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Fundamentally the meaning of expense is expenditure of cash. Depreciation however is an expense item unlike any other expense item as cash expenditure there is none whatsoever. Any asset item undergoes wear and tear over the years, is subject to the aging process and gradually becomes obsolete. Hence the value of an asset reduces. As an asset reaches the end of its useful life it loses its value or depreciates and therefore replacement is necessary. The cost of depreciation of assets is written off over their useful life. Since depreciation is an expense where cash is not involved it would on the one hand lower the reported earnings of a company and on the other increase cash flow freely. To determine the profits or net income the receipts would have to be reduced proportionate to costs. Cost of assets that are in use but there isn’t any immediate depletion is one such cost that reduces receipts proportionately to ascertain net income or profit.   Allocation of assets cost over a period of time reduces the value of an asset to the extent of the cost of an asset initially. Later on when an asset is disposed off there could be a gain or loss on disposal. There are several methods of allocating cost of assets to periods in which an organization is likely to benefit from the use of the assets. Since an asset can be depreciated it is known as  a depreciable asset. Technically depreciation is a basis of allocation. It’s not a method of valuation of assets. However on the balance sheet the value of an asset is determined after depreciation. Any activity related to business that has the potential to generate income by using tangible assets, there would be recurring costs in relation to those assets. Assets that are potentially beneficial in future periods have related future costs as well. The costs are deferred instead of being treated as an expense in the current period. Depreciation expense therefore is recorded as an expense allocation in the current period for financial reporting purposes. Usually this is done rationally and systematically. The criteria that are taken into consideration are:
  • cost of the asset
  • expected salvage value or residual value of the assets
  • estimated useful life and
  • a method of allocating costs over the useful life
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