Need for Depreciation

12/08/2008 20:58


Need for Depreciation:

Learning Objectives:

  1. Why does the need for calculating and charging depreciation arise.

The Need for depreciation arises for the following reasons:

Ascertainment of True Profit or Loss:

Depreciation is a loss. So Unless it is considered like all other expenses and losses, true profit or loss cannot be ascertained. In other words, depreciation must be considered in order to into out true profit or loss of a business.

Ascertainment of True Cost of Production:

Goods are produced with the help of plant and machinery which incurs depreciation in the process of production. This depreciation must be considered as a part of the cost of production of goods. Otherwise, the cost f production would be shown less than the true cost. Sales price is fixed normally on the basis of cost of production. So, if the cost of production is shown less by ignoring depreciation, the sale price will also be fixed at low level resulting in a loss to the business.

True Valuation of Assets:

Value of assets gradually decreases on account of depreciation, if depreciation is not taken into account, the value of asset will be shown in the books at a figure higher than its true value and hence the true financial position of the business will not be disclosed through balance sheet.

Replacement of Assets:

After sometime an asset will be completely exhausted on account of use. A new asset must then be purchased requiring a large sum of money. If the whole amount of profit is withdrawal from business each year without considering the loss on account of depreciation, necessary sum may not be available for buying the new asset. In such a case the required money is to be collected by introducing fresh capital or by obtaining loan or by selling some other assets. This is contrary to sound commerce policy.

Keeping Capital Intact:

Capital invested in buying an asset, gradually diminishes on account of depreciation. If loss on account of depreciation is not considered in determining profit or loss at the year end, profit will be shown more. If the excess profit is withdrawal, the working capital will gradually reduce, the business will become weak and its profit earning capacity will also fall.