Which of the following explains the concept of depreciation:

1. An annual allowance for wear and tear of a capital good.
2. The capital good gradually used up in each year's production process.
3. Cost of replacement of a capital good due to an accident.
4. Fall in the value of fixed asset due to unexpected change in technology.
5. Cost of the good divided by number of years of its useful life.

A, B, E only

The deletion which is made from the value of gross investment in order to accommodate regular wear and tear of capital, is called depreciation. Let us examine this concept called depreciation a little more in detail. Let us consider a new machine that a firm invests in. This machine may be in service for the next twenty years after which it falls into disrepair and needs to be replaced. We can now imagine as if the machine is being gradually used up in each year’s production process and each year one twentieth of its original value is getting depreciated. So, instead of considering a bulk investment for replacement after twenty years, we consider an annual depreciation cost every year. This is the usual sense in which the term depreciation is used and inherent in its conception is the expected life of a particular capital good, like twenty years in our example of the machine. Depreciation is thus an annual allowance for wear and tear of a capital good. In other words it is the cost of the good divided by number of years of its useful life. 

Depreciation does not take into account unexpected or sudden destruction or disuse of capital as can happen with accidents, natural calamities or other such extraneous circumstances.