Depreciation.

 

The purpose of depreciation is to match the cost of the fixed asset over its productive life to the revenues the business earns from the asset. It is very difficult to directly link the cost of the asset to revenues, hence, the cost is usually assigned to the number of years the asset is productive.

It s just an allocation process as per matching principle instead of a technique which determines the fair market value of the fixed asset.

If we do not use depreciation in accounting, then we have to charge all assets to expense once they are bought. This will result in huge losses in the following transaction period and in high profitability in periods when the corresponding revenue is considered without an offset expense. Hence, companies which do not use the depreciation expense in their accounts will incur front-loaded expenses and highly variable financial results.

Also, charging depreciation in profit and loss statement results in reduction of taxable profits which in turn reduces the tax amount to be paid.