Depreciation, Provisions and Reserves

Depreciation

Depreciation is the systematic allocation of the cost of a tangible fixed asset over its useful life. It represents the wearing out, consumption, or loss in value of an asset arising from its use, passage of time, or obsolescence.

Causes of Depreciation:
Physical wear and tear due to regular use.
Passage of time (even idle assets deteriorate).
Obsolescence — newer technology makes older assets outdated.
Depletion — relevant for natural resources like mines.
Accidents and natural disasters.

1.Why is Depreciation Charged?
2.To show the asset at its correct value in the Balance Sheet.
3.To match the cost of the asset against the revenue it helps generate (Matching Concept).
4.To retain funds within the business for replacement of assets.

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Methods of Depreciation

1. Straight Line Method (SLM) / Fixed Instalment Method

Under SLM, an equal amount of depreciation is charged every year throughout the useful life of the asset.

Formula:
Annual Depreciation = (Cost of Asset - Scrap Value) / Useful Life (in years)

Rate of Depreciation (%) = (Annual Depreciation / Cost of Asset) x 100

The book value of the asset reaches the scrap value at the end of its life.
Suitable for assets that provide equal benefit each year (e.g., leasehold property, furniture).

2. Written Down Value Method (WDV) / Diminishing Balance Method

Under WDV, depreciation is calculated at a fixed percentage on the opening book value of each year. The amount of depreciation decreases each year.

Annual Depreciation = Book Value at Start of Year x Rate of Depreciation (%)

Book value never reaches zero.
Suitable for assets that are more productive when new (e.g., machinery, vehicles).
Also called the Reducing Balance Method.

Difference between SLM and WDV:
| Aspect | SLM | WDV |
|--------|-----|-----|
| Depreciation amount | Constant every year | Decreasing every year |
| Book value at end | Reaches scrap value | Never reaches zero |
| Calculation basis | Original cost | Opening book value |

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Accounting Treatment of Depreciation

Method 1: Direct Credit to Asset Account
Debit Depreciation Account; Credit Asset Account.
Asset appears at net book value in the Balance Sheet.
Depreciation Account is closed by transfer to Profit & Loss Account.

Method 2: Provision for Depreciation Account (Accumulated Depreciation)
Debit Depreciation Account; Credit Provision for Depreciation Account.
The Asset Account retains its original cost.
In the Balance Sheet, Provision for Depreciation is deducted from the asset cost.

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Provisions

A Provision is an amount set aside out of profits to cover a known liability whose amount or timing is uncertain at the time of preparation of accounts.

Examples:
Provision for Doubtful Debts (Bad Debts Provision)
Provision for Discount on Debtors
Provision for Taxation
Provision for Repairs and Renewals

Key Features:
Created against a specific liability or loss.
Charged to the Profit & Loss Account (reduces profit).
It is a charge on profits — must be made even if there is no profit.

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Reserves

A Reserve is an amount set aside out of profits to strengthen the financial position of the business or to meet future contingencies that are not specific liabilities.

1.Types of Reserves:
2.Revenue Reserve – Created from revenue profits (General Reserve, Specific Reserve).
3.Capital Reserve – Created from capital profits (profit on sale of fixed assets, premium on issue of shares).
4.General Reserve – Created for general strengthening; can be used for any purpose.
5.Specific Reserve – Created for a specific purpose (e.g., Dividend Equalisation Reserve, Debenture Redemption Reserve).
6.Secret Reserve – When a company shows a weaker financial position than reality (undervaluing assets or overvaluing liabilities). Allowed for certain banking companies.

Provision vs. Reserve:
| Aspect | Provision | Reserve |
|--------|-----------|---------|
| Purpose | Meet a specific liability | General or specific strengthening |
| Profit needed? | No — charge on profit | Yes — appropriation of profit |
| Shown in P&L | Yes (as expense) | No (below the line) |
| Use | Must be used for the purpose | Can be used freely (general reserve) |

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Worked Examples

Example 1 (SLM): A machine costs Rs. 50,000. Scrap value Rs. 5,000. Useful life 5 years. Calculate annual depreciation.
Annual Depreciation = (50,000 - 5,000) / 5 = Rs. 9,000 per year.
Rate = (9,000 / 50,000) x 100 = 18%.

Example 2 (WDV): Book value of machinery on 1 April 2022 is Rs. 40,000. Depreciation rate 20% WDV. Calculate depreciation for 2022-23 and book value at end.
Depreciation = 40,000 x 20/100 = Rs. 8,000.
Closing Book Value = 40,000 - 8,000 = Rs. 32,000.

Example 3

On 1 Oct 2022, a vehicle costing Rs. 1,20,000 was purchased. SLM at 10% p.a. Year end 31 March 2023. Calculate depreciation.
Period = 6 months. Depreciation = 1,20,000 x 10/100 x 6/12 = Rs. 6,000.

Example 4

Show the journal entry for charging depreciation using the Provision for Depreciation method. Depreciation = Rs. 5,000.
Entry: Debit Depreciation Account Rs. 5,000; Credit Provision for Depreciation Account Rs. 5,000.
Then: Debit Profit & Loss Account Rs. 5,000; Credit Depreciation Account Rs. 5,000.

Example 5

Provision for doubtful debts at 5% on debtors of Rs. 80,000. Existing provision = Rs. 2,000. Calculate the amount to be charged to P&L.
Required provision = 5% x 80,000 = Rs. 4,000.
Additional charge = 4,000 - 2,000 = Rs. 2,000 to be debited to P&L.

Example 6

A firm creates a General Reserve of Rs. 10,000 from profits. Journal entry:
Debit Profit & Loss Appropriation Account Rs. 10,000; Credit General Reserve Rs. 10,000.

Example 7

Distinguish with an example — A company sets aside Rs. 3,000 for taxation (provision) vs. setting aside Rs. 3,000 for a building fund (specific reserve).
Provision for taxation is a known liability; it is a charge on profits. Building Fund Reserve is an appropriation of profit for a specific future purpose but not a current liability.

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Common mistakes

Confusing provision (charge on profit — compulsory) with reserve (appropriation — requires profit).
Under WDV, always apply the rate to the opening book value of the year, not the original cost.
Under SLM, always apply the rate to the original cost, not the reduced book value.
Forgetting to pro-rate depreciation when an asset is purchased mid-year.

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Summary

Depreciation reduces the book value of assets systematically and ensures correct profit measurement. SLM gives constant annual charges while WDV gives higher charges in early years. Provisions cover specific anticipated liabilities, while reserves strengthen the business for general or specific future needs. Both are essential concepts for accurate financial reporting.