Depreciation is a decrease in the price of an asset with the course of time, due in particular to wear and tear. All assets whose advantage is derived for a long period of time, generally more than one year period are called as Fixed Assets. These assets reduce in value year after year due to wear and tear or lapse of time. This reduction in the value of Fixed Assets is called Depreciation. The depreciation needs to be provided because an asset is bound to undergo wear and tear over a period of time. This reduces the working capacity and efficiency of the asset.
Need for Providing Depreciation:
The need for providing depreciation in accounting records arises due to any one or more of the following reasons.
- To ascertain correct profit/loss
Depreciation is an expense and becomes a significant constituent of the cost of production. For proper matching of cost with revenues, it is necessary to charge depreciation against revenue in each accounting year, to calculate the correct net profit or a net loss. If no depreciation is charged and when assets are shown at the original cost year after year, Balance Sheet will not disclose the correct state of affairs of a business.
- To present a true and fair view of the financial position
Financial position can be studied from the balance sheet and for the preparation of balance sheet, fixed assets are required to be shown at their true value. If the amount of depreciation is not provided on fixed assets in the books of account, the value of fixed assets will be shown at a higher value than it’s real value in the balance sheet. As such it will not reflect the true and fair financial position of the business. If assets are shown in the balance sheet without any charge made for their use or depreciation, then their value must have been overstated in the balance sheet and will not reflect the true financial position of the business. Hence, to present a true and fair view of the financial position of the business, it is necessary that depreciation must be deducted from the book value of the assets in the balance sheet.
So, for the purpose of reflecting the true financial position, it is necessary that depreciation must be deducted from the assets and then at such reduced value these may be shown in the balance sheet.
- To ascertain the real cost of production
Goods are formed with the aid of plant and equipment which incurs depreciation in the procedure of production. For ascertaining the real cost of production, it is necessary to provide depreciation. This depreciation must be measured as a part of the cost of production of goods. Otherwise, the cost of production would be exposed to less than the true cost.
- To make Provision for replacement of assets
If depreciation is not provided, the profits of the apprehension will be overstated and can be distributed to the shareholders as a dividend. Depreciation is provided to replace the assets when it becomes useless. Assets used in the business need replacement after the termination of their service. Provision for depreciation is a charge to profits and loss account through depreciation is not paid. It is always not probable to find out the helpful life of assets.
The amount of depreciation accumulated during the working life of the asset provides supplementary working capital besides providing a sum at the end of the working life of the asset for its replacement. When an asset is incessantly used, a time will come when the asset is to be given up and therefore its substitute is necessary.