Depreciation is a component of cost that is used to calculate accurate profit estimates, which are subsequently given to the company’s shareholders in the form of dividends. The quantity of distributable earnings is reduced when depreciation is added to the cost.
By keeping a depreciation account, a portion of the distributable profit is kept in the firm as a reserve, which may later be utilized to buy new machinery or for other purposes, reducing the profits or dividends received by the owners.
Depreciation is treated as an “expense” in the business. Because it is an expense, it is inversely proportional to the profitability of an enterprise. Or in simple terms, the more the depreciation charged, the less is the profit.
Depreciation is charged as a percentage of the cost of an asset. So it is advisable that the business should purchase an asset only if it is certain that it will be used in the business soon enough to produce revenue. Otherwise depreciation will be charged and profitability adversely affected, but no value can be derived from such asset.