Every organisation carrying on a business, profession or any other operation faces the need to charge depreciation on its fixed asset to present a true and clear picture of the financial position of the concern. To ascertain the actual capacity of assets at the end of each financial year, it becomes mandatory to state them at their true cost.
This requirement for providing depreciation or devaluation in accounting records emerges from conceptual, practical and legal business consideration. These contemplations give depreciation a specific significance as a cost of doing business.
Following are some of the factors that cause the need for depreciation in a business concern –
1. Matching of Costs and Revenue: An asset once acquired cannot serve the purpose of the business for infinite periods to come.The basis of the rationale of fixed resources in business operations is that these are utilized in the gaining of revenue. Each asset will undoubtedly experience some wear and tear and thus lose value, when it is put to use in business. This wear and tear could be a reason for the efflux of time or any technological obsolescence.
Therefore, depreciation is as much the expense as some other cost brought about in the typical course of business. It is a charge against the income of the comparing time frame and should be deducted before showing net profit as per general accounting standards.
2. Consideration of Tax: Deterioration or depreciation is a deductible expense for tax purposes. However, tax rules for the calculation of devaluation sum need not really be like current business practices.
The Income Tax Act, 1961 only provides depreciation following the written down value method and does not approve of the straight line method.
3. True and Fair Financial Position: If assets are not depreciated, their value in the books of accounts would be overstated and therefore it will present a wrong picture of the monetary position of the business. Likewise, this isn’t allowed either by established accounting practices or by specific provisions of law.
The various stakeholders of the company are interested in knowing the true and accurate facts so that they can form an informed decision.
4. Compliance with Law: Another major reason for the need for depreciation is compliance with legal requirements prevailing in the economy. Apart from tax guidelines and regulations, there are certain specific enactments and legislations that indirectly force some business associations like corporate enterprises to give depreciation on fixed assets and resources.
Depreciation is needed to comply with the legal requirements and also to get an idea about the true finances of the company. Without charging depreciation, the asset balance in the balance sheet would be overvalued and thus would inflate the monetary position of the company thereby providing an incorrect overall picture.