People will casually speak of depreciation as a decline in value or “using-up” of an asset. However, in accounting jargon, the term is meant to refer to the allocation of an asset’s cost to the accounting periods benefited. It is not an attempt to value the asset. Thus, it is often said that depreciation is a process of “allocation” not “valuation.” Once an asset’s cost is determined, it next becomes necessary to determine the accounting periods benefited (i.e., service life).
Determining the service life of an asset is an essential first step in calculating the amount of depreciation attributable to a specific period. Several factors must be considered:
Physical deterioration — “Wear and tear” will eventually cause most assets to simply wear out and become useless. Thus, physical deterioration serves to establish an outer limit on the service life of an asset.
Obsolescence — The shortening of service life due to technological advances that cause an asset to become out of date and less desirable.
Inadequacy — An economic determinant of service life which is relevant when an asset is no longer fast enough or large enough to fill the competitive and productive needs of a company.
Factors such as these must be considered in determining the service life of a particular asset. In some cases, all three factors come into play. In other cases, one factor alone may control the determination of service life. Importantly, service life can be completely different from physical life. For example, computers are often replaced even though still physically functional.
Recognize that some assets have an indefinite (or permanent) life. One prominent example is land. Accordingly, it is not considered to be a depreciable asset.
|Did you learn?|
|Carefully define depreciation.|
|Distinguish between service life and physical life.|
|What key factors affect the determination of service life?|