Read this article to learn about the six important principle needed for charging depreciation in accounting.
1. Matching Cost with the Revenues:
The basic aim of providing the depreciation is to apply the matching principle. The matching principle offsets the revenue generated in an accounting period against the cost of goods and services which have been consumed for generating that revenue.
For the purpose of ascertaining true and actual income of the business enterprise during any accounting year, it is necessary that all expenses incurred for earning revenue must be considered so that proper cost valuation and income determination can be done. Keeping this in view, depreciation must be debited to Profit &Loss A/c, since loss in value of fixed assets is also an expense like other business expenses.
2. Presentation of True and Fair View of the Financial Statements:
Financial statements of any business enterprise consists of ‘Income Statement’ i.e., Profit and Loss A/c and ‘Positional Statement’ i.e., Balance Sheet. It is necessary that these financial statements should show true and fair view of the income and net worth of the business.
By not charging depreciation, both the net profit as shown by the profit and loss account and value of assets as shown in the balance sheet would be overstated with the amount of depreciation. Thus, a true picture of the financial position of the business cannot be drawn.
3. Funds for Immediate Replacement of Asset:
Every fixed asset such as machines, motor cars, furniture etc. normally depreciates in value over a period of time, irrespective of regular repairs and efficient management. A possible exception is made in respect of land because it has an indefinite useful life and its cost tends to increase over period of time.
Also, depreciation is neither inflow nor outflow of cash, so the amount of depreciation charged to Profit and Loss Account is retained in business every year. In case of replacement of an asset, adequate funds in the depreciation account are available in the business and the same can be used for replacing the asset.
4. Restriction on Payment of Dividend:
In the case of joint stock company, dividend is payable on net profits. If the depreciation is not charged, the net profits of the business enterprise would be much more than the actual. The overstatement of the net profits will lead to payment of higher dividends, which ultimately reduces the capital.
5. Reduction in Tax Liability:
Depreciation is an allowable expense charged on the income of the business enterprise. By charging depreciation, tax liability of the business can be reduced. If depreciation is not charged on net profit then the net profit of the business enterprise would be much more than the actual. Therefore, depreciation should be charged on the income so that the profits of the business can be reduced to actual, which ultimately result in reduction of income tax too.
6. Legal Obligation:
In addition to tax regulations, it is necessary for certain types of business organisations, such as joint stock companies, to charge depreciation before declaring any dividends.