Why Depreciation?

A depreciate asset is one that has a finite life extending over several accounting periods. Machinery is a depreciable asset, while land is not. Depreciation is intended to show the consumption of economic benefits during an accounting period. The economic benefits associated with all depreciate assets are eventually consumed, and the consumption of these benefits as an expense in the statement of financial performance.

A second and more contentious reason for providing for depreciation is in order for a business to maintain the capacity to continue its production. Clearly if a machine comes producing the goods. This, of course, assumes that it wishes to replace the machine which itself has underlying assumptions about the product still being produced, the technology in terms of production processes being the same, and so on. Such a measure depends on how you define wealth and whether that changes. For example, a car might be seen as an asset until such time as the world runs out of petrol reserves; at that stage we might not want to include a car in our measure of wealth. Therefore, to have retained profits in order to ensure we always had a car would not have been appropriate.

This second reason for providing for depreciation is also contentious because in fact all accounting depreciation does is to spread the original cost and maintain the original capital. In fact operating capacity is not maintained through depreciation, as no account is taken of charges in prices, in technology, or in consumer demand. Neither are the changes in the size of the business taken into account. This might have implications in terms of economics of scale. We cannot guarantee that we will have enough funds left in the business as a result of our depreciation charges to replace an existing machine with one of equal capacity should we wish to.