Need for Depreciation

The need for charging a reasonable amount of depreciation over the estimated useful life of the asset arises for following purposes:

1.    To ascertain the true income: The cost of the fixed asset is in the nature of capital expenditure and is not charged to revenues of the accounting period in which the asset is purchased or the period in which the said asset is sold or discarded. Thus the cost of the asset less its salvage value must be allocated in a rational manner to the periods that received benefits from the use of the asset. Thus depreciation is an item of business expenses and must be provided and recorded for a proper matching of cost with the revenue, a condition necessary for the purpose of calculating true income for each accounting period of asset use.

2.    To show the asset at its proper value: In the absence of depreciation charge, the asset will be shown at its acquisition cost year after year in the balance sheet. This is an unfair practice and the balance sheet would fail to show the true financial position.

3.    To maintain the capital invested in the cost of the asset intact in the business so that it can be reinvested in the profit – earning process.

4.    To retain out of profit funds for replacement: All fixed assets become useless sooner or later and therefore must be replaced by the purchase of new assets. Provision for funds has to be made well in advance so that assets are replaced without any financial crisis. If the fund are not retained from the available annual profits and are fully distributed, it will be difficult to find the necessary funds for replacement. Indian Company Act has therefore made it compulsory for companies to provide for prescribed depreciation before declaring dividends.

5.    To allocate the cost of the fixed asset to products it (business unit) produces in order to find out their accurate cost of production.

6.    To compute tax liability of the owner: In such cases the rate of depreciation is influenced by the tax-laws.

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