In common usage the term ‘depreciation’ refers to a decline in the value of any kind of property. But in Accounting its use is restricted to the expiration of the cost of tangible fixed assets. Except land, all other physical assets have a limited period of useful life.
They are used to generate income over its economic life. Hence, their cost should be properly allocated as expense to the accounting periods in which these assets are used.
The accounting process for this gradual conversion of the cost of fixed assets into expense is called as ‘depreciation’. Depreciation is defined as “a permanent, continuing and gradual shrinkage in the book value of a fixed asset due to use, wear and tear, obsolescence or efflux ion of time.”
The Accounting Standard No.6 of the Institute of Chartered Accountants of India (I.C.A.I) defines depreciation as a measure of wearing out, consumption, or other loss of value of a depreciable asset arising from use, efflux ion of time, or obsolescence through technology and market changes.
Objectives or Need for Providing Depreciation
(a) To ascertain true profits
Depreciation is a charge for capital assets used in earning profits and therefore, it should be viewed as business expenditure. Unless proper charge for this expense is made in accounts, the correct profit cannot be ascertained.
(b) To show the assets at their proper values
Depreciation must be accounted for in order to show the assets at their proper values and thereby present a true and fair view of the financial position of the business. Unless depreciation is provided, the value of the assets will be overstated in the Balance Sheet and it will not reflect the true and fair view of the business.
(c) To create funds for replacement of assets
Depreciation is non-cash expenditure. Hence, the amount of depreciation charged to Profit and Loss account remains in the business and the amount thus accumulated during the working life of the asset provides funds for its replacement at the end of the working life of the asset.
(d) To keep the capital in tact
If depreciation is not charged, the amount of profit will be inflated. If such profits are distributed among the owners, then it will amount to the distribution of fixed capital from the business. In the long run it will affect the financial health of the business.
(e) Statutory Need: Provision of depreciation is a statutory need
Section 205 of the Indian companies Act has made compulsory for a joint stock company to provide for depreciation before distributing the profits as dividends.