Depreciation is necessary in accounting because long-term tangible assets are used for more than one accounting period and provide economic benefits over their useful lives. The entire cost of such an asset should not be charged as an expense in the year of purchase when the asset is expected to benefit the business in future periods. Therefore, the cost of the asset is systematically allocated over the periods in which it is used.
Determination of Correct Profit
One of the main needs for providing depreciation is to determine the correct net income or profit of a business. For calculating profit, the revenue earned from business activities must be reduced by the appropriate costs relating to those activities.
The use of fixed assets is a cost of carrying out business activities. Although an asset such as equipment is not immediately consumed, a part of its economic benefit is used during each accounting period. Therefore, an appropriate amount of the asset’s cost is recognised as depreciation expense.
If depreciation is not charged, the expenses of the accounting period may be understated and the profit may be overstated. Charging depreciation helps allocate the cost of using the asset to the period benefiting from its use and assists in determining the appropriate accounting profit.
Application of the Matching Principle
Depreciation is required for the proper application of the matching principle. According to this concept, costs should be recognised in the accounting periods in which the related economic benefits are obtained.
A long-term asset may be used to generate revenue for several years. Therefore, its cost should be allocated among those years instead of being treated entirely as an expense in the year of acquisition.
Depreciation matches a portion of the asset’s cost with the periods in which the asset is used. Thus, it provides a rational and systematic allocation of asset cost over its useful life.
Proper Allocation of Asset Cost
Depreciation is necessary to allocate the cost of a depreciable asset over its estimated useful life. A business acquires a tangible asset with the expectation of receiving future economic benefits from its use.
As the asset is used, these benefits are gradually consumed. Depreciation represents the current accounting period’s share of the asset’s cost.
The allocation is generally based on the cost of the asset, expected residual or salvage value, estimated useful life, and an appropriate method of apportioning the cost over that useful life.
Proper Presentation of Assets in the Balance Sheet
Depreciation affects the amount at which fixed assets are presented in the Balance Sheet. As depreciation is recognised, the carrying amount of the asset is reduced to reflect the portion of its cost that has already been allocated to previous accounting periods.
Depreciation may be recorded directly against the relevant asset or through a separate Accumulated Depreciation Account. Accumulated depreciation is a contra-account associated with the relevant fixed asset.
Showing accumulated depreciation separately helps preserve the historical cost of the asset while also showing the cumulative amount of depreciation recorded against it. Thus, the financial statements can separately reflect the original cost and the depreciation accumulated over time.
Recognition of the Consumption of Asset Benefits
A tangible asset is acquired because it is expected to provide economic benefits in future accounting periods. As the asset is used in business activities, part of these benefits is consumed.
Depreciation is necessary to recognise this consumption in the financial statements. The depreciation expense for a period represents the portion of the asset’s cost allocated to the benefits obtained during that period.
Therefore, depreciation ensures that the cost of using a long-term asset is recognised gradually over the periods benefiting from the asset.
Avoiding Immediate Recognition of the Entire Asset Cost
If an asset is expected to provide benefits in future periods, its entire cost should not be treated as a current expense immediately. A part of the cost must be deferred and allocated to future accounting periods.
Depreciation provides the mechanism for allocating this deferred cost. Each accounting period is charged with an appropriate portion of the asset’s cost until the cost is allocated over its useful life.
This treatment prevents the entire cost of a long-term asset from affecting the profit of only one accounting period.
Accounting and Tax Purposes
Businesses depreciate long-term assets for both accounting and tax purposes. For accounting purposes, depreciation allocates the cost of a tangible asset over its useful life and affects the profit reported in the Income Statement.
The method of depreciation used in accounting affects net income, while the reduction in the carrying amount of the asset affects the Balance Sheet. Depreciation may also be relevant for taxation purposes according to the applicable rules.
Effect on Financial Statements
Depreciation is needed because it has an important effect on the financial statements of a business. Depreciation expense is charged to the Profit and Loss Account or Income Statement, thereby affecting the net income of the entity.
The cumulative effect of depreciation may be shown through accumulated depreciation in the Balance Sheet, which reduces the carrying amount of the related fixed asset.
Depreciation is a non-cash expense. It reduces accounting profit but does not require a current cash outflow. Therefore, depreciation is generally added back while reconciling net income with cash from operating activities in the Statement of Cash Flows.
Exam Focus
Depreciation is required to determine correct profit, apply the matching principle, systematically allocate the cost of a tangible asset over its useful life, and properly present the carrying amount of assets in the Balance Sheet.
The entire cost of a long-term asset should not be charged in the year of purchase when the asset provides benefits for several accounting periods. Instead, the cost is allocated to the periods in which the business obtains economic benefits from the asset.
Depreciation expense affects the Income Statement and net income, while accumulated depreciation affects the carrying amount of fixed assets in the Balance Sheet. Depreciation is a non-cash expense and does not involve a current cash outflow.