What Is the Purpose of Depreciation?

The purpose of depreciation is to match the cost of a productive asset, that has a
useful life of more than a year, to the revenues earned by using the asset. The
asset’s cost is usually spread over the years in which the asset is used. Over the
asset’s useful life, depreciation systematically moves the asset’s costs from
the balance sheet to expenses on an income statement.

Depreciation is an allocation process in order to achieve the matching principle. It is

not a technique for determining the fair market value of an asset.

What Are the Causes of Depreciation?

Depreciation allocates the cost of a tangible asset over its useful life and is used to
account for declines in value is called depreciation. The causes of depreciation are:

Wear and Tear

Any asset gradually breaks down over a certain time while using it, as parts wear
out and need to be replaced. Eventually, must be disposed of because it can no
longer be repaired. This is most prevalent for production equipment, which usually
has a manufacturer’s recommended lifespan that is based on a certain number of
units produced. Other assets, such as buildings, can be repaired and upgraded for
long periods of time.

Perishability

Some assets have an extremely short lifespan. This condition is most applicable to
inventory, rather than fixed assets.

Usage Right
A fixed asset such as software or a database might only usable to your business
for a certain period of time. Its lifespan terminates when the usage rights expire.
Depreciation must be completed by the end of the usage period.

Natural Resource Usage

With natural resources assets, such as an oil or gas reservoir, the depletion of the
resource causes depreciation. In this case, it is called depletion, rather than
depreciation. The pace of depletion changes when a company alters its estimate of
reserves remaining.

Inefficiency/Obsolescence

When more efficient equipment becomes available, old equipment might become
obsolete. This reduces the usability of the original equipment.

Causes of Depreciation:

1. By Constant Use: The constant use of any asset by a business causes wear
and tear, which causes a decrease in the value of those assets. As a result, the
capacity of the asset to serve in the business is reduced.
2. By Passing of Time: The value of assets also decreases when an asset is
exposed to forces of nature like wind, rain, etc., even if it is not put to any use.
3. By Obsolescence: Obsolescence is also one main reason for depreciation.
An existing asset can become outdated in some time due to technological
changes, improvements in production methods, changes in market demand,
etc., as a result, the demand for the asset decreases, as the old asset is not
able to fulfill the requirements of the business.
4. By Expiration of Legal Rights: There are some assets that are used in the
business for a certain time period. The time period is determined by an
agreement in which the tenure to use that particular asset is mentioned.
Example: Patents, Copyrights, Lease, etc.
5. By Accident: Assets can be destroyed due to some abnormal factors, such
as earthquakes, floods, etc. This leads to a decrease in the value of the asset.
Thus, it needs to be taken into account.

Need for Depreciation:

1. For Ascertaining the True Profit or Loss: The actual profit of any business
can only be determined when all the expenses and losses of the business for
the particular year are deducted from the total revenue earned by the business.
If the company does not provide depreciation on assets, then it will not be
adjusted in the revenue of the firm, and also the assets will be recorded as
over-valued. Because of this, the true financial position of the company is not
ascertained
2. For Tax Benefit: Depreciation provides tax benefits to the company as the
depreciation is adjusted to the profit before the payment of taxes. By this, the
taxable income is reduced, and the firm has to pay less tax on a decreased
profit.
3. To Ascertain the Accurate Cost of Production: Depreciation is similar to
any other expenses that are incurred in the normal course of business. The
accurate cost of production can only be determined after taking depreciation
into account.
4. To Provide Fund for Replacement of an Asset: Depreciation is debited to
Profit and Loss A/c, but it is a non-cash expense, i.e., no actual cash is paid in
charging depreciation. Hence, the amount of the depreciation is retained in the
business and used for providing funds in purchasing a new asset.
5. To Prevent the Distribution of Profits out of Capital: If the depreciation is
not charged by any company, the Profit and Loss A/c will show excess profit
instead of actual profit. This excess profit can be withdrawn by the owner or
the shareholders of the company. Hence, the amount distributed as profit
includes some amount of depreciation which should not happen.
Top 7 Causes for Depreciation
#1 – Due to Wear & Tear during Usage of Asset
It is one of the primary reasons for the depreciation of assets. Most of
the assets are worn off or deteriorate due to the continuous usage of
the asset. Such as Plant & Machinery used to produce goods,
buildings, vehicles, etc. As in the case of machinery used for
production, the continuous usage & running of machinery, the
working or production capacity of the machinery diminishes over the
period & the value of the machinery also decreases in the market. So
for the fair presentation of the entity’s financial position, it is necessary
to reduce the proportionate value of the machinery in the books.
#2 – Compliance of Accounting Standards
Applicable to Entity
As per the applicability of accounting standards to the entity, the
entity needs to follow the provisions mentioned in the bars. It is done
as per the matching concept that needs to be followed in the entity’s
accounting. As per the matching concept, the depreciation is to be
charged for the respective as the income through the asset has also
been booked for the period mentioned above in the books of
accounts.

#3 – Technological Advancement of
Supplementary Assets in Market
The value of the fixed assets used by the enterprise gradually
decreases if the new upgraded version of the asset with the better
technological advanced features is present in the market, providing
more benefits to the customer than the old obsolete version of the
asset. In such a case, the requirement of the old asset gradually
decreases, and so does its recoverable amount in the market. Hence
it is necessary to show the value of the asset at a fair amount or
reasonable amount in the financials.
#4 – Use of Provided Life of Asset
In some fixed assets, the useful life of the assets is provided in
consumption units like an asset ‘X’ will run for 10000 hours. Hence the
allocation of the asset’s cost is as per the consumption or its usage in
hours.

#5 – Amortization of Assets as per License

Period or Usage Period
Some of the assets like license, patent,
copyrights, leasehold properties, etc., can only be used for the
provided period. At the lapse of such time, the asset could not be
used. Hence its cost needs to be allocated or amortized as per the
usage period of the assets. At the end of the useful period, assets
should be written off from the books of accounts.
#6 – Depreciation Needs to be Done for
Wasting Assets as per Extraction of Resources
In case of wasting assets like coal mine, well of oils, etc., are
amortized and used per the extraction of natural resources done from
them during the period. In the case of such types of wasting assets,
there are limited resources that an entity can extract from such assets
for the organization’s use. Therefore, as per the estimated total
extraction that will be done from the wasting asset and the amount
already extracted, the respective period will be considered for the
asset’s depreciation during that period.
#7 – The Absolute Need for Maintenance of
Fixed Assets for Proper Productivity of Asset
The plant & machinery used in the manufacturing of products in a
manufacturing company needs regular maintenance for full-time
productivity to be received from the usage of such machinery. Even
after a certain period, some essential parts of the machinery will be
replaced with brand new parts. For such, the depreciation needs to be
charged so that the parts that are to be replaced in the future are
appropriately accounted for and written off during its life.
The following are the objectives of providing depreciation:

1. Knowledge of True Profits

When an asset is purchased, it is nothing more than payment in advance for
an expense. For example, purchasing a building for $100,000 for business
purposes will save rent in the future.

However, after a certain number of years, the building will become useless.
The cost of the building is, therefore, nothing except paying rent in advance
for years.

Any paid rent would have been charged as an expense to determine the
true profits made by the business during a particular period.

Therefore, the amount paid for the purchase of the building should be
charged over the period for which the asset would be serviceable.

2. True Financial Position

The assets depreciate in their value on account of various factors.

To present a true state of affairs of the business, the assets should be shown in
the balance sheet, at their proper values.

In case depreciation is not charged, the balance sheet will not indicate a true
view of the state of affairs of the business.

3. Replacement of Assets
The business uses assets to earn revenue. On account of constant use or lapse
of time and similar other causes, a stage may come when the assets need to
be replaced. Providing depreciation retains a part of the business profits,
which can purchase new assets.

4. Correct Cost of Production

Depreciation is a cost of production, and if depreciation is not charged, the
cost of production so determined will not be correct.
Financial accoun ng and cost accoun ng are both essen al components of accoun ng that serve

different purposes but share some similari es:

1. Accoun ng Principles: Both financial and cost accoun ng adhere to generally accepted
accoun ng principles (GAAP) or relevant accoun ng standards in their respec ve domains.
These principles ensure consistency, accuracy, and reliability of financial informa on.

2. Record-Keeping: Both types of accoun ng require accurate record-keeping. They involve the
collec on, organiza on, and analysis of financial data to provide meaningful informa on to
decision-makers.

3. Double-Entry System: Both financial and cost accoun ng o en use the double-entry system,
which ensures that every financial transac on has corresponding debit and credit entries in the
accoun ng records.

4. Use of Accounts: Financial and cost accoun ng use various accounts to track transac ons and
prepare financial statements. For example, they both use asset, liability, and equity accounts in
their respec ve systems.

5. Repor ng: Both financial and cost accoun ng generate reports. Financial accoun ng primarily
produces financial statements like the income statement, balance sheet, and cash flow
statement, while cost accoun ng generates cost reports and analysis to assist in management
decision-making.

6. Management Support: While financial accoun ng focuses on providing informa on to external

stakeholders, cost accoun ng provides valuable informa on to internal management. Both aim
to help organiza ons make informed decisions.

7. Cost Alloca on: Both types of accoun ng involve the alloca on of costs. Financial accoun ng
allocates costs to products or services for external repor ng, such as cost of goods sold, while
cost accoun ng allocates costs to specific cost centers or ac vi es to analyze and control costs
within the organiza on.

8. Accrual Basis: Financial and cost accoun ng o en use the accrual basis of accoun ng,
recognizing revenue and expenses when they are earned or incurred, rather than when cash is
exchanged.

9. Compliance: Both types of accoun ng must comply with relevant laws and regula ons. Financial
accoun ng adheres to regula ons set by financial authori es, while cost accoun ng complies
with internal policies and procedures.

10. Data Analysis: Both financial and cost accoun ng involve data analysis to provide meaningful
insights. Financial accoun ng analyzes data to assess a company's financial health, while cost
accoun ng analyzes data to help improve opera onal efficiency and cost management.

Despite these similari es, it's crucial to understand that financial and cost accoun ng serve dis nct
purposes. Financial accoun ng primarily focuses on providing informa on to external stakeholders like
investors, regulators, and creditors, while cost accoun ng is an internal tool designed to support
management decisions by providing detailed informa on on costs and cost behavior within an
organiza on.

Cost accoun ng plays a crucial role in helping businesses manage their finances and make informed
decisions. Its primary purpose is to collect, record, analyze, and report financial informa on related to

the costs of producing goods or services. Here are some key roles and func ons of
cost accoun ng:
1. Cost Determina on: Cost accoun ng helps in determining the cost of producing products or
delivering services. This includes both direct costs (e.g., raw materials, labor) and indirect costs
(e.g., overhead, administra ve expenses).

2. Cost Control: It helps in controlling costs by iden fying cost variances and devia ons from
budgets or standards. This enables management to take correc ve ac ons to reduce or
eliminate excessive costs.

3. Performance Evalua on: Cost accoun ng is essen al for assessing the performance of different
departments, products, or projects within an organiza on. It provides a basis for comparing
actual costs against planned or standard costs, aiding in performance measurement and
evalua on.

4. Pricing Decisions: Cost accoun ng helps in se ng appropriate pricing for products or services by
taking into account the cost structure and profit margin requirements. It ensures that pricing
covers both direct and indirect costs while allowing for a reasonable profit.

5. Budge ng and Forecas ng: Cost accoun ng is integral to the budge ng process. It assists in
crea ng budgets and financial forecasts by providing insights into the expected costs of
produc on and opera ons.

6. Inventory Valua on: It helps in determining the value of inventory on the balance sheet.
Methods like FIFO, LIFO, or weighted average are employed to assess the cost of goods sold and
ending inventory.

7. Cost Alloca on: In cases where costs are shared among mul ple products or departments, cost
accoun ng provides a framework for alloca ng these costs fairly and accurately. This ensures
that each en ty bears its appropriate share of the common costs.

8. Decision Making: Managers rely on cost accoun ng data to make informed decisions, such as
whether to discon nue a product line, invest in new machinery, or outsource certain func ons.
It provides cost-based informa on to support these choices.

9. Variance Analysis: Cost accoun ng allows for the analysis of cost variances, helping management
pinpoint areas where costs deviate from expecta ons. This is crucial for iden fying inefficiencies
and opportuni es for improvement.
 10. Profitability Analysis: By dissec ng costs and revenues, cost accoun ng helps in evalua ng the
profitability of different products, customer segments, or business divisions. It allows businesses
to focus on their most profitable ac vi es.

11. Compliance and Repor ng: Cost accountants play a role in ensuring that financial reports comply
with accoun ng standards and regula ons. They are responsible for providing accurate and
reliable cost-related informa on in financial statements.

12. Resource Alloca on: Cost accoun ng assists in the alloca on of resources, whether it's alloca ng
funds, labor, or materials to different projects or departments based on their cost-effec veness.

In summary, cost accoun ng is a vital func on in organiza ons that helps in cost management, decision-
making, and financial performance evalua on. It provides the data and analysis needed to maintain cost
efficiency, make informed choices, and drive profitability.

Changing the deprecia on of assets is an important accoun ng and

financial management prac ce for several reasons:

1. Accuracy of Financial Statements: Deprecia on is the alloca on of the cost of a tangible asset
over its useful life. Accurate deprecia on ensures that the financial statements reflect the true
value of the assets, which is crucial for investors, lenders, and management to make informed
decisions.

2. Tax Implica ons: Deprecia on affects the taxable income of a business. By adjus ng the
deprecia on, a company can poten ally lower its taxable income, which can lead to reduced tax
liability. However, changes in deprecia on methods or rates can also have tax consequences, so
it's essen al to ensure compliance with tax laws.

3. Asset Valua on: Changing deprecia on can impact the book value of assets on the balance
sheet. Accurate asset valua on is important for determining a company's net worth and its
ability to meet financial obliga ons.

4. Capital Budge ng: Accurate deprecia on figures are crucial for making informed decisions about
capital investments. They help in assessing the economic feasibility of asset replacement or
expansion projects.

5. Comparability: Consistency in deprecia on methods allows for be er comparison of a

company's financial performance over me. Changing deprecia on methods or rates frequently
can make it difficult to assess the financial health and trends of a business.

6. Regulatory Compliance: Different industries and regions may have specific regula ons and
accoun ng standards governing deprecia on. Changing deprecia on methods or rates may
require compliance with these standards, or it may raise red flags with regulatory authori es.
 7. Asset Management: Accurate deprecia on helps in tracking the actual wear and tear of assets.
This, in turn, aids in managing maintenance, repair, and replacement needs effec vely.

8. Stakeholder Confidence: Consistency and transparency in financial repor ng, including

deprecia on prac ces, build trust and confidence among investors, creditors, and other
stakeholders.

9. Profit and Loss Impact: Changes in deprecia on affect the income statement. Altering
deprecia on can either increase or decrease reported profits, poten ally influencing the
percep on of the company's financial performance.

10. Risk Assessment: Accurate deprecia on allows for a be er understanding of the financial risks
associated with asset management. It can help iden fy when assets may need replacement or
when there's a risk of asset impairment.

In summary, changing the deprecia on of assets can have significant implica ons for a company's
financial repor ng, tax liability, decision-making, and regulatory compliance. Therefore, any changes in
deprecia on methods or rates should be carefully considered, well-documented, and communicated
transparently to stakeholders. Addi onally, it's advisable to consult with financial professionals or
accountants when making such changes to ensure they are made in accordance with accoun ng
principles and legal requirements.

Costs can be classified in various ways depending on the context and purpose of
classifica on. One common classifica on of costs is based on their behavior in rela on to changes in
produc on or ac vity levels. These classifica ons include:

1. Fixed Costs:

 Fixed costs remain constant within a certain produc on or ac vity range. They do not
vary with changes in output. Examples include rent, salaries of permanent staff, and
insurance premiums.

2. Variable Costs:

 Variable costs change in direct propor on to changes in produc on or ac vity levels.

Examples include raw materials, direct labor, and sales commissions.

3. Semi-Variable (Mixed) Costs:

 Semi-variable costs have elements of both fixed and variable costs. They consist of a
fixed component and a variable component. For example, a telephone bill might have a
fixed monthly fee and variable charges based on usage.

4. Direct Costs:
  Direct costs are expenses that can be traced directly to a specific product, project,
department, or cost center. For example, the cost of materials used in manufacturing a
product is a direct cost.

5. Indirect Costs (Overhead Costs):

 Indirect costs cannot be traced directly to a specific product or project. Instead, they are
incurred to support overall opera ons and are allocated to various cost centers or
products. Examples include rent for a factory building, office supplies, and managerial
salaries.

Func on-wise classifica on refers to categorizing expenses or costs based on their purpose or the
func ons they serve within an organiza on. Here's a classifica on of costs based on three common
func ons:

a) Produc on Cost:

Produc on costs are related to the manufacturing or crea on of a company's products or services. These
costs are directly ed to the produc on process and can include:

1. Raw Materials Cost: The expenses associated with purchasing the materials needed for
produc on.

2. Labor Cost: The wages and benefits paid to produc on workers.

3. Manufacturing Overhead: Indirect costs like u li es, rent for the produc on facility,
deprecia on of machinery, and maintenance.

4. Equipment Costs: Expenses related to the purchase and maintenance of produc on machinery
and equipment.

b) Office & Administra ve Cost:

Office and administra ve costs are expenses related to the day-to-day opera on of an organiza on.
These costs support the administra ve func ons of the business and can include:

1. Salaries and Wages: The compensa on for employees who work in administra ve roles, such as
office staff and management.

2. Office Supplies: Costs associated with office materials, such as paper, pens, and computers.

3. Rent and U li es: The expenses for office space, electricity, water, and hea ng.

4. Insurance: Costs associated with various types of insurance, including liability insurance and
workers' compensa on.

5. Deprecia on: The gradual reduc on in value of assets like office furniture and equipment.

c) Selling & Distribu on Cost:

Selling and distribu on costs are related to the marke ng and distribu on of a company's products or
services. These costs include:
 1. Sales and Marke ng Expenses: Costs for adver sing, sales promo ons, and marke ng
campaigns.

2. Sales Team Salaries and Commissions: Compensa on for sales representa ves and commissions
paid based on sales.

3. Distribu on Costs: Expenses for warehousing, transporta on, and logis cs to get products to
customers.

4. Travel and Entertainment Expenses: Costs related to sales and business development ac vi es,
including travel, meals, and entertainment for clients.

5. Packaging Costs: Expenses for packaging materials and design.

Accoun ng plays a pivotal role in crea ng processes for values and

accountability within organiza ons. It serves as the language of business, helping to track,
measure, and communicate financial informa on. Here's how accoun ng contributes to the
establishment of values and accountability:

1. Financial Transparency: Accoun ng provides a structured and systema c way to record and
report financial transac ons. This transparency helps stakeholders, including investors,
regulators, and employees, to understand the financial health of an organiza on. Transparent
financial repor ng is a key value in corporate governance.

2. Value Measurement: Accoun ng allows organiza ons to measure the value of their assets,
liabili es, and equity. This is cri cal for assessing the overall financial health of a company and its
ability to create value for shareholders and other stakeholders.

3. Resource Alloca on: Accoun ng aids in the alloca on of resources. It helps organiza ons
iden fy areas where resources are most needed and where they are most efficiently u lized.
This is important in pursuing strategic goals and adhering to the values of efficiency and
effec veness.

4. Budge ng and Planning: Budgets are an integral part of the accoun ng process. They enable
organiza ons to plan for the future, set financial goals, and allocate resources in line with their
values and strategic objec ves. Budgets help ensure that resources are used accountably and in
alignment with the organiza on's goals.

5. Performance Evalua on: Accoun ng provides a means to evaluate the performance of different
divisions, departments, or individuals within an organiza on. This helps in accountability by
assessing whether the objec ves and values set by the organiza on are being met.
 6. Compliance and Accountability: Accoun ng is essen al for ensuring compliance with legal and
regulatory requirements. It helps organiza ons meet their tax obliga ons, report to government
agencies, and adhere to accoun ng standards. This promotes accountability and prevents fraud
and misconduct.

7. Stakeholder Communica on: Accoun ng reports, such as financial statements and disclosures,
serve as a means of communica on between an organiza on and its stakeholders. Transparent
repor ng fosters trust and accountability, as stakeholders can make informed decisions based on
the informa on provided.

8. Ethical Accoun ng Prac ces: Upholding ethical values is crucial in accoun ng. Adhering to
ethical principles, such as honesty and accuracy in financial repor ng, is a fundamental
component of crea ng a culture of accountability within an organiza on.

9. Risk Management: Accoun ng helps iden fy and quan fy financial risks. It allows organiza ons
to take proac ve measures to manage these risks, demonstra ng a commitment to values like
prudence and risk awareness.

10. Con nuous Improvement: Accoun ng data and performance metrics can be used to iden fy
areas that need improvement. This supports a culture of con nuous improvement and
accountability by focusing on enhancing processes and outcomes.

In summary, accoun ng serves as the founda on for values and accountability within organiza ons. It
facilitates transparency, value measurement, resource alloca on, and performance evalua on while
promo ng ethical behavior and compliance. By providing accurate and reliable financial informa on,
accoun ng helps ensure that organiza ons adhere to their values and are held accountable for their
ac ons and financial results

Accoun ng is o en described as an informa on system

because it primarily revolves around the process of collec ng, recording, summarizing, and
communica ng financial informa on about an organiza on's economic ac vi es. This informa on is
essen al for various stakeholders, including management, investors, creditors, and regulatory
authori es, to make informed decisions. Here's how accoun ng func ons as an informa on system:

1. Data Collec on: Accoun ng begins by gathering data on all financial transac ons within an
organiza on. These transac ons can include sales, purchases, expenses, investments, loans, and
more. Data is collected from various sources such as invoices, receipts, bank statements, and
other financial documents.

2. Recording: Once the data is collected, it needs to be recorded systema cally. This is typically
done using a double-entry accoun ng system, where each transac on is recorded with debits
and credits in appropriate accounts. This process ensures that the accoun ng equa on (Assets =
Liabili es + Equity) always remains balanced.
 3. Classifica on and Categoriza on: The recorded transac ons are categorized and classified into
different accounts, such as assets, liabili es, equity, revenue, and expenses. This step helps
organize financial informa on for analysis and repor ng.

4. Summariza on: Periodically, accountants prepare financial statements, including the balance
sheet, income statement, and cash flow statement. These statements summarize the financial
posi on and performance of the organiza on, providing a high-level view of its financial health.

5. Repor ng: Accoun ng informa on is communicated to various stakeholders through financial

reports. These reports help investors assess the company's performance, creditors evaluate
creditworthiness, and management make informed decisions. The reports also assist in mee ng
regulatory and tax compliance requirements.

6. Analysis and Interpreta on: Financial data is analyzed to iden fy trends, make comparisons, and
draw meaningful conclusions about an organiza on's financial performance. This analysis is vital
for strategic decision-making and planning.

7. Decision Support: The primary purpose of the accoun ng informa on system is to provide
relevant and reliable informa on to support decision-making. Management uses financial data
to allocate resources, set budgets, and assess the profitability and efficiency of various business
opera ons.

8. Compliance and Accountability: Accoun ng also serves a crucial role in ensuring that
organiza ons adhere to accoun ng standards, regula ons, and legal requirements. This helps
maintain transparency and accountability, especially in publicly traded companies.

9. Audi ng: External and internal auditors review an organiza on's financial records to verify their
accuracy and adherence to accoun ng standards. This process further enhances the reliability of
the informa on provided by the accoun ng system.

In summary, accoun ng func ons as an informa on system that collects, records, processes,
summarizes, and communicates financial data to facilitate decision-making, maintain transparency, and
ensure compliance. It plays a fundamental role in helping individuals and organiza ons understand and
manage their financial resources and performance.