cause is most common for production equipment, which typically has a manufacturer's recommended life span that is based on a certain number of units produced. Other assets, such as buildings, can be repaired and upgraded for long periods of time.
- Perishability. Some assets have an extremely short life span. This condition is most applicable to inventory, rather than fixed assets.
- Usage rights. A fixed asset may actually be a right to use something (such as software or a database) for a certain period of time. If so, its life span terminates when the usage rights expire, so depreciation must be completed by the end of the usage period.
- Natural resource usage. If an asset is natural resources, such as an oil reservoir, the depletion of the resource causes depreciation (in this case, it is called depletion, rather than depreciation). The pace of depletion may change if a company subsequently alters its estimate of reserves remaining.
- Inefficiency/obsolescence. Some equipment will be rendered obsolete by more efficient equipment, which reduces the usability of the original equipment.
A variation on the depreciation concept is the destruction of or damage to equipment. If this happens, the equipment must be written down or written off to reflect its reduced value and possibly shorter useful life. Another variation is asset impairment, where the carrying cost of an asset is higher than its market value. If impairment occurs, the difference is charged to expense, which reduces the carrying amount of the asset.
When there is damage to or impairment of an asset, it can be considered a cause of depreciation, since either event changes the amount of depreciation remaining to be recognized.