Depreciation of Fixed Assets – What Exactly is Depreciation?
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life
– International Accounting Standards 16
Before looking further at what is depreciation of fixed assets or how to calculate the depreciation of fixed assets, it is important that you understand the meaning of an expense in accounting.
Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets…
– International Financial Reporting Standard
Let’s just focus on the bolded part for now.
So What Exactly is an Expense?
Suppose you just ate an apple and paid $1 for it. This $1 will be considered an expense for you because it is a decrease in economic benefit. You might be thinking: “Hey, sure I have paid $1, but this outflow resulted in an apple worth $1. Where is the decrease in economic benefits?”
But the key here is you have consumed the apple. You do not get anything out of that same apple again. You now have $1 less in your wallet and the apple is gone for good. This is why the $1 represents a decrease in economic benefit and hence considered an expense.
But What Does That Have To Do With Depreciation?
Suppose this time you bought an apple tree for $500. This tree will grow 500 apples over the next 5 years. This transaction sets your bank account back by $500, but what you get in exchange – the tree – can offer you benefits in the future: the privilege to enjoy apples for the coming years.
This tree fits into the definition of an asset: a resource that generates future economic benefits.
Note that as you start to consume some of the apples, the value of the tree decreases. This is because as fewer apples are left, the future benefit you get from the tree drops. There is a fall in asset value.
At the same time, your consumption of the apples implies an expense. As with what happens in the first scenario, the apple you eat is gone for good and you cannot get any future benefits from that particular apple again.
In short, the apple tree qualifies as an asset. However, as you pick the fruits from the tree and put them into your mouth, the value of the tree declines and you incur an expense.
This is what happens in depreciation.
Depreciation in a Business
When a company acquires a machine, it records an increase in fixed assets (aka. non-current assets). However, you cannot expect the machine to last forever. It can only generate economic benefits for a limited period of say 5 years. After that period, it may break down or become obsolete. Therefore, like the case of the apple tree, when the company uses the machine (the asset), two things happen:
- the value of that machine declines (less remaining productivity) and
- the company incurs an expense (the business consumed the productivity brought by the machine; this consumption gone for good)
In the next article, we will explore how accountants handle depreciation.
Horngren, C., Sundem, G., Elliott, J., & Philbrick, D. (2014). Measuring Income to Assess Performance. In Introduction to financial accounting (Eleventh ed., p. 48)