Economic Depreciation Definition
Economic depreciation is defined as the wear and tear of an asset beyond its expected capacity or utility which means that suppose we have an asset and we expected the depreciation run to go for four years but it becomes obsolete and scrap in a span of only three years it is said to be economically depreciated.
Economic depreciation is defined as the gradual decrease in the value of assets in a period of time due to some major changes in the factors crucial to the economy. These types of depreciation are specifically linked to real estate where the property can incur a drastic change in its valuation due to some sudden events like the closure of the road it is built, depleting neighborhood or any kind of unfavorable conditions. Economic depreciation stands to be different from normal accounting depreciation because in accounting depreciation the value of asset gets depleted over a set period of time-based on a planned schedule but in cases of economic depreciation the asset becomes scrap way before the planned schedule due to some unforeseen events.
How does Economic Depreciation Work?
Economic depreciation is generally termed as the process by which assets lose their market value due to some kind of influential factors which overall leads to the degradation of the market value of the asset. At times when the owners need to sell their assets, they prefer economic depreciation over accounting depreciation when they want to sell their assets at the market rate. Also, economic depreciation broadly impacts the sale price of any kind of asset which the owners want to sell in the market. It is very common among owners to keep a check and monitor the rate of economic deprecation pertaining to the asset one wishes to sell.
When it comes to accounting for business needs, accountants will never record economic depreciation in their books of accounts or financial statement for big capital assets. Instead, they prefer to use the book value of the particular asset for the main reporting needs. One of the keys areas where economic depreciation is considered for financial analysis is in the field of real estate. Economic depreciation can also serve as a need of forecasting methodology when the analyst wants to forecast how much of revenue the good or service will generate in the future.
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Causes of Economic Depreciation
Following are the causes –
- Wear and tear of Assets: With the passage of time it is impossible to save assets from wear and tear and this becomes a mandatory attachment with every asset. Thus the decline in the physical condition of the asset is linked to the market value when we need to sell it again and this happens by depreciating the financial or monetary value of the asset and accounting the same for it in the mode of depreciation.
- Technological Advancements: Technology is changing at a rapid pace and every other day new technologies are substituting the older ones. The replacement occurs based on the effectiveness and efficiency of newer forms of technology which further leads to depreciation of assets which run on older forms of technology.
- Perishability: Assets which comes into use as raw materials or inventory have certain expiry date i.e. they need to be utilized within a certain point of time. They generally lose their value over a period of time and ultimately lose their value as time progresses. Thus these assets need to be depreciated over a period of time.
- Expiration of Rights: Assets like patents, copyrights, trademarks which are non-tangible in nature are only valid for a specific period of time which is generally the contract period for which the rights have been granted or contracted for. Thus this calls for depreciating the value of such intangible assets before the rights expire which is broadly called amortization. Thus when amortization of intangible assets occurs it is accounted in such a way that when the rights of the assets expire the value of the asset actually becomes zero or the asset becomes no more useful.
Economic Depreciation vs Accounting Depreciation
The method of calculation of economic depreciation is much more complex than that of calculating the accounting depreciation. When it comes to accounting depreciation an asset suppose for example a non-tangible one is amortized based on a fixed schedule i.e. it is more time-based and this schedule we call in accounting term as amortization schedule whereas in cases of economic depreciation there is no fixed period or schedule involved. It gets amortized based on some influencing factor which affects its market value. The same goes for tangible assets too. In accounting depreciation, the depreciation is calculated over a set period of time or schedule whereas in economic depreciation the value of asset gets depreciated quite before the set point of time due to some influencing factor that affects the market value of the asset.
The rate of economic depreciation is considered to be almost half of that of accounting depreciation. This difference between both results in the provision of a subsidy and also the replacement of capital at an earlier stage. Economic depreciation can be easily created on a model platform or accounted for by the creation of impairment charges. Economic depreciation is more based on the concept of capital investment whereas accounting depreciation is driven tax laws or IRS rules which states that if a machine has a life of 5 years it will be depreciated at the same rate regardless of how much life more it could stay in service.
All assets, be it tangible or non-tangible are subject to economic depreciation. It is just the company policy on how this can be analyzed and the effects be followed differently. A company generally is not concerned about market influences or affects its assets but it is more concerned about how the market affects its liquidity position. When it comes to depreciation a company is more concerned about how the assets are marked to market on the final books of accounts since this has a bigger impact on the overall financial performance of a company.
On the other hand, economic depreciation is given more weight by the investors since it affects the portfolio they are holding and also impacts their total net worth on a periodical basis. Economic depreciation is more prevalent among real estate industries where asset owners may see a huge spike and decline in the value of assets on account of several economic factors that directly or indirectly affect the overall market value of the assets.
This has been a guide to Economic Depreciation and its definition. Here we discuss how does economic depreciation work along with its causes and differences from accounting depreciation. You may also have a look at the following articles –