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 accounting and cost accounting are both essential components of accounting that serve

different purposes but share some similarities:

1. Accounting Principles: Both financial and cost accounting adhere to generally accepted
accounting principles (GAAP) or relevant accounting standards in their respective domains.
These principles ensure consistency, accuracy, and reliability of financial information.

2. Record-Keeping: Both types of accounting require accurate record-keeping. They involve the
collection, organization, and analysis of financial data to provide meaningful information to
decision-makers.

3. Double-Entry System: Both financial and cost accounting often use the double-entry system,
which ensures that every financial transaction has corresponding debit and credit entries in the
accounting records.

4. Use of Accounts: Financial and cost accounting use various accounts to track transactions and
prepare financial statements. For example, they both use asset, liability, and equity accounts in
their respective systems.

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

6. Management Support: While financial accounting focuses on providing information to external

stakeholders, cost accounting provides valuable information to internal management. Both aim
to help organizations make informed decisions.

7. Cost Allocation: Both types of accounting involve the allocation of costs. Financial accounting
allocates costs to products or services for external reporting, such as cost of goods sold, while
cost accounting allocates costs to specific cost centers or activities to analyze and control costs
within the organization.

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

9. Compliance: Both types of accounting must comply with relevant laws and regulations. Financial
accounting adheres to regulations set by financial authorities, while cost accounting complies
with internal policies and procedures.

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

Despite these similarities, it's crucial to understand that financial and cost accounting serve distinct
purposes. Financial accounting primarily focuses on providing information to external stakeholders like
investors, regulators, and creditors, while cost accounting is an internal tool designed to support
management decisions by providing detailed information on costs and cost behavior within an
organization.

Cost accounting 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 information related to

the costs of producing goods or services. Here are some key roles and functions of
cost accounting:
1. Cost Determination: Cost accounting 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, administrative expenses).

2. Cost Control: It helps in controlling costs by identifying cost variances and deviations from
budgets or standards. This enables management to take corrective actions to reduce or
eliminate excessive costs.

3. Performance Evaluation: Cost accounting is essential for assessing the performance of different
departments, products, or projects within an organization. It provides a basis for comparing
actual costs against planned or standard costs, aiding in performance measurement and
evaluation.

4. Pricing Decisions: Cost accounting helps in setting 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. Budgeting and Forecasting: Cost accounting is integral to the budgeting process. It assists in
creating budgets and financial forecasts by providing insights into the expected costs of
production and operations.

6. Inventory Valuation: 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 Allocation: In cases where costs are shared among multiple products or departments, cost
accounting provides a framework for allocating these costs fairly and accurately. This ensures
that each entity bears its appropriate share of the common costs.

8. Decision Making: Managers rely on cost accounting data to make informed decisions, such as
whether to discontinue a product line, invest in new machinery, or outsource certain functions.
It provides cost-based information to support these choices.

9. Variance Analysis: Cost accounting allows for the analysis of cost variances, helping management
pinpoint areas where costs deviate from expectations. This is crucial for identifying inefficiencies
and opportunities for improvement.
 10. Profitability Analysis: By dissecting costs and revenues, cost accounting helps in evaluating the
profitability of different products, customer segments, or business divisions. It allows businesses
to focus on their most profitable activities.

11. Compliance and Reporting: Cost accountants play a role in ensuring that financial reports comply
with accounting standards and regulations. They are responsible for providing accurate and
reliable cost-related information in financial statements.

12. Resource Allocation: Cost accounting assists in the allocation of resources, whether it's allocating
funds, labor, or materials to different projects or departments based on their cost-effectiveness.

In summary, cost accounting is a vital function in organizations that helps in cost management, decision-
making, and financial performance evaluation. It provides the data and analysis needed to maintain cost
efficiency, make informed choices, and drive profitability.

Changing the depreciation of assets is an important accounting and

financial management practice for several reasons:

1. Accuracy of Financial Statements: Depreciation is the allocation of the cost of a tangible asset
over its useful life. Accurate depreciation 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 Implications: Depreciation affects the taxable income of a business. By adjusting the
depreciation, a company can potentially lower its taxable income, which can lead to reduced tax
liability. However, changes in depreciation methods or rates can also have tax consequences, so
it's essential to ensure compliance with tax laws.

3. Asset Valuation: Changing depreciation can impact the book value of assets on the balance
sheet. Accurate asset valuation is important for determining a company's net worth and its
ability to meet financial obligations.

4. Capital Budgeting: Accurate depreciation 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 depreciation methods allows for better comparison of a

company's financial performance over time. Changing depreciation 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 regulations and
accounting standards governing depreciation. Changing depreciation methods or rates may
require compliance with these standards, or it may raise red flags with regulatory authorities.

7. Asset Management: Accurate depreciation helps in tracking the actual wear and tear of assets.
This, in turn, aids in managing maintenance, repair, and replacement needs effectively.
 8. Stakeholder Confidence: Consistency and transparency in financial reporting, including
depreciation practices, build trust and confidence among investors, creditors, and other
stakeholders.

9. Profit and Loss Impact: Changes in depreciation affect the income statement. Altering
depreciation can either increase or decrease reported profits, potentially influencing the
perception of the company's financial performance.

10. Risk Assessment: Accurate depreciation allows for a better understanding of the financial risks
associated with asset management. It can help identify when assets may need replacement or
when there's a risk of asset impairment.

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

Costs can be classified in various ways depending on the context and purpose of
classification. One common classification of costs is based on their behavior in relation to changes in
production or activity levels. These classifications include:

1. Fixed Costs:

 Fixed costs remain constant within a certain production or activity 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 proportion to changes in production or activity 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 operations and are allocated to various cost centers or
products. Examples include rent for a factory building, office supplies, and managerial
salaries.

Function-wise classification refers to categorizing expenses or costs based on their purpose or the
functions they serve within an organization. Here's a classification of costs based on three common
functions:

a) Production Cost:

Production costs are related to the manufacturing or creation of a company's products or services. These
costs are directly tied to the production process and can include:

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

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

3. Manufacturing Overhead: Indirect costs like utilities, rent for the production facility,
depreciation of machinery, and maintenance.

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

b) Office & Administrative Cost:

Office and administrative costs are expenses related to the day-to-day operation of an organization.
These costs support the administrative functions of the business and can include:

1. Salaries and Wages: The compensation for employees who work in administrative roles, such as
office staff and management.

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

3. Rent and Utilities: The expenses for office space, electricity, water, and heating.

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

5. Depreciation: The gradual reduction in value of assets like office furniture and equipment.

c) Selling & Distribution Cost:

Selling and distribution costs are related to the marketing and distribution of a company's products or
services. These costs include:

1. Sales and Marketing Expenses: Costs for advertising, sales promotions, and marketing
campaigns.
 2. Sales Team Salaries and Commissions: Compensation for sales representatives and commissions
paid based on sales.

3. Distribution Costs: Expenses for warehousing, transportation, and logistics to get products to
customers.

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

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

Accounting plays a pivotal role in creating processes for values and

accountability within organizations. It serves as the language of business, helping to track,
measure, and communicate financial information. Here's how accounting contributes to the
establishment of values and accountability:

1. Financial Transparency: Accounting provides a structured and systematic way to record and
report financial transactions. This transparency helps stakeholders, including investors,
regulators, and employees, to understand the financial health of an organization. Transparent
financial reporting is a key value in corporate governance.

2. Value Measurement: Accounting allows organizations to measure the value of their assets,
liabilities, and equity. This is critical for assessing the overall financial health of a company and its
ability to create value for shareholders and other stakeholders.

3. Resource Allocation: Accounting aids in the allocation of resources. It helps organizations

identify areas where resources are most needed and where they are most efficiently utilized.
This is important in pursuing strategic goals and adhering to the values of efficiency and
effectiveness.

4. Budgeting and Planning: Budgets are an integral part of the accounting process. They enable
organizations to plan for the future, set financial goals, and allocate resources in line with their
values and strategic objectives. Budgets help ensure that resources are used accountably and in
alignment with the organization's goals.

5. Performance Evaluation: Accounting provides a means to evaluate the performance of different

divisions, departments, or individuals within an organization. This helps in accountability by
assessing whether the objectives and values set by the organization are being met.

6. Compliance and Accountability: Accounting is essential for ensuring compliance with legal and
regulatory requirements. It helps organizations meet their tax obligations, report to government
agencies, and adhere to accounting standards. This promotes accountability and prevents fraud
and misconduct.
 7. Stakeholder Communication: Accounting reports, such as financial statements and disclosures,
serve as a means of communication between an organization and its stakeholders. Transparent
reporting fosters trust and accountability, as stakeholders can make informed decisions based on
the information provided.

8. Ethical Accounting Practices: Upholding ethical values is crucial in accounting. Adhering to

ethical principles, such as honesty and accuracy in financial reporting, is a fundamental
component of creating a culture of accountability within an organization.

9. Risk Management: Accounting helps identify and quantify financial risks. It allows organizations
to take proactive measures to manage these risks, demonstrating a commitment to values like
prudence and risk awareness.

10. Continuous Improvement: Accounting data and performance metrics can be used to identify
areas that need improvement. This supports a culture of continuous improvement and
accountability by focusing on enhancing processes and outcomes.

In summary, accounting serves as the foundation for values and accountability within organizations. It
facilitates transparency, value measurement, resource allocation, and performance evaluation while
promoting ethical behavior and compliance. By providing accurate and reliable financial information,
accounting helps ensure that organizations adhere to their values and are held accountable for their
actions and financial results

Accounting is often described as an information system

because it primarily revolves around the process of collecting, recording, summarizing, and
communicating financial information about an organization's economic activities. This information is
essential for various stakeholders, including management, investors, creditors, and regulatory
authorities, to make informed decisions. Here's how accounting functions as an information system:

1. Data Collection: Accounting begins by gathering data on all financial transactions within an
organization. These transactions 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 systematically. This is typically
done using a double-entry accounting system, where each transaction is recorded with debits
and credits in appropriate accounts. This process ensures that the accounting equation (Assets =
Liabilities + Equity) always remains balanced.

3. Classification and Categorization: The recorded transactions are categorized and classified into
different accounts, such as assets, liabilities, equity, revenue, and expenses. This step helps
organize financial information for analysis and reporting.
 4. Summarization: Periodically, accountants prepare financial statements, including the balance
sheet, income statement, and cash flow statement. These statements summarize the financial
position and performance of the organization, providing a high-level view of its financial health.

5. Reporting: Accounting information 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 meeting
regulatory and tax compliance requirements.

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

7. Decision Support: The primary purpose of the accounting information system is to provide
relevant and reliable information to support decision-making. Management uses financial data
to allocate resources, set budgets, and assess the profitability and efficiency of various business
operations.

8. Compliance and Accountability: Accounting also serves a crucial role in ensuring that
organizations adhere to accounting standards, regulations, and legal requirements. This helps
maintain transparency and accountability, especially in publicly traded companies.

9. Auditing: External and internal auditors review an organization's financial records to verify their
accuracy and adherence to accounting standards. This process further enhances the reliability of
the information provided by the accounting system.

In summary, accounting functions as an information 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 organizations understand and
manage their financial resources and performance.