Depreciation is an expense like any other revenue expense. But it is not paid in cash. In spite of this, it is taken into consideration while preparing accounts due to the following reasons :
1. To find out true and fair profit: In order to know the true and fair profit or loss of the business, all expenses and incomes should be considered. Depreciation is the reduction in the value of the asset and thus shows a part of the consumed asset. So, it is a revenue expenditure and without considering this, a true picture of profit or loss will not be available. In short, it is essential to consider depreciation to know the true and fair profit-loss of the business. Thus, it is debited to Profit and Loss Account.
2. To know the true and fair financial position: If the assets of the business are shown at a price less than their depreciation in the Balance Sheet, then a true and fair financial position will be indicated. If depreciation is not deducted from the concerned asset, the Balance Sheet will not reflect a true position of financial affairs.
3. Replacement of the asset: In any business, if the value of the asset decreases after a specified period, it becomes necessary to acquire or purchase a new asset to replace the old one. For this, a provision for depreciation is made to keep the capital intact. Normally, the amount transferred in this, maybe invested in some government or gilt-edged securities. At the time of replacement of an asset, the amount will be realised by selling such securities. Thus, it is not required to raise new capital as new asset can be purchased from such provision.
4. To determine the true cost of production: In order to determine the cost of goods produced in factory or services, expense affecting production or production-related expenses should be considered. Thus, like other expenses depreciation on depreciable assets used in business is essential to be considered to determine the cost of goods. If depreciation, being an expense is not taken into account, then the true cost of the goods produced cannot be determined.
5. To comply with legal provision: According to section 205 of Companies Act, no company can distribute dividends without making a provision for depreciation from its profits. It is prudent to provide for depreciation from the viewpoint of sound accounting principles.
6. To consider as a paid business expense: The revenue expenses of a business are based on time. Depreciation too is a revenue expense based on time. Depreciation is also pre-paid expense of business. Therefore, it is written off proportionately at the end of each accounting year as depreciation. Hence, depreciation should be considered as a paid business expense.
7. Determination of selling price: Profit of business is based on selling price of goods or services. And selling price of goods or services is based on cost of goods or service. Therefore, to arrive at a selling price of goods or services, total cost is determined, where depreciation is included.
