Objectives of Providing Depreciation
The need for charging depreciation arises due to the following objectives:
1. To Ascertain the True Cost of Production: Depreciation or decrease in the value of fixed asset arises when the asset is used in production of goods or services.
Hence the cost of utilizing the asset is an indirect cost and it is necessary to charge depreciation as an item of cost of production. If depreciation on fixed assets is not charged, the cost records will not present a true and fair view of the cost of production.
2. To Ascertain Correct Income: Depreciation is a charge against the income or revenue in an accounting period and should be deducted from the income earned to ascertain correct income of the business. It is an invisible cost and is not paid to external persons. True and correct profit can be ascertained only when depreciation is charged against income. Otherwise, the Profit and Loss Account or Income Statement will not present a true and fair view of the business.
3. To Show a True and Fair View of Financial Position: Balance Sheet reveals the financial position of the business. The value of fixed assets should be shown in Balance Sheet after deduction of depreciation. Otherwise, the value of fixed assets will be overstated and the Balance Sheet will not show a true and fair view of the financial position of the business.
4. To Comply with Legal Requirements: Companies formed and registered under Companies Act. According to this, two companys hould compulsorily provide for depreciation before payment of dividend to shareholders.
5. To Accumulate Funds for Replacement of Asset: A portion of profit is set aside every year in the form of depreciation for replacement of an asset. Depreciation which is accumulated over a period of time is used for a specific purpose of replacement of the asset at the end of its useful life.
6. To Keep Capital Intact: Keeping the capital intact has always been the focal point in business. The amount of depreciation charged against every years profit should be appropriated. Omission or understatement of depreciation results will inflate profit. If any dividend is distributed out of inflated profit, it would be an incorrect return on capital and will decrease the value of the business.
7. To Plan Tax Liability:
Tax planning is the legitimate right of every assesse. Depreciation can be used as tax saving device. It is an admissible expense while computing income from business. Income tax liability is reduced by claiming depreciation. A suitable depreciation policy is always essential to minimize tax liability.