Question

Explain the concept of depreciation. What is the need for charging depreciation and what are the causes of depreciation?

Answer 1

Depreciation means fall in book value of depreciable fixed assets because of

1. wear and tear of the asset,

2. passage/efflux of time,

3. obsolescence

4. accident.

The need for providing depreciation is:

1. To ascertain the correct profit: Correct profit or loss can be ascertained when all the expenses and losses incurred for earning revenues are charged to Profit and Loss Account.

Assets are used for earning revenues and its cost is charged in form of depreciation from Profit and Loss Account.

2. To show true and fair view of the financial position: If depreciation is not charged, assets will be shown at higher value than their actual value in the balance sheet.

Consequently, the balance sheet will not reflect true and fair view of financial statements.

3. To retain, out of profit, funds for replacement: Unlike other expenses, depreciation is non-cash expense.

So, the amount of depreciation debited to the profit and loss account will be retained in the business.

These funds will be available for replacement of fixed assets when its useful life ends.

4. To ascertain correct cost of production: Depreciation on the assets, which are engaged in production, is included in the cost of production.

If depreciation is not charged, the cost of production is underestimated, which will lead to low selling price and thus leads to low profit.

5. To meet the legal requirement: To comply with the provisions of the Companies Act and Income Tax Act, it is necessary to charge depreciation.

The causes of depreciation are as stated below:

1. Use of Asset i.e., wear and tear: Due to constant use of the fixed assets there exist a normal wear and tear that leads to fall in the value of the assets.

2. Passage/Efflux of Time: Whether assets are used or not, with the passage of time, its effective life will decrease.

3. Obsolescence: Due to new technologies, innovations and inventions, assets purchased today may become outdated by tomorrow which leads to the obsolescence of fixed assets.

4. Accidents: An asset may lose its value due to mishaps such as a fire accident, theft or natural calamities and they are permanent in nature.