Sunday, 29 May 2011

Accounting Implications of Depreciation

I. Depreciation is a charge against profits. It is not a cash cost. It is a notional loss. The
estimated depreciation of an accounting period is matched against revenues of that
period. The profit or loss of that period is calculated after charging depreciation.
2 It is a compulsory charge. It is not an appropriation of profits. Unless it is considered,
the process of matching costs with revenues become defective.
3. Depreciation. as already pointed out, helps to arrive at correct profit or loss. Final
accounts can be correctly prepared only when depreciation has been correctly charged.

4. Depreciation is necessary to value fixed assets at the end of each accounting period.
Unless it is charged. the assets become overstated.
5. Due to inflation, effective capital of a business is eroded continuously. It means, more
amount of capital becomes needed to replenish the same amount of assets consumed or
utilized every year in the process of production. By charging adequate depreciation, a
proper balance of real capital is maintained.
6. ‘Old order change yielding place to new’. This age-old belief obviates the charging of
depreciation. Old may be gold but that cannot be expected to last for ever. Decay and
senility have to be accepted for which the concept of depreciation has to be applied as
a yardstick of measurement, of such decay.
7. Depreciation Accounting paves the way for replacement of assets. When the effective
and working life of an asset comes to an end, it is replaced by a new asset. Depreciation,
being a notional cost, helps to set aside a fund every year. Such fund is utilized to
acquire the net asset. Thus the requirement of additional capital or loan can be avoided.
8. As per section 205 of the Companies Act of India, a company has to provide for adequate
depreciation before declaring dividends. There arc provisions of the Income Tax
Act of India regarding the adequacy of depreciation. So charging of depreciation is a
legal compliance which a business has to observe.

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