Cause of Depreciation of tangible Assets

Depreciation is defined as the ease of making a systematic and rational allocation of the cost of tangible assets over their useful lives. In India, the concept of depreciation is critical for both financial reporting and tax purposes. In several respects, depreciation helps the business properly manage the asset to meet regulatory requirements. This blog delves into the detailed causes of tangible asset depreciation. 

 

  1. Wear and Tear

“Wear and tear” describes the gradual deterioration of an item’s physical condition over time due to regular use. All physical assets face this most common depreciation. 

Example: In this view, a delivery truck utilized by any logistics company in India experiences real-time operations that make the body, tires, and engine deteriorate, thus deteriorating the efficiency and value of the truck.

 

  1. Obsolescence

Obsolescence is a condition in which an asset grows out of date due to technological advancement or changes in market preference or statutory changes which will make the asset either less useful or lose its use. 

Example: Computers and smartphones become quickly obsolete with continuous technological innovations. The company may have to upgrade if it is using an old model not compatible with new software.

 

  1. Depletion

Depletion, on the other hand, is the extraction and consumption of resources like mines, oil wells, and forests, which leads to resource diminishment. 

Example: For example, an Indian company extracting coal, like any other mine, will experience a depletion of its coal resources. Depletion implies that the accessible reserves are going to get scarce very soon, and hence even the value of the asset will reduce.

 

  1. Physical Deterioration

Rust, corrosion, and weather-related disasters are the primary sources of damage. Regular maintenance is required for this class, as it is the most unavoidable source of damage. 

Example: Agricultural machinery exposed to harsh weather conditions in rural India will rust and corrode over time, affecting its functionality and value.

 

  1. Legal or Contractual Limits

Some tangible assets have a life that is limited by law or contract. These contracts or laws take away the capacity of the asset to perform its intended function. 

Example: If a business has made leasehold improvements on a rented property in India, such improvements are considered to be depreciable over the lease period. If the lease is for a certain number of years and the business finds the leasehold improvements useless at the end of the term, they might not hold any residual value.

 

  1. Changes in Market Conditions

Changes in the demand and supply of the markets can impact the market conditions, thereby causing changes in the value of the assets. As a result, the asset’s value can quickly depreciate. 

Example: For example, a drastic decrease in demand for specific types of fabrics will cause the machinery of a textile manufacturing unit in India to experience rapid depreciation in value.

 

  1. Economic and Regulatory Factors

Changes in economic policies, inflation rates, and regulatory frameworks can influence asset erosion at any given moment. In reality, these variables often modify the costs associated with maintaining, replacing, and operating assets. 

Example: For example, if India modifies its laws to enforce stricter environmental regulations, the company will need to upgrade its factory or replace some equipment to meet the environmental standards. This will result in a rapid depreciation charge on the existing machinery.

 

  1. Usage Patterns

The manner and intensity of the asset’s use will strongly establish its depreciation. An asset that is greatly and intensely used will depreciate much more quickly. 

Example: For instance, because to the high mileage and continuous travelling, a personal car will start to breakdown at a slower rate than a taxi operating in the most congested city of Mumbai.

 

  1. Technological Advancements

Current equipment and other assets may become ineffective or outdated due to ongoing technological changes, necessitating replacements even though their usefulness may not fully exhaust. 

Example: Used in electronics production, manufacturing equipment may become outdated very quickly as new and more efficient machinery becomes available, with the depreciation of the older equipment also happening at a quicker pace.

 

  1. Maintenance Practices

Level and standard of maintenance of an asset affects how much an asset depreciates. If the maintenance is of high quality, it can even lengthen the useful life of the asset, yet poor maintenance only serves to catalyze depreciation. 

Example: Regularly maintained and serviced industrial machinery in any Indian factory is likely to depreciate much more slowly than its poorly maintained counterparts.

 

  1. Accidents and Mishandling

Accidents, mishandling, or misuse can severely damage assets, causing them to depreciate quickly or even necessitate immediate replacement. 

Example: For instance, mishandled or accident-prone work-related machinery would result in a much faster depreciation of the asset’s value.

 

  1. Environmental Factors

Environmental factors such as humidity, temperature fluctuations, and chemical exposure may degrade physical condition. 

Example: Metal structures and equipment can rust more quickly in the humid and salty coastal regions of India, accelerating their depreciation. 

Questions to test your understanding 
  • Which one of the following best defines ‘wear and tear’ as a cause of depreciation? 
  1. Legal Restrictions on the Use of Assets 
  2. Obsolescence of assets due to technological changes 
  3. Gradual reduction of the value of a resource by use 
  4. Changes in economic policies in relation to asset value 

  

  • For depreciation purposes, what is the meaning of ‘obsolescence’? 

 

  1. Physical damage from an accident and the consequential diminishment of value 
  2. The depreciation of an asset as a result of the consumption of natural resources 
  3. The condition in which an asset becomes obsolete due to new technology or market change 
  4. Depreciation caused by poor maintenance practices 

  

  • So, what’s ‘depletion’ and how does it cause tangible asset depreciation?
  1. By legal or contractual restrictions on how an asset may be used 
  2. Extraction and consumption of natural resources 
  3. Because of rust or corrosion, with time 
  4. Through technological development, equipment is no longer useful. 

  

  • In the category ‘physical deterioration,’ which of the following factors mainly results in depreciation? 
  1. Technology has evolved. 
  2. Wear and tear 
  3. Disasters happen because of weather, corrosion, 
  4. Market conditions change. 

  

  • Why might legal or other contractual restrictions lead to asset impairment? 
  1. As the asset wears out over its useful life 
  2. Due to the obsolescence of the asset 
  3. The useful life of the asset is limited by an enforceable law or contract. 
  4. Depletion of an asset’s reserves
 

Conclusion 

Therefore, in order to manage the assets effectively, Indian business organisations cannot ignore the causes of depreciation. Depreciation can be caused by various factors such as wear and tear, technical obsolescence, depletion, physical degradation, regulatory constraints, market and economic conditions, use patterns, maintenance plans, accidents, and environmental factors. With that knowledge, business organisations could plan ahead strategies for replacing, maintaining, and upgrading assets so as to keep operational efficiency high and meet their financial reporting requirements. 

FAQ's

Depreciation is the uniform, periodic allocation of the cost of tangible assets over their useful lives. It is important in India in the context of financial accounting and taxation, as it helps businesses deal with their assets to meet the requirements of regulators.

Wear and tear are the decline of an asset over time due to usage, which leads to lower efficiency and value. For example, a delivery truck that is constantly on the move will show signs of wear and tear on the body, tyres, and engine. 

Obsolescence is the process of piling an asset into an obsolete state, primarily due to technological innovations or market preference changes. For instance, we must replace old computer models to ensure their compatibility with new software. 

Depletion occurs when the volume of natural resources, such as coal or oil, decreases, resulting in a decrease in the asset’s value. For example, a coal extraction company will experience depletion as its access to reserves drops.

Some assets are law-bound or have a contract life that limits their services in terms of the usefulness factor. For example, leasehold improvements made on rented property are normally depreciable over the term of the lease agreement and will have no residual value at the end of the lease.

Changes in market conditions, such as demand and supply fluctuations, affect asset values and lead to rapid depreciation. For instance, a sudden shock to the demand for some fabrics can substantially reduce the value of machinery employed in textile manufacturing.

Economic policies, inflation rates, and regulatory environments all impact the cost of holding and using assets. For example, changes in the regulatory environment towards greater environmental protection may result in supplementary equipment investments and, hence, faster depreciation of existing machinery.

The frequency and quality of maintenance directly impact the asset’s depreciation rate. A good-quality maintenance schedule will retard the rate of depreciation of an asset, while poor maintenance will have the opposite effect. Regularly serviced industrial machinery depreciates more slowly than equally quality machinery that receives infrequent maintenance.