Depreciation is the gradual reduction in the value of the asset. The value diminishes due to constant usage and obsolescence. Depreciation is provided only for fixed assets, such as plant, machinery, equipment, building and furniture. Depreciation is never provided on assets that are current in nature. Current assets include cash, stock in hand and receivables. There are several factors that help in determining the annual depreciation of the asset.
Cost of the Asset
The costs incurred to purchase the asset play a very important role in determining the depreciation value. The cost of the asset is the amount paid to acquire it plus the costs of installing it minus the discounts received by the seller. If the company incurred high costs to purchase it, it is very unlikely to replace the asset very soon.
Estimated Useful Life
The estimated useful life also has a bearing on the determination of depreciation. If the asset is likely to be useful for many years to come, it is going to be depreciated each year annually at a lower rate than if its lifespan were estimated to be very low. The estimated useful life is computed after analyzing the productive capabilities of previously used, similar types of asset.
Nature of the Asset
This is very important in estimating the amount of depreciation and the time frame in which the asset must be written off completely. Assets engaged in the production processes are likely to have higher rates of depreciation in comparison to buildings. It is important to use accelerated methods of depreciation for the assets that are used to manufacture. These methods aim to diminish the majority of the assets' value in the earlier years of their operations.
The company must carefully understand the legalities in various governmental acts before fixing on its depreciation amounts. All the statutory and legal provisions must be carefully evaluated. For example, a company cannot pay out dividends to its stockholders unless it provides for depreciation.