Question

What are the objectives of providing depreciation?

Answer 1

Following are the objectives of providing depreciation:

• To find out the true profit or loss:

1. According to the matching principle, the expenses incurred during a period must be matched with revenue earned during that period.
2. Hence, when an asset is used for generating income for a business, the cost of the asset attributable to the use, i.e., the reduction in the book value of the asset proportionate to the benefit derived from it, should be charged against the revenue.
3. This is to be done to find out the true cost of production and profit or loss of the business for every accounting period.

• To present the true and fair view of financial position:

1. When the depreciation is charged on fixed assets, the book value of fixed assets is reduced to that extent and the remaining value is shown in the balance sheet.
2. The balance represents the value of the benefit that is yet to be derived from them.
3. The written down value is the true value of fixed assets which represent cost not yet written off.
4. The balance sheet must represent a true and fair view of financial status.
5. Hence, fixed assets must be shown at their written-down value.

• To facilitate the replacement of fixed assets:

1. When the depreciation is debited to the profit and loss account, an equal amount is either retained in the business or invested outside the business.
2. When the useful life of an asset comes to an end, a new asset can be purchased by using the resources available in the business.

• To avail tax benefits:

1. As per the Indian Income Tax Act, while computing tax on business income, depreciation is deductible from income.
2. Hence, depreciation is computed and charged to the profit and loss accounts to reduce tax liability.

• To comply with legal requirements:

1. Depreciation is provided on fixed assets to comply with the provisions of law apart from Income Tax Act.
2. For example, Section 123(1) of the Indian Companies Act, 2013, requires every company to provide depreciation on fixed assets before declaring dividends to its shareholders.