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Depreciation is the process of spreading the cost of fixed assets over the number of years during which benefit of the asset is received. The fall in value or utility of fixed assets due to so many causes like wear and tear, decay, effluxion of time or obsolescence, replacement, breakdown, fall in market value etc.
In other words, a part of Gross profit is set aside as provision for depreciation so that net profit is reduced.
Say, for example if an asset costs $100,000 and its useful life is 10 years so every year the value of that asset is reduced by $10,000. This $10,000 is recorded in the debit side of Profit &Loss Account which reduces the net profit. If depreciation is maintained for 10 years then the proprietor would have accumulated fund of $100,000 and he can replace the old asset with a new one.
Amount of depreciation charged per year = (Cost of asset+ Installation charges- Scrap value) / Useful life
Purpose for Depreciation
From the above example we can understand why we should charge depreciation. The following are the purpose of charging depreciation of fixed assets:
(1) To ascertain in the true profit of the business.
(2) To show the true presentation of financial position.
(3) To provide fund for replacement of assets.
(4) To show the assets at its reasonable value in the balance sheet.