Concept of Depreciation and Depreciation Reserve Fund

The concept of depreciation refers to the gradual decrease in the value of the capital stock either through the physical tear and wear obsolescence or changes in demand for services of the capital.

Concept of Depreciation:

It refers to the decrease in the economic value of the capital stock over time. while fixed assets/capital stock is in use, that goes down in value due to normal wear and tear mad accidental damages. Furthermore. they go down in value. It is because they become obsolete or outdated due to changes in technology or change in demand. Thus. depreciation can be said as the loss of value in fixed assets in use on account of normal wear and tear, accidental damages, and obsolescence. Hence, It can be known as the consumption of capital stock or fixed assets.

In other words, the concept of depreciation refers to the value of fixed capital or fixed assets which is used or consumed in the process of production. 

Causes of Depreciation:

1. Normal Wear and Tear: It refers to the decline in the physical value of the capital stock due to continuous use.

2. Obsolescence: Because of rapid changes in technology, existing technology becomes outdated and is replaced is new and more efficient technology.

3. The normal rate of accidental damages: It includes the damages to fixed assets beyond their routine repairs and maintenance.

Concept of Depreciation Reserve Fund: 

As we know fixed assets are consumed or used during the process of production of final goods. Thus, these assets need to be replaced from time to time because of depreciation. And, the replacement of fixed assets requires the funds to finance them. For this purpose, the provision of funds is established on an annual basis. And, this provision made, is known as a depreciation reserve fund. 

Example:

Suppose a piece of machinery is purchased for Rs.5,00,000. And, its expected life is 5 years. Then, the annual provision for funds to replace the machinery after 5 years would be 5,00,000/5 = Rs. 50,000. It is known as a depreciation reserve fund. 

Significance:

The creation of the depreciation reserve fund implies the replacement fund. Thus, the overall investment or gross investment in the economy tends to increase with the increase in investment. Accordingly, the level of output increases. This leads to an increase in income level and employment. And hence, the overall growth of the economy gets accelerated.

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References:

Introductory Microeconomics – Class 11 – CBSE (2020-21)