Depreciation is the decrease in the value of an asset over time, primarily due to wear and tear, obsolescence, and the passage of time. There are several factors that can cause depreciation, including:
- Physical deterioration: The wear and tear that an asset experiences during its useful life can cause it to lose value. For example, a car’s paint may fade, its engine may become less efficient, and its upholstery may wear out.
Practical example: A delivery truck used for daily business operations will experience wear and tear from constant use. This wear and tear, like worn tires and a less efficient engine, leads to the depreciation of the truck’s value.
- Functional obsolescence: When an asset becomes less useful or efficient due to advancements in technology or changes in market preferences, it experiences functional obsolescence. This can lead to a decrease in its value over time.
Practical example: A company that uses an older computer system for managing its operations may experience a decrease in efficiency and productivity due to the system’s outdated technology. This results in functional obsolescence and the depreciation of the computer system’s value.
- Economic obsolescence: External factors, such as changes in laws, regulations, or market conditions, can cause an asset to lose value. This type of depreciation is also known as external obsolescence.
Practical example: A coal power plant may lose value as a result of new environmental regulations that limit carbon emissions. These regulations make the plant less profitable and cause its value to depreciate.
- Normal life expectancy: Assets have a limited useful life, and as they approach the end of their useful life, they generally lose value.
Practical example: A piece of machinery used in a manufacturing plant may have a useful life of 10 years. As the machinery approaches the end of its life, it may become less reliable and efficient, causing it to depreciate in value.
- Market conditions: The supply and demand for certain assets can influence their value. If there is a decrease in demand for a particular asset or an increase in supply, the asset’s value may depreciate.
Practical example: During an economic downturn, the demand for luxury cars may decrease, causing the value of these cars to depreciate as fewer people are interested in purchasing them.