Depreciation, Provisions and ReservesClass 11 Financial Accounting 1 Notes

Depreciation

Depreciation is the decline in the value of a fixed asset due to its use, the passage of time, or becoming outdated (obsolescence). In accounting, it is the process of spreading the cost of an asset over its useful life. This aligns with the Matching principle, which states that expenses should be matched with the revenues they help generate in the same accounting period.

Since a fixed asset like a machine provides benefits for several years, its entire cost is not treated as an expense in the year of purchase. Instead, a portion of its cost is charged as an expense each year. This annual expense is called depreciation.

Meaning of Depreciation

Depreciation is a permanent, continuous, and gradual decrease in the book value of a fixed asset. It's important to remember that this is based on the asset's original cost, not its current market value.

According to Accounting Standard-6 (AS-6), depreciation is a measure of the wearing out, consumption, or other loss of value of a depreciable asset. It is allocated over the asset's expected useful life.

Depreciable assets are assets that:

• Are expected to be used for more than one accounting period.
• Have a limited useful life.
• Are held for use in the production or supply of goods and services, for rental, or for administrative purposes (not for resale).

Features of Depreciation

• Decline in Book Value: It reduces the value of fixed assets as shown in the accounting records.
• Includes Various Causes: It covers value loss from use, time, or obsolescence (e.g., a new model of a machine makes the old one less valuable).
• Continuing Process: It occurs throughout the useful life of the asset.
• Expired Cost: It is treated as an expense and must be deducted before calculating taxable profits.
• Non-Cash Expense: It does not involve an actual outflow of cash. It is simply the accounting process of writing off a capital expenditure that has already been incurred.

Depreciation and other Similar Terms

Other terms are used for the decline in value of different types of assets, but they are treated similarly in accounting.

Depletion

The term depletion is used for the extraction of natural resources like minerals from mines or quarries. As the resource is extracted, the value of the mine or quarry decreases. The main difference is that depletion relates to the exhaustion of economic resources, while depreciation relates to the usage of a manufactured asset.

Amortisation

Amortisation refers to writing off the cost of intangible assets over a specific period. Intangible assets are non-physical assets like patents, copyrights, trademarks, and goodwill.

Causes of Depreciation

The primary causes of depreciation include:

• Wear and Tear due to Use or Passage of Time: Assets deteriorate from being used in business operations. Even if not used, they can degrade over time due to exposure to elements like weather.
• Expiration of Legal Rights: Some assets, like patents, copyrights, or leases, have a pre-determined legal life. Their value expires when these legal rights end.
• Obsolescence: An asset becomes obsolete, or "out-of-date," when a better or more technologically advanced alternative becomes available. This can be due to technological changes, improved production methods, or shifts in market demand.
• Abnormal Factors: Unexpected events like accidents, fires, earthquakes, or floods can cause a permanent decline in an asset's usefulness and value.

Need for Depreciation

Charging depreciation is essential for several reasons:

• Matching of Costs and Revenue: To determine the true profit for a period, the cost of using an asset (depreciation) must be charged against the revenue earned during that period.
• Consideration of Tax: Depreciation is a deductible expense for tax purposes, which can reduce a company's tax liability.
• True and Fair Financial Position: If depreciation is not charged, assets will be overvalued in the Balance Sheet, presenting an incorrect financial position.
• Compliance with Law: Laws and accounting standards require businesses, especially corporate enterprises, to provide for depreciation on their fixed assets.

Factors Affecting the Amount of Depreciation

The amount of depreciation to be charged depends on three key factors:

Cost of Asset

This is the original cost or historical cost of the asset. It includes the purchase price plus all necessary costs to get the asset ready for use, such as:

• Freight and transportation costs
• Transit insurance
• Installation and commissioning costs
• Registration costs

Estimated Net Residual Value

Also known as scrap value or salvage value, this is the estimated sale value of the asset at the end of its useful life, minus any costs associated with its disposal.

Depreciable Cost

This is the amount that will be charged as depreciation over the asset's life. It is calculated as: Depreciable Cost = Cost of Asset - Estimated Net Residual Value

Estimated Useful Life

This is the period over which an asset is expected to be used by the business. It is its economic or commercial life, which may be shorter than its physical life. An asset might still be physically functional but no longer commercially viable to operate. Useful life can be expressed in years, units of output, or working hours.

Methods of Calculating Depreciation Amount

The two most common methods for calculating depreciation in India are the Straight Line Method and the Written Down Value Method.

Straight Line Method

The Straight Line Method (SLM) is one of the simplest and most widely used methods. It assumes that the asset is used equally over its entire useful life.

• It is also known as the fixed installment method because the depreciation amount remains constant every year.
• The formula to calculate annual depreciation is: Depreciation = (Cost of asset - Estimated net residual value) / Estimated useful life of the asset
• The rate of depreciation can be calculated as: Rate of Depreciation = (Annual depreciation amount / Acquisition cost) x 100

Advantages of Straight Line Method

• Simplicity: It is easy to understand and apply.
• Full Depreciation: The asset's full depreciable cost is written off over its useful life.
• Easy Comparison: The constant depreciation charge makes it easier to compare profits across different years.
• Suitability: It is suitable for assets with a consistent usage pattern and accurately estimable useful life, such as leasehold buildings.

Limitations of Straight Line Method

• Faulty Assumption: It assumes equal utility from the asset each year, which is often unrealistic.
• Increasing Burden on Profits: As an asset gets older, repair expenses tend to increase. Since the depreciation amount stays the same, the total charge against profit (depreciation + repairs) increases in later years.

Written Down Value Method

Under the Written Down Value (WDV) Method, depreciation is charged on the book value (cost less accumulated depreciation) of the asset at the beginning of each year.

• It is also known as the reducing balance method or diminishing value method because the amount of depreciation decreases every year.
• This method is based on the more realistic assumption that an asset provides more benefit in its earlier years and less as it gets older.
• A pre-determined percentage is applied to the shrinking book value of the asset each year.

• Year 1 Depreciation: 10% of ₹2,00,000 = ₹20,000. Book value is now ₹1,80,000.
• Year 2 Depreciation: 10% of ₹1,80,000 = ₹18,000. Book value is now ₹1,62,000.
• Year 3 Depreciation: 10% of ₹1,62,000 = ₹16,200. And so on.

Advantages of Written Down Value Method

• Realistic Assumption: It matches higher depreciation charges with the higher utility of the asset in its early years.
• Equal Burden on Profits: The total charge (depreciation + repairs) remains relatively constant over the asset's life, as depreciation is high when repairs are low, and vice versa.
• Accepted by Tax Law: The Income Tax Act recognizes this method for tax purposes.
• Reduces Obsolescence Loss: A large portion of the cost is written off early, reducing the potential loss if the asset becomes obsolete.

Limitations of Written Down Value Method

• Asset Value Never Reaches Zero: The book value of the asset is never fully written off to zero.
• Difficulty in Rate Calculation: Ascertaining a suitable rate of depreciation can be complex.

Straight Line Method and Written Down Method: A Comparative Analysis

Methods of Recording Depreciation

There are two main ways to record depreciation in the books of account.

Charging Depreciation to Asset account

Under this method, the depreciation amount is credited directly to the asset account, reducing its book value.

1. At the end of the year, for depreciation:
   • Depreciation A/c Dr.
   • To Asset A/c
2. To transfer depreciation to Profit & Loss account:
   • Profit & Loss A/c Dr.
   • To Depreciation A/c

In the Balance Sheet, the asset is shown at its net book value (Cost - Depreciation charged to date).

Creating Provision for Depreciation Account/Accumulated Depreciation Account

This method is designed to show the asset at its original cost throughout its life, with depreciation accumulated in a separate account.

• The asset account always shows the original cost.
• A separate Provision for Depreciation Account (or Accumulated Depreciation Account) is created to store the total depreciation charged so far.

1. At the end of the year, for depreciation:
   • Depreciation A/c Dr.
   • To Provision for Depreciation A/c
2. To transfer depreciation to Profit & Loss account:
   • Profit & Loss A/c Dr.
   • To Depreciation A/c

In the Balance Sheet, the asset is shown at its original cost on the asset side, with the Provision for Depreciation account shown either on the liabilities side or as a deduction from the asset's cost.

Disposal of Asset

An asset can be disposed of at the end of its useful life or during its life.

When an asset is sold, the amount received is credited to the Asset Account. Any remaining balance in the Asset Account represents a profit or loss on the sale, which is then transferred to the Profit and Loss Account.

If a Provision for Depreciation Account is maintained, the total accumulated depreciation for that specific asset must first be transferred from the Provision for Depreciation Account to the Asset Account before the sale is recorded.

Use of Asset Disposal Account

To get a clear picture of all transactions related to a sale, a temporary account called the Asset Disposal Account can be opened. This is especially useful when a part of an asset is sold and a Provision for Depreciation account is maintained.

The process is as follows:

1. Transfer the original cost of the asset being sold to the Asset Disposal Account.
   • Asset Disposal A/c Dr.
   • To Asset A/c
2. Transfer the accumulated depreciation of that asset to the Asset Disposal Account.
   • Provision for Depreciation A/c Dr.
   • To Asset Disposal A/c
3. Record the sale proceeds.
   • Bank A/c Dr.
   • To Asset Disposal A/c
4. Transfer the final balance (profit or loss) to the Profit and Loss Account.
   • For a loss: Profit and Loss A/c Dr. To Asset Disposal A/c
   • For a profit: Asset Disposal A/c Dr. To Profit and Loss A/c

Effect of any Addition or Extension to the Existing Asset

When an addition or extension is made to an existing asset, the cost is capitalized (added to the cost of the asset) and depreciated over its useful life.

• If the addition becomes an integral part of the asset, it should be depreciated over the remaining useful life of the main asset.
• If the addition retains a separate identity and can be used independently, it should be depreciated separately over its own useful life.

Provisions and Reserve

Provisions

A provision is an amount set aside to cover a known liability or a likely loss related to the current accounting period, where the exact amount is not yet certain. Creating provisions is essential for determining the true net profit and follows the principle of Prudence or Conservatism.

Examples of provisions include:

• Provision for depreciation
• Provision for bad and doubtful debts
• Provision for taxation
• Provision for repairs and renewals

In the Balance Sheet, a provision is either deducted from the related asset (e.g., Provision for Doubtful Debts is deducted from Sundry Debtors) or shown on the liabilities side.

Accounting Treatment for Provisions

The accounting treatment for most provisions is similar. For example, to create a Provision for Doubtful Debts, a business estimates what percentage of its credit customers (debtors) might not pay. This estimated amount is recorded with the following journal entry:

• Profit and Loss A/c Dr.
• To Provision for Doubtful Debts A/c

Reserves

A reserve is a part of the profit retained in the business to meet future needs, such as funding growth and expansion, or to cover unexpected contingencies.

Reserves strengthen the financial position of the business but reduce the amount of profit available for distribution to the owners. They are shown on the liabilities side of the Balance Sheet under the head Reserves and Surpluses.

Examples of reserves include:

• General Reserve
• Workmen Compensation Fund
• Investment Fluctuation Fund
• Capital Reserve
• Dividend Equalisation Reserve

Difference between Reserve and Provision

Types of Reserves

Reserves can be classified in several ways.

Based on Purpose:

• General Reserve: A reserve created without any specific purpose. Management can use it freely for any reason, such as strengthening the business's financial position. It is also called a free reserve.
• Specific Reserve: A reserve created for a specific purpose and can only be used for that purpose. Examples include Dividend Equalisation Reserve (to maintain a stable dividend rate) and Debenture Redemption Reserve (to provide funds for paying back debentures).

Based on Source of Profit:

• Revenue Reserves: Created from revenue profits, which are profits earned from the normal operating activities of the business. These are generally available for distribution as dividends. Examples include General Reserve and Workmen Compensation Fund.
• Capital Reserves: Created from capital profits, which do not arise from normal business operations. These profits are not available for dividend distribution. They can be used for specific purposes like writing off capital losses or issuing bonus shares. Examples of capital profits include profit on the sale of fixed assets and premium on the issue of shares.

Difference between Revenue and Capital Reserve

Importance of Reserves

Reserves are important for a business because they help in:

• Meeting future contingencies and unexpected losses.
• Strengthening the overall financial health of the business.
• Providing funds for future expansion and growth.
• Redeeming long-term liabilities like debentures.

Secret Reserve

A secret reserve is a reserve that is not disclosed in the Balance Sheet. Its existence is not known to outside stakeholders. Management may create a secret reserve to reduce the disclosed profits and tax liability in good years, and then use this reserve to show improved profits during lean periods.

Secret reserves can be created by:

• Charging higher depreciation than necessary.
• Underrating the value of inventories (stock).
• Charging a capital expenditure (like the purchase of a small asset) to the Profit and Loss Account.
• Making an excessive provision for doubtful debts.

While not transparent, the creation of secret reserves within reasonable limits is sometimes justified on grounds of prudence and business strategy.