Depreciation means the decline in the value of fixed assets due to use and wear and tear. The objective of charging depreciation is to spread the cost of the fixed asset over its useful life for the purpose of ascertaining the result of operations as well as accumulation of fund for replacement of asset. It is a source of internal financing which does not affect the working capital of the concern as it does not involve outflow of any cash like other expenses.
The provision for depreciation has the following features:
1. Tax Benefit:
Although provision for depreciation is a non-cash expense, it is a charge against profit which ultimately reduces the tax burden of the company.
2. Replacement of Asset:
Depreciation expense is a non-cash expense and is accumulated for replacement of the asset at the end of the life of the asset.
3. Non-cash Expense:
Unlike other expenses, provision for depreciation does not involve any outflow of cash.
Provision for depreciation has certain advantages, which are as follows:
i. True Profit:
Depreciation expense is a charge against profit and helps to ascertain the true profit of the concern.
ii. Replacement of Assets:
Provision for depreciation provides sufficient funds at the end of the life to replace the existing asset.
Provision for depreciation suffers from the following limitations:
i. Difficult to Replace Assets:
It is not possible to replace the asset through provision for depreciation because depreciation is charged on the historical cost of the asset.
ii. Determination of Life:
The provision for depreciation is calculated taking into account the estimated life of the asset. Determination of estimated life is difficult to ascertain. If the asset is not used up to its estimated life, the recovery of cost of investment is not possible.