Concept of Depreciation
Depreciation refers to loss of value of fixed assets in use. It is also called consumption of fixed capital. At the level of economy as a whole, it is called current replacement cost.
Depreciation involves three types of expenses as under:
(a) Normal Wear and Tear: It refers to those expenses which are borne an account of wear and tear of fixed assets (like machines) due to their continuous use.
(b) Obsolescence: It refers to those expenses which are incurred by the producers because of some capital equipment (owing to change in technology or changes in demand). Obsolescence occurring due to change in technology or change in demand is called expected obsolescence. It is different from unexpected obsolescence which is ascribed to natural calamities like floods or fire. To be noted, only expected obsolescence is included in the estimation of depreciation.
(c) Sudden Damages: It refers to accidental breakdown of the plants and machinery.
A producer need to maintain depreciation reserve fund to cope with three types of expense related to depreciation. This is essential to replace the worn-out assets. Otherwise, his production capacity (in term of his fixed assets) would tend to shrink. At the national level, if current replacement cost is not accounted for, production capacity of the nation would reduce, implying a fall in the flow of goods and services. Accounting for current replacement cost, we are only maintaining our existing production capacity (or capital stock). Investment expenditure, occurring on account of replacement of the worn out assets is also called replacement investment.
By estimating depreciation, we are thus highlighting: (a) the significance of replacement cost, (b) the distinction between gross investment and net investment enhancing capital stock (or production capacity of the nation).
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