In accounting terms, depreciation is defined as the reduction of recorded cost of a fixed asset in a systematic manner until the value of the asset becomes zero or negligible.
An example of fixed assets are buildings, furniture, office equipment, machinery etc.. A land is the only exception which cannot be depreciated as the value of land appreciates with time.
The need for depreciation accounting arises on three grounds:
- To calculate proper profit: according to matching concept of accounting, profit of any year can be calculated only when all costs of earning revenues have been properly charged against them. Asset is an important tool in earning revenues. The fall in the book value of assets reflects the cost of earning revenues from the use of assets in the current year and hence like other costs like wages, salary, etc., it must also be provided for proper matching of revenues with expenses.
- To show true financial position: the second ground for providing depreciation is that it should result in carrying forward only that part of asset which represents the unexpired cost of expected future service. If the depreciation is not provided then the asset will appear in the balance sheet at the overstated value.
- To make provision for replacement of assets: if no changes were made for depreciation, profits of the concern would be more to that extent. By making an annual charge for depreciation, a concern would be accumulating resources enough to enable it to replace an asset when necessary. Replacement, thus, does not disturb the financial position of the concern.