Need for Depreciation:
Learning Objectives:
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Why does the need for
calculating and charging depreciation arise.
The Need for depreciation arises for
the following reasons:
Ascertainment of True Profit or Loss:
Depreciation is a loss. So
Unless it is considered like all other expenses and losses, true profit or
loss cannot be ascertained. In other words, depreciation must be considered
in order to into out true profit or loss of a business.
Ascertainment of True Cost of Production:
Goods are produced with the
help of plant and machinery which incurs depreciation in the process of
production. This depreciation must be considered as a part of the cost of
production of goods. Otherwise, the cost f production would be shown less
than the true cost. Sales price is fixed normally on the basis of cost of
production. So, if the cost of production is shown less by ignoring
depreciation, the sale price will also be fixed at low level resulting in a
loss to the business.
True Valuation of Assets:
Value of assets gradually
decreases on account of depreciation, if depreciation is not taken into
account, the value of asset will be shown in the books at a figure higher
than its true value and hence the true financial position of the business
will not be disclosed through balance sheet.
Replacement of Assets:
After sometime an asset will
be completely exhausted on account of use. A new asset must then be
purchased requiring a large sum of money. If the whole amount of profit is
withdrawal from business each year without considering the loss on account
of depreciation, necessary sum may not be available for buying the new
asset. In such a case the required money is to be collected by introducing
fresh capital or by obtaining loan or by selling some other assets. This is
contrary to sound commerce policy.
Keeping Capital Intact:
Capital invested in buying an
asset, gradually diminishes on account of depreciation. If loss on account
of depreciation is not considered in determining profit or loss at the year
end, profit will be shown more. If the excess profit is withdrawal, the
working capital will gradually reduce, the business will become weak and its
profit earning capacity will also fall.
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