Need for Providing Depreciation

If a firm did not charge depreciation on its fixed assets, its final accounts would tell a misleading story in several distinct ways. The following reasons are each a separate, examinable point.

1. To ascertain the true profit or loss. An asset is used to earn revenue every year, so the cost of 'using it up' is as real a business expense as rent or salaries. Unless this cost (depreciation) is deducted from revenue, the Profit and Loss Account will overstate profit.

2. To present the true financial position. The Balance Sheet is supposed to show assets at their true worth. Showing a five-year-old machine at its original purchase price, ignoring the value it has lost through years of wear, would overstate the firm's assets and give a false picture of its financial position.

3. To provide funds for replacement of the asset. Charging depreciation each year (even though no cash actually leaves the business at the point of the entry) retains that amount of profit inside the business rather than letting it all be distributed as dividends or drawings — so that, by the end of the asset's useful life, the firm has, in effect, built up funds towards replacing it.

4. To comply with legal requirements. Company law and related regulations require depreciation to be charged before profits are declared or dividends distributed, so that a company does not pay out its own capital as if it were profit. …