Need for Providing Depreciation

Depreciation is an allocation of the cost of an asset over its useful life and is not a valuation process of the asset. The Need for Providing Depreciation is discussed below


Need for Providing Depreciation


The following are the various reasons due to which there arises a need for providing depreciation.

To Determine True Net Profit or Net Loss: Correct profit or loss can be ascertained only when all the expenses and losses incurred during an accounting period for earning revenues are charged to the Profit and Loss Account. Assets are used in various business operations for earning revenues and therefore, its cost should be charged in the form of depreciation from the Profit and Loss Account. Therefore, if depreciation is not charged, then the net result shown by the Profit and Loss Account would not reveal the true profit or loss.

To Reveal True and Fair View of Financial Position: If depreciation is not charged in the books, then assets would be shown at a higher value than their actual value in the Balance Sheet. Consequently, the Balance Sheet fails to reflect the true and fair view of the Financial Position of a business at the end of an accounting period.

To Determine Cost of Production: Depreciation on Plant and Machinery and on other assets, which are engaged in production, is included in the cost of production. Cost of production is a basis for determining the selling price of products in the market. Therefore, if depreciation is not provided, then the cost of production is underestimated, which will lead to the low sale price in the market and thus leads to lower profits.

Distribution of Dividend Out of Profit: In case depreciation is not charged from the revenues, the profit shown by the Profit and Loss Account will be more than actual. This may lead to the distribution of more profits as dividends out of capital instead of retaining the profit in the business. This will in turn lead to the flight of scarce capital out of the business.

For Replacement of Assets: Unlike other expenses, depreciation is not a cash expense, rather it is a non-cash transaction. So, the amount of depreciation charged will be retained in the business. This amount, in the future, can be used for the replacement of fixed assets after their useful life.

Consideration of Tax: When depreciation is charged, the Profit and Loss Account will disclose lesser profit as compared to when depreciation is not charged. This depicts the reduced profits and thus the business will be liable for a lesser tax amount.

Other Terminologies related to Depreciation Depletion: This term refers to the reduction in the availability of natural resources due to extraction, mining, and quarrying. It helps to ascertain the reduction in product reserves of natural resources. In other words, it refers to the number of natural resources used or consumed during an accounting period.

Obsolescence: This term refers to the loss in the capital value of the existing fixed assets that are not physically worn out. This reduction in the value takes place due to the advancement and appreciation of technology, scientific innovations, and inventions, change in fashion, adoption of cost-efficient production techniques, etc.

Amortization: This term refers to the reduction in the value of intangible assets over their useful life. Intangible assets are those assets that do not have physical existence such as, Goodwill, Copyrights, Patents, etc. It measures the number of intangible assets used during an accounting period.


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