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1. Introduction

Fixed assets such as machinery, buildings, furniture and vehicles are used in the business for a number of years. With the passage of time and constant use, these assets lose their value. This gradual reduction in the value of a fixed asset is called depreciation. Depreciation is not a loss of cash but a loss of value, and it must be charged as an expense every year so that the profit of the business is not overstated and the asset is shown in the books at a fair value. The chapter also explains provisions, which are amounts set aside to cover known future losses, and reserves, which are appropriations of profit for strengthening the business.

Depreciation is a non-cash expense, which means it reduces the profit but does not involve any outflow of cash in the year in which it is charged. The provision for depreciation is accumulated in a separate account, and the two methods most commonly used are the Straight Line Method and the Written Down Value Method. Provisions and reserves, on the other hand, affect the retained earnings of the business and are shown on the liabilities side of the Balance Sheet.

2. Meaning and Causes of Depreciation

Depreciation is the gradual and permanent decrease in the value of a fixed asset due to wear and tear, passage of time, obsolescence or accidents. The main causes of depreciation are:

  1. Wear and tear: constant use of the asset reduces its value.
  2. Passage of time: some assets lose value with the lapse of time even if unused, such as a leasehold asset.
  3. Obsolescence: the asset becomes outdated due to technological changes, such as old machinery being replaced by modern machines.
  4. Accident or natural factors: accidental damage reduces the value of the asset.
  5. Depletion: natural resources such as mines and quarries get exhausted with extraction.

Depreciation does not arise out of market fluctuations; a fall in the market price of an asset is not depreciation.

3. Need and Objectives of Depreciation

Depreciation is charged because of the following needs:

  1. To ascertain the true profit or loss of the business, as the asset's cost must be spread over its useful life.
  2. To show the asset in the Balance Sheet at its true value.
  3. To provide funds for the replacement of the asset.
  4. To calculate the correct cost of production.
  5. To comply with the matching concept, since the expense of using the asset must be matched with the revenue it helps to earn.

4. Factors Determining Depreciation

The main factors affecting the amount of depreciation are:

  1. The original cost of the asset, including installation and other incidental expenses.
  2. The estimated useful life of the asset.
  3. The estimated residual or scrap value of the asset at the end of its life.
  4. The method of depreciation used.
  5. Legal and technical requirements.

5. Methods of Calculating Depreciation

5.1 Straight Line Method (Fixed Instalment Method)

Under this method, an equal amount of depreciation is charged every year over the useful life of the asset.

$$Depreciation = \frac{Cost - Residual \ Value}{Estimated \ Useful \ Life}$$

For example, if a machine costs Rs 1,00,000, has a residual value of Rs 10,000 and a life of 9 years, then:

$$Depreciation = \frac{1,00,000 - 10,000}{9} = Rs \ 10,000 \ per \ year$$

The rate of depreciation can also be computed as:

$$Rate = \frac{Depreciation}{Cost} \times 100$$

5.2 Written Down Value Method (Diminishing Balance Method)

Under this method, depreciation is charged at a fixed rate on the book value of the asset at the beginning of each year. The amount of depreciation decreases year after year.

$$Depreciation = Book \ Value \times Rate$$

For example, if the book value is Rs 1,00,000 and the rate is 10%, the first year's depreciation is Rs 10,000, the second year's is 10% of Rs 90,000, that is Rs 9,000, and so on.

5.3 Comparison of the Two Methods

Under the straight line method, the depreciation amount is constant and the book value decreases uniformly. Under the written down value method, the depreciation amount decreases each year and the book value falls rapidly in the early years. The written down value method is generally preferred for assets whose efficiency declines with use, while the straight line method suits assets whose services are used uniformly.

6. Accounting Treatment of Depreciation

When depreciation is charged directly to the asset account:

Depreciation A/c Dr. To Asset A/c

At the end of the year, the depreciation account is closed by transferring it to the Profit and Loss Account: Profit and Loss A/c Dr. To Depreciation A/c

When a provision for depreciation is maintained:

Depreciation A/c Dr. To Provision for Depreciation A/c

The asset continues to appear at its original cost, and the accumulated depreciation is shown as a deduction from the asset in the Balance Sheet.

7. Provisions

A provision is an amount set aside out of profits to meet a known liability, the amount of which is not certain but can be estimated with reasonable accuracy. Examples are the provision for doubtful debts, provision for discount on debtors and provision for repairs. A provision is a charge against profit, which means it is debited to the Profit and Loss Account even before the profit is known. It is shown on the liabilities side of the Balance Sheet or as a deduction from the related asset.

Provision for doubtful debts is calculated on the debtors as:

$$Provision = Debtors \times Rate \ of \ Provision$$

If there is an opening provision, the new provision is compared with it and only the difference is charged to the Profit and Loss Account.

8. Reserves

A reserve is an appropriation of profit, that is, a part of the profit that is set aside to strengthen the financial position of the business. Unlike a provision, a reserve is created only out of profit and is a part of the capital. Reserves may be revenue reserves or capital reserves. General reserves strengthen the business, while specific reserves are created for a definite purpose such as the dividend equalisation reserve or the debenture redemption reserve. Secret reserves are created without being disclosed in the Balance Sheet.

Distinction between Provision and Reserve

Basis Provision Reserve
Nature Charge against profit Appropriation of profit
Purpose Known liability of uncertain amount Strengthening the business
Created from Profit, even before profit is known Only out of profit
Effect on profit Reduces the profit Reduces the divisible profit
Shown in Balance Sheet As a liability or deduction from asset On the liabilities side as part of capital

Quick Revision Tables

Table 1: Methods of Depreciation

Basis Straight Line Method Written Down Value Method
Amount of depreciation Equal every year Decreases every year
Basis of charge Original cost Book value at the start
Book value Reduces uniformly Reduces rapidly
Suitability Uniform services Assets losing value quickly

Table 2: Provision vs Reserve

Basis Provision Reserve
Charge or appropriation Charge against profit Appropriation of profit
Purpose Known liability Future strengthening
Effect on taxable profit Reduces it Does not reduce it
Shown as Deduction from asset or liability Part of capital in Balance Sheet

Table 3: Key Formulas

Item Formula
Straight line depreciation (Cost - Residual Value) / Useful Life
Rate of depreciation Depreciation / Cost x 100
WDV depreciation Book Value x Rate
Provision for doubtful debts Debtors x Rate

Mind Map

graph TD A["Depreciation, Provisions and Reserves"] --> B["Depreciation"] B --> C["Causes: wear and tear, time, obsolescence"] B --> D["Methods"] D --> E["Straight Line Method"] D --> F["Written Down Value Method"] A --> G["Accounting Treatment"] G --> H["Depreciation A/c Dr., To Asset A/c"] G --> I["Provision for Depreciation A/c"] A --> J["Provision"] J --> K["Known liability of uncertain amount"] A --> L["Reserve"] L --> M["Appropriation of profit"] A --> N["Provision vs Reserve"] N --> O["Charge vs appropriation of profit"]

Important Diagrams (SVG)

Diagram 1: Comparison of Straight Line and Written Down Value Methods

Straight Line vs Written Down Value Method Straight Line Method Written Down Value Method Depreciation = (Cost - Scrap) / Life Depreciation = Book Value x Rate Equal amount every year Decreasing amount every year Fixed instalment charge High charge in early years Example Machine cost Rs 1,00,000, scrap Rs 10,000, life 9 years SLM: Rs 10,000 every year | WDV at 10%: Rs 10,000, 9,000, 8,100... Golden Rule SLM gives constant depreciation, while WDV gives higher depreciation in the early years of the asset's life.

Diagram 2: Provisions and Reserves in the Profit and Loss Distribution

Provisions and Reserves Profit of the Business before charging provisions Provision Charge against profit Known liability of uncertain amount Reserve Appropriation of profit Strengthens the business Part of capital Examples Provision for doubtful debts, discount, repairs | General reserve, capital reserve Golden Rule Provisions are charges against profit, while reserves are appropriations of profit; both appear on the liabilities side.

Common Mistakes

  1. Depreciation is treated as a cash outflow, whereas it is a non-cash expense and involves no payment of cash in the year of charge.
  2. The written down value method is used to calculate depreciation on the original cost, while it is always calculated on the book value at the beginning of the year.
  3. Provision is confused with reserve; a provision is a charge against profit while a reserve is an appropriation of profit.
  4. The scrap value is ignored while computing depreciation under the straight line method, although it must be deducted from the cost.
  5. The accumulated depreciation is added to the asset instead of being deducted from it in the Balance Sheet.
  6. Students forget that depreciation is not charged on the market value but on the cost and the book value.
  7. Provisions for doubtful debts are treated as expenses of the year in full, ignoring the opening provision which requires only the difference to be charged.

Exam Tips

  1. Write the formula for the straight line method clearly as (Cost - Residual Value) / Estimated Useful Life.
  2. Show a solved example of both methods for the same asset to bring out the difference.
  3. Give the journal entries: Depreciation A/c Dr., To Asset A/c, and later Profit and Loss A/c Dr., To Depreciation A/c.
  4. In the provision for doubtful debts question, remember that only the difference between the new and old provision is charged.
  5. Make a comparison table of provision and reserve to score full marks.
  6. Mention that depreciation is a non-cash expense and follows the matching concept.
  7. Practice the calculation of the provision for doubtful debts along with the discount on debtors.

Conclusion

Depreciation, provisions and reserves are essential tools for presenting a true and fair view of the business. Depreciation allocates the cost of fixed assets over their useful lives and is charged through the straight line or written down value method. Provisions cover known liabilities of uncertain amounts and are charges against profit, while reserves are appropriations of profit that strengthen the financial position of the business. A correct understanding of the distinction between provisions and reserves, and of the methods of depreciation, is fundamental to the preparation of accurate final accounts.