Q.Explain the concept of depreciation. What is the need for charging depreciation and what are the causes of depreciation?

The Need for Depreciation – A First Look

Think of a new car. The moment you drive it out of the showroom, its value drops. Not because it's broken, but because it's now "second-hand." Now imagine you run a delivery business and buy that car for ₹5,00,000. You use it for five years. At the end of five years, you sell it for ₹1,00,000. The car didn't just vanish — it helped you earn money for five years. But its cost wasn't a one-time expense; it was spread across those five years.

That spreading-out is the heart of depreciation.

What Depreciation Really Means

Depreciation is the permanent, continuous, and gradual decrease in the value of a fixed asset due to its use, the passage of time, or obsolescence (technology making it outdated). It is not a loss of cash — you don't pay depreciation to anyone. It is a non-cash expense that recognises that the asset's useful life is being consumed.

Key points to hold onto:

• It applies only to fixed assets (machinery, buildings, vehicles, furniture) — not to land (which doesn't wear out) or current assets like stock.
• It is charged every year over the asset's estimated useful life.
• It is estimated — we guess how long the asset will last and what it will be worth at the end (its scrap value).

Why Do We Need Depreciation? Three Reasons

1. To show the true profit (matching principle)

If you bought a machine for ₹2,00,000 that lasts 10 years, and you treat the whole ₹2,00,000 as an expense in the first year, your profit for that year would be terribly low — and profits for the next nine years would be falsely high. That's misleading. Depreciation spreads the cost fairly across all the years the machine helps you earn revenue. This is the matching concept in action: match the expense with the income it generates.

2. To show the true value of the asset on the balance sheet

Without depreciation, your balance sheet would show the machine at ₹2,00,000 every year — even when it's old and worn. Depreciation reduces the asset's book value each year, giving a more realistic picture of what the business owns.

3. To provide for replacement

By charging depreciation, a business sets aside (in effect) a portion of profit each year. When the asset finally needs replacement, the accumulated depreciation represents funds that have been retained in the business — not paid out as dividends — and can be used to buy a new asset.

Accounting Treatment – The Journal Entry

When depreciation is charged, two things happen:

• The expense is recognised (depreciation goes to the Profit & Loss Account).
• The asset's value is reduced (either directly or through a separate accumulated depreciation account).

The standard journal entry is:

Then, at the end of the year, the Depreciation Account is closed by transferring it to the Profit & Loss Account:

Two methods of recording the credit side:

• Direct method: Credit the asset account itself. The asset's book value is reduced directly each year.
• Provision method: Credit a separate "Accumulated Depreciation" or "Provision for Depreciation" account. The asset continues to appear at its original cost, and the accumulated depreciation is shown as a deduction from it on the balance sheet.

Where Depreciation Appears in the Final Accounts

In the Profit & Loss Account (as an expense):

In the Balance Sheet (as a deduction from the asset):

Direct method:

Provision method:

A Word on the Formula

Depreciation is calculated using one of several methods. The simplest is the Straight Line Method:

Depreciation = (Cost of Asset – Estimated Scrap Value) ÷ Estimated Useful Life

For example, an asset costing ₹1,00,000 with a scrap value of ₹10,000 and a life of 5 years:

Depreciation per year = (1,00,000 – 10,000) ÷ 5 = ₹18,000

The Written Down Value Method applies a fixed percentage to the reducing balance each year — but that's a topic for another day.

The Bottom Line

Depreciation exists because assets wear out, and their cost must be fairly shared across the years they help you earn. Without it, profits are distorted, assets are overvalued, and the business has no systematic way to set aside funds for replacement. It is not a loss of cash — it is a loss of value, and accounting must reflect that truth.