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Certain assets, such as buildings and equipment, depreciate, or decline in value, over time.
You can amortize, or write off, the cost of such an asset over its estimated useful life, thereby reducing your taxable income without reducing the cash you have on hand.
- the fall in the value of an ASSET during the course of its working life. The condition of plant and equipment used in production deteriorates over time and these items will eventually have to be replaced. Accordingly, a firm needs to make financial provision for the depreciation of its assets.
Depreciation is an accounting means of dividing up the HISTORIC COST of a FIXED ASSET over a number of accounting periods which correspond with the asset's estimated life. The depreciation charged against the revenue of successive time periods in the PROFIT-AND-LOSS ACCOUNT serves to spread the original cost of a fixed asset yielding benefit to the firm over several trading periods. In the period-end BALANCE SHEET such an asset would be included at its net book value (cost less cumulative depreciation deducted to date). This depreciation charge does not attempt to calculate the reducing market value of fixed assets, so that balance sheets do not show realization values.
Different formulas used to calculate depreciation can lead to variations in the balance sheet value of a fixed asset and in the charge against GROSS PROFIT for depreciation. The second formula in Fig. 33 gives a large depreciation charge in the early periods of the fixed asset's life and a small charge in the later years (accelerated depreciation). In the interests of consistency, firms generally do not change the depreciation formula used for their fixed assets but stick to the same formula indefinitely.
All these depreciation formulas base the depreciation charge on the historic cost of fixed assets. However, during a period of INFLATION it is likely that the REPLACEMENT COST of an asset is likely to be higher than its original cost. Therefore, prudent companies need to make PROVISION for higher replacement costs in the form of a REVALUATION RESERVE. See INFLATION ACCOUNTING, CAPITAL CONSUMPTION, APPRECIATION, CREATIVE ACCOUNTING.
- a decrease in the EXCHANGE RATE of a currency against other currencies under a FLOATING EXCHANGE RATE SYSTEM, reflecting a fall in market demand for that currency combined with a rise in market demand for other countries' currencies. The effect of a depreciation is to make imports (in the local currency) more expensive and exports (in the local currency) cheaper, thereby assisting in the removal of a BALANCE OF PAYMENTS deficit by acting to reduce import demand for goods and services and increasing export demand.
Depreciations, like DEVALUATION, provide firms with an opportunity to expand sales and boost profitability by improving their price competitiveness in both home and export markets. See DEVALUATION for further discussion. Contrast with APPRECIATION, definition 2. See EXCHANGE RATE EXPOSURE.
depreciationINTEREST is payable on deposit accounts, normally at rates above those paid on current accounts, in order to encourage clients to deposit money for longer periods of time. Unlike with a current account, cheques cannot generally be drawn against deposit accounts. See BANK DEPOSIT.
- a fall in the value of a CURRENCY against other currencies under a FLOATING EXCHANGE-RATE SYSTEM, as shown in Fig. 43 (a). A depreciation of a currency's value makes IMPORTS (in the local currency) more expensive and EXPORTS (in the local currency) cheaper, thereby reducing imports and increasing exports, and so assisting in the removal of a BALANCE OF PAYMENTS deficit. For example, as shown in Fig. 43 (b), if the pound-dollar exchange rate depreciates from £1.60 to £1.40, then this would allow British exporters to reduce their prices by a similar amount, thus increasing their price competitiveness in the American market (although they may choose not to reduce their prices by the full amount of the depreciation in order to boost profitability or devote more funds to sales promotion, etc.) By the same token, the depreciation serves to raise the sterling price of American products imported into Britain, thereby making them less price-competitive than British products in the home market. In order for a currency depreciation to ‘work’, four basic conditions must be satisfied:
- how successful the depreciation is depends on the reactions of export and import volumes to the change in relative prices, i.e. the PRICE ELASTICITY OF DEMAND for exports and imports. If these volumes are low, i.e. demand is inelastic, trade volumes will not change much and the depreciation may in fact worsen the situation. On the other hand, if export and import demand is elastic then the change in trade volume will improve the payments position. Balance-of-payments equilibrium will be restored if the sum of export and import elasticities is greater than unity (the MARSHALL-LERNER CONDITION);
- on the supply side, resources must be available, and sufficiently mobile, to be switched from other sectors of the economy into industries producing exports and products that will substitute for imports. If the economy is fully employed already, domestic demand will have to be reduced and/or switched by deflationary policies to accommodate the required resource transference;
- over the longer term, ‘offsetting’ domestic price, rises must be contained. A depreciation increases the cost of essential imports of raw materials and foodstuffs, which can push up domestic manufacturing costs and the cost of living. This in turn can serve to increase domestic prices and money wages, thereby necessitating further depreciations to maintain price competitiveness;
- finally, a crucial requirement in underpinning the ‘success’ of the above factors and in maintaining long-run equilibrium is for there to be a real improvement in the country's industrial efficiency and international competitiveness. (See ADJUSTMENT MECHANISM entry for further discussion.) See BALANCE-OF-PAYMENTS EQUILIBRIUM, INTERNAL-EXTERNAL BALANCE MODEL, PRICE ELASTICITY OF SUPPLY.
- the fall in the value of an ASSET during the course of its working life. Also called amortization. The condition of plant and equipment used in production deteriorates over time, and these items will eventually have to be replaced. Accordingly, a firm is required to make financial provision for the depreciation of its assets.
Depreciation is an accounting means of dividing up the historic cost of a FIXED ASSET over a number of accounting periods that correspond with the asset's estimated life. The depreciation charged against the revenue of successive time periods in the PROFIT-AND-LOSS ACCOUNT serves to spread the original cost of a fixed asset, which yields benefits to the firm over several trading periods. In the period end BALANCE SHEET, such an asset would be included at its cost less depreciation deducted to date. This depreciation charge does not attempt to calculate the reducing market value of fixed assets, so that balance sheets do not show realization values.
Depreciation formulas base the depreciation charge on the HISTORIC COST of fixed assets. During a period of INFLATION, however, it is likely that the REPLACEMENT COST of an asset is likely to be higher than its original cost. Thus, prudent companies need to make provision for higher replacement costs of fixed assets. See INFLATION ACCOUNTING, CAPITAL CONSUMPTION, APPRECIATION ?.
(1) In accounting, the process of deducting some portion of the acquisition cost of property over time,as an expense against income,to reflect the fact that the property is becoming less valuable and will eventually require replacement. One cannot allow a $3,000,000 building to remain on the books for 35 years as an asset at the same value and then,suddenly one year,demol-
ish the building, write off $3,000,000 against income for that particular year, and then construct another building or move. (2) In appraisal, a reduction in the calculations for the reproduction cost of an improvement, in order to arrive at a value of the improvement in its current state, not as it would be if it were reproduced and brand new.