Accountancy: Class 11 (Part 1) — Chapter 7: Depreciation, Provisions and Reserves

Section I: Depreciation

7.1 Introduction & Meaning of Depreciation

Matching principle requires that the revenue of a given period is matched against the expenses for the same period. Depreciation represents the decline in the value of a fixed asset due to use, passage of time, or obsolescence.

According to AS-6 (Revised): "Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change."

7.1.2 Features of Depreciation

It is a decline in the book value of fixed assets.
It includes loss of value due to effluxion of time, usage, or obsolescence.
It is a continuing process.
It is an expired cost and must be deducted before calculating taxable profits.
It is a non-cash expense; it does not involve any cash outflow.

7.2 Depreciation and Other Similar Terms

Depletion: Used in the context of extraction of natural resources (e.g., mines, quarries) which reduces the availability of the quantity of the material.
Amortisation: Refers to writing-off the cost of intangible assets (e.g., patents, copyrights, trademarks, goodwill).

7.3 Causes of Depreciation

Wear and tear due to use or passage of time.
Expiration of legal rights (e.g., leaseholds, patents).
Obsolescence (due to technological changes or market demand shifts).
Abnormal factors (e.g., accidents, fire, natural calamities).

7.4 Need for Depreciation

Matching of Costs and Revenue: To charge the cost of asset consumption against the revenue earned.
Consideration of Tax: Depreciation is a deductible expense for tax purposes.
True and Fair Financial Position: To prevent overvaluation of assets on the Balance Sheet.
Compliance with Law: Specific legislations compel corporate enterprises to provide depreciation.

7.5 Factors Affecting Depreciation

Cost of Asset: Includes invoice price, freight, transit insurance, installation cost, and commissioning expenses.
Estimated Net Residual Value: Also known as scrap value or salvage value, the estimated net realizable value at the end of its useful life.
Estimated Useful Life: The period over which the asset is expected to be used by the enterprise.

7.6 Methods of Calculating Depreciation

1. Straight Line Method (SLM)

Also known as the Fixed Installment Method. Depreciation remains constant from year to year.

$$\text{Depreciation} = \frac{\text{Cost of Asset} - \text{Estimated Net Residual Value}}{\text{Estimated Useful Life of the Asset}}$$

$$\text{Rate of Depreciation} = \frac{\text{Annual Depreciation Amount}}{\text{Acquisition Cost}} \times 100$$

2. Written Down Value Method (WDV)

Also known as the Reducing Balance Method. Depreciation is calculated as a fixed percentage of the book value at the beginning of each year.

$$R = \left[1 - \sqrt[n]{\frac{s}{c}}\right] \times 100$$

Where $R$ = Rate of depreciation, $n$ = Expected useful life, $s$ = Scrap value, $c$ = Cost of asset.

7.7 Comparison of SLM and WDV

Basis of Difference	Straight Line Method	Written Down Value Method
Basis of charging	Original cost	Book value (cost less depreciation till date)
Annual depreciation charge	Fixed (Constant) every year	Declines year after year
Total charge (Depreciation + Repairs)	Unequal (increases in later years)	Almost equal every year
Income Tax recognition	Not recognised	Recognised

7.8 Methods of Recording Depreciation

Method 1: Charging Depreciation to Asset Account

Transaction	Journal Entry
For purchase of asset	Asset A/c Dr. To Bank/Vendor A/c
For providing depreciation	Depreciation A/c Dr. To Asset A/c
For transferring to P&L	Profit & Loss A/c Dr. To Depreciation A/c

Method 2: Creating Provision for Depreciation Account

Transaction	Journal Entry
For providing depreciation	Depreciation A/c Dr. To Provision for Depreciation A/c
For transferring to P&L	Profit & Loss A/c Dr. To Depreciation A/c

Section II: Provisions and Reserves

7.11 Provisions

A Provision is an amount set aside by debiting the Profit and Loss Account to meet a known liability or loss, the amount of which cannot be determined with accuracy.

Provision for Depreciation
Provision for Bad and Doubtful Debts
Provision for Taxation

7.12 Reserves

A Reserve is an appropriation of profit retained in the business to strengthen its financial position or meet future contingencies.

General Reserve: Created for general purposes, freely usable.
Specific Reserve: Created for a specific purpose (e.g., Dividend Equalisation Reserve, Debenture Redemption Reserve).
Revenue Reserve: Created out of normal operating profits.
Capital Reserve: Created out of capital profits (e.g., premium on issue of shares, profit on sale of fixed assets).

7.13 Secret Reserve

A Secret Reserve is a reserve that does not appear in the Balance Sheet. It is created by showing profits at a lower figure than actuals (e.g., by excessive depreciation or undervaluation of stock).