Key Points

Depreciation is the permanent, continuing, and gradual decrease in the book value of a fixed tangible asset due to its use, passage of time, or obsolescence. It is an expired cost allocated over the useful life of the asset.

The primary causes of depreciation include wear and tear from usage, effluxion (passage) of time, obsolescence due to technological changes, expiration of legal rights like patents or leases, and abnormal factors like accidents.

Depreciation applies to tangible fixed assets. Depletion is used for the extraction of natural resources like mines and quarries, while Amortisation is the process of writing off the cost of intangible assets like patents and goodwill.

Depreciation is charged to ascertain the true profit or loss by matching costs with revenues (Matching Principle), to present a true and fair view of the financial position, and for tax compliance. It is a non-cash operating expense.

The amount of depreciation is determined by three main factors: the total cost of the asset (including acquisition and installation), its estimated useful life, and its estimated net residual or salvage value.

Under the Straight Line Method, a fixed and equal amount of depreciation is charged every year throughout the asset's useful life. The formula is (Cost of Asset - Estimated Salvage Value) / Estimated Useful Life.

Under the Written Down Value Method, depreciation is charged at a fixed percentage on the book value (or reducing balance) of the asset each year. This results in a higher depreciation amount in the early years and a lower amount in later years.

SLM charges depreciation on the original cost, resulting in a constant annual charge. WDV charges depreciation on the book value, resulting in a declining annual charge. WDV is recognized by income tax laws.

In this method, the depreciation amount is credited directly to the Asset Account. The asset is then shown in the Balance Sheet at its net book value (Cost less Depreciation).

In this method, depreciation is credited to a separate account called 'Provision for Depreciation' or 'Accumulated Depreciation'. The asset is shown at its original cost in the Balance Sheet, with the provision shown as a deduction from it.

An Asset Disposal Account is prepared at the time of an asset's sale to show all related transactions in one place. It is debited with the original cost of the asset and credited with accumulated depreciation and sale proceeds to ascertain profit or loss on disposal.

A provision is an amount set aside for a known liability or expense, the exact amount of which is not certain. It is a charge against profit and is created to ascertain the true profit for the accounting period.

A reserve is an amount set aside out of profits to strengthen the financial position of the business, finance future growth, or meet future contingencies. It is an appropriation of profit, not a charge against it.

The main difference is that a provision is a charge against profit made for a known liability, whereas a reserve is an appropriation of profit made to strengthen the business. Provisions must be made even if there is a loss, while reserves can only be created from profits.

Revenue Reserves are created from profits earned in the normal course of business (e.g., General Reserve). Capital Reserves are created from capital profits, which are not from normal operations (e.g., profit on sale of fixed assets).

A General Reserve is created without any specific purpose and can be used freely by the management. A Specific Reserve is created for a particular purpose and can only be used for that purpose, such as a Debenture Redemption Reserve.

A Secret Reserve is a reserve that is not disclosed on the balance sheet. It can be created by methods such as charging excessive depreciation, undervaluing assets, or making excessive provisions for doubtful debts.