The basic aim behind depreciation is that it simply spreads the value of asset over its useful life hence expensing out its value in proportion to the period it has been used. In this way, the asset is fully expensed out once it reaches the end of its life and is useless or scraps. Hence, the book value of an asset at any time is its cost less the accumulated depreciation from date to the date of purchase. Therefore, the depreciated vale may or may not be equivalent to the market value of the asset at any time. This means that as depreciation is means of logically expensing out an asset throughout its period of usage and useful life, it is not aimed at reaching a market value of the asset. Let’s look at a comprehensive example here to simplify the concept using a practical demonstration for a real life example. For instance, consider a building that has a cost of $100,000 and a useful life of 10 years.
This means that the value of building needs to be reduced eventually to nil in company accounts by the end of 10 years and for this purpose, depreciation is put into practice. After the end of first year the book value after depreciation of the building would be $90,000 (assuming 10% straight line depreciation. On the other hand, the market value at the time may be more or less than that based on external factors such as market and economic conditions along with the building’s structural condition. Therefore, depreciated value will be useful simply in terms of business reporting function and not for external pricing and valuation of the building.
In case the depreciated value may be equivalent to the market value of the asset, it may be a mere coincidence but not the actual motive behind this accounting concept. The actual motive behind the application of depreciation is not to assign the asset with its market value at that time but just to expense out the cost in proportion to the usage therefore ensuring that the total cost is expensed out effectively once the asset reaches the end of its useful life. This enables us to comprehend how depreciation simply takes notice of the cost of an asset and allocates it wisely in the company books for a logical reporting purpose. Therefore, it is duly understood that “depreciation is a process of allocation and not valuation”.
