Nature of Depreciation As we have discussed, land has an unlimited life and therefore can provide unlimited services. On the other hand, other fixed assets such as equipment, buildings, and land improvements lose their ability, over time, to provide services. As a result, the costs of equipment, buildings, and land improvements should be transferred to expense accounts in a systematic manner during their expected useful lives. This periodic transfer of cost to expense is called depreciation. The adjusting entry to record depreciation is usually made at the end of each month or at the end of the year. This entry debits Depreciation Expense and credits a contra asset account entitled Accumulated Depreciation or Allowance for Depreciation. The use of a contra asset account allows the original cost to remain unchanged in the fixed asset account. Factors that cause a decline in the ability of a fixed asset to provide services may be identified as physical depreciation or functional depreciation. Physical depreciation occurs from wear and tear while in use and from the action of the weather. Functional depreciation occurs when a fixed asset is no longer able to provide services at the 1evel for which it was intended. For example, a personal computer made in the 1980s would not be able to provide an Internet connection. Such advances in technology during this century have made functional depreciation an increasingly important cause of depreciation. The term depreciation as used in accounting is often misunderstood because the same term is also used in business to mean a decline in the market value of an asset. However, the amount of a fixed asset’s unexpired cost reported in the balance sheet usually does not agree with the amount that could be realized from its sale. Fixed assets are held for use in a business rather than for sale. It is assumed that the business will continue as a going concern. Thus, a decision to dispose of a fixed asset is based mainly on the usefulness of the asset to the business and not on its market value. Another common misunderstanding is that accounting for depreciation provides cash needed to replace fixed assets as they wear out. This misunderstanding probably occurs because depreciation, unlike most expenses, does not require an outlay of cash in the period in which it is recorded. The cash account is neither increased nor decreased by the periodic entries that transfer the cost of fixed assets to depreciation expense accounts.