Maintenance of capital is indispensable for continuous flow of income. To maintain capital intact provision for depreciation must be made. This can be explained considering two cases:
- When depreciation is provided in accounts
- When depreciation is not provided in accounts
When depreciation is not provided in accounts
A large amount of capital is invested in the assets to generate income. Such income is distributed among shareholders in the form of dividend. If depreciation is not provided, then the income of a concern is reflected at inflated figure. The concern may distribute dividend out of such inflated profit, which may cause capital erosion.
Putting it differently, fixed assets are used in the production process for several accounting periods. However, its utility declines gradually. After several years, utility of fixed assets is fully exhausted and it needs to be discarded. Ultimately, business looses its capital invested in the fixed asset. For further production, business requires additional capital to replace such exhausted assets with new one. Hence without depreciation, it fails to maintain its capital intact.
When depreciation is provided in accounts
Fixed assets are used in the production process and get exhausted after certain period. Hence, it is necessary to allocate cost of fixed assets over several periods. Through depreciation, firm set asides a part of profit for replacement of asset and remaining profit may be distributed among the owners of the business. Such retained profit may be invested in external securities. Gradually, a large amount is accumulated which can be utilised for replacement of exhausted fixed asset. Ultimately, capital is maintained intact.
Though depreciation is provided to maintain capital intact, but it fails to maintain intact the real value of capital. As in accounting, assets are recorded at historical cost and depreciation is also restricted to its historical cost. However, in an inflationary economy, money looses its value. So, amount retained in the business through depreciation is not sufficient for replacement of asset. Hence, depreciation maintains nominal value of capital but fails to maintain its real value. Please share your valuable views.