1. Depreciation
Depreciation is the permanent, continuous, and gradual shrinkage in the book value of a fixed asset over its estimated useful life due to wear and tear, obsolescence, or passage of time.
- Amortization: Used for intangible assets (Goodwill, Patents).
- Depletion: Used for wasting assets (Mines, Oil wells).
Causes of Depreciation:
- Constant use (Wear and tear).
- Expiry of time (e.g., Leases).
- Obsolescence (technological changes or new inventions).
- Accidents.
Need / Objectives of charging Depreciation:
- To ascertain true profit or loss (Matching concept).
- To present a true and fair view of the financial position.
- To accumulate funds for the replacement of the asset.
- To calculate the correct cost of production.
2. Methods of Calculating Depreciation
For Class 11, the two primary methods are:
A. Straight Line Method (SLM) / Original Cost Method / Equal Instalment Method
- Under this method, a fixed and equal amount is charged as depreciation every year over the useful life of the asset.
- Formula:
$$\text{Depreciation} = \frac{\text{Original Cost} - \text{Estimated Scrap Value}}{\text{Estimated Useful Life}}$$
- Rate of Depreciation:
$$\text{Rate} = \frac{\text{Annual Depreciation}}{\text{Original Cost}} \times 100$$
- Merits: Simple to calculate, asset value can be reduced to zero.
- Demerits: Total charge (Depreciation + Repairs) to P&L A/c becomes unequal over the years (repairs increase as the asset gets older).
B. Written Down Value (WDV) Method / Diminishing Balance Method
- Under this method, depreciation is charged at a fixed rate, but on the reducing balance (Book Value) of the asset every year.
- Merits: Total charge (Depreciation + Repairs) remains somewhat uniform over the years. Recognized by Income Tax authorities.
- Demerits: Asset value can never be reduced to absolute zero. Formula to calculate the rate is complex.
3. Accounting Treatment of Depreciation
There are two ways to record depreciation:
Case 1: When Provision for Depreciation A/c is NOT maintained.
Depreciation is directly credited to the Asset A/c.
- Entry: Depreciation A/c Dr. To Asset A/c
Case 2: When Provision for Depreciation A/c (Accumulated Depreciation A/c) IS maintained.
Depreciation is not credited to the Asset A/c. The Asset remains at its original cost in the books.
- Entry: Depreciation A/c Dr. To Provision for Depreciation A/c
4. Provisions
A Provision is an amount retained by way of providing for any known liability, the amount of which cannot be determined with substantial accuracy.
- Created out of Profit and Loss Account.
- It is a charge against profit (must be made even if there is a loss).
- Examples: Provision for Doubtful Debts, Provision for Depreciation, Provision for Taxation.
5. Reserves
A Reserve is an appropriation of profits meant for strengthening the financial position of the business or meeting an unforeseen future contingency.
- Created out of Profit and Loss Appropriation Account.
- It is an appropriation of profit (created only if there are profits).
- Examples: General Reserve, Capital Reserve, Dividend Equalization Reserve.
Types of Reserves:
- Revenue Reserve: Created out of normal revenue profits. (e.g., General Reserve, Specific Reserves).
- Capital Reserve: Created out of capital profits (e.g., profit on sale of fixed assets, premium on issue of shares). It cannot be used for distributing regular dividends.
- Secret Reserve: A reserve whose existence or amount is not disclosed in the balance sheet. Created by understating assets or overstating liabilities. (Allowed only for certain institutions like banks).