DEPRECIATION. In accounting, the term "depreciation" is applied to that inevitable wastage in the value of assets due to some cause inherent in the thing itself, as distinct from fluctua tions in value that arise from external causes. Depreciation may arise owing to the operation of (a) human, or (b) natural laws. Leaseholds and copyrights have, by the operation of the law, a limited duration of life, on the expiration of which no proprietory rights survive. Whatever may have been expended on such rights is accordingly expenditure to be recouped (if at all) out of the advantages derived from the use of the property during a definite known period. If due provision be made for depreciation it will take the form of charging against the profits of each successive year its due proportion of the total outlay, so that when the work ing life has expired the whole of the outlay will have been charged against profits. When depreciation takes place as the result of natural laws, it is caused by wear and tear, natural decay, or obsolescence. Its effect is very similar to that of depreciation from legal causes, save that the period of utility—the working life—is not precisely known, but has to be estimated. Moreover, in many cases, the effect of wear and tear is to impair the effi ciency of the equipment gradually, with the result that its value as a profit-earner tends to diminish year by year. Nevertheless, the problem is essentially the same; the whole of the original outlay (minus its residual value, if the latter be worth consider ing) is a proper charge against the profits earned during the period that the article is in use. Due provision for depreciation during that extended period will involve each successive year's profits being charged with its due proportion of the total sum to be provided.
As a matter of calculation, the total sum may be distributed over the required series of years by (a) equal, (b) gradually diminishing, (c) gradually increasing, or (d) irregular instal ments. In practice all four methods are in use; they are often called respectively the straight-line, fixed percentage, annuity, and revaluation methods.
When expenditure upon renewals is more or less continual, there is ordinarily no difficulty about financing such expenditure out of revenue, but where relatively large sums have to be found infrequently, it is usually desirable to supplement the accounting provision for depreciation by a physical accumulation of funds available to meet the cost of renewals. This is done by investing year by year a sum equal to the amount charged against profits for depreciation and reinvesting any income derived from such investments, thus building up what is called a sinking fund.
Theoretically, provision for the depreciation of every wasting asset should be effected as the result of a separate calculation. In practice, however, assets are usually grouped into a compara tively small number of separate accounts, and the provision in respect of each group is based upon the average life of the items composing it. The success of such a device as this depends en tirely upon the adequacy of the grouping arrangements. Very often the grouping is overdone.
There should be no real difficulty about calculating in advance due provision for depreciation proper, but it is not, of course, possible to calculate with equal precision the effect of obsoles cence. All that can be done is to keep the estimate of the work ing life low. Successful undertakings often deliberately under estimate the working life, as a sort of insurance against obsoles cence. If this be over-done a secret reserve is created.
(L. R. D.)