Depreciation, Provisions and Reserves:

 Depreciation: Concept, Features, Causes, factors

 Other similar terms: Depletion and Amortisation
 Methods of Depreciation:
i. Straight Line Method (SLM)
ii. Written Down Value Method (WDV)
 Difference between SLM and WDV;
 Advantages of SLM and WDV
 Accounting treatment of depreciation
i. Charging to asset account
ii. Creating provision for depreciation/accumulated depreciation account
iii. Treatment for disposal of asset
 Provisions and Reserves: Difference
 Types of Reserves:
i. Revenue reserve
ii. Capital reserve
iii. General reserve
iv. Specific reserve
v. Secret Reserve
 Difference between capital and revenue reserve

Depreciation:
Depreciation refers to the decrease in the value of fixed assets due to wear and tear,
passage of time, outdatedness, etc.

Features of Depreciation:
a) It is the decrease in the value of fixed assets.
b) It is a permanent decrease in the value of fixed asset.
c) It is a gradual and continuous process.
d) It is a decrease in the book value of the asset and not the market value.
e) The term depreciation is used in respect of tangible fixed assets and not for
intangible fixed assets.

Causes of depreciation:
1) Wear and tear (constant use)
2) Passage of time
3) Outdatedness /obsolescence
4) Permanent fall in market value
5) Other reasons like accidents, natural calamities, etc.

Need/Importance/Objectives of Providing Depreciation:

1) For ascertaining the true profit or loss.
2) For showing the true & fair financial position.
3) To provide funds for replacement of assets.
4) For avoiding over payment of income tax.
Important terms:
 Amortisation: It refers to writing off the cost of intangible assets like patents,
trademarks, goodwill which have utility for a specified period of time.
 Depletion: It is used in the context of extraction of natural resources from mines,
quarries, etc. that reduces the availability of the quantity of material or resources
available. Eg.: In a coal mine, depletion is the decline in the value of the mine due to
the exhaustion of coal.
 Depreciation, amortisation & depletion: They are similar terms used in different
context. In accounting, the treatment for the above is similar.

Factors affecting the amount of depreciation:

a) Cost of the asset
b) Estimated use of useful life of asset
c) Estimated scrap value

Methods of calculating depreciation:

1) Straight line method
2) Written down value method
3) Annuity method
4) Depreciation fund method
5) Insurance policy method
6) Revaluation method
7) Depletion depreciation method
8) Machine hour rate method.

Advantages of straight line method:

 It is simple and easy to understand.
 The burden of depreciation on profit and loss account is equal for all years.
 Comparison of profit and loss for different years is easy as the amount is the same of
depreciation charged every year.
 Assets can be depreciated to the net scrape value or zero value.

Disadvantages of straight line method:

 This method is not approved by Income tax act.
 Loss of interest on investment made on an asset is not considered.
 No provision is made for replacement.
 Burden to profit and loss account is not in accordance with efficiency and utility of the
asset.
 It becomes difficult to calculate depreciation on each machine when there are a number
of machines in the same organisation with different life spans.
 It seems illogical to charge depreciation on the original cost of the asset every year
when the balance of the asset is declining year after year.
 Suitability: This method is suitable to those assets with smaller value, which do not
require much repairs and maintenance and render uniform service year after year like
patents, furniture, etc.

Written Down Value Method/Diminishing Balance Method/Reducing Balance

Method:
Under this method, depreciation is charged on the book value of the asset. So, the
amount of depreciation on the asset decreases every year.

Advantages Written Down Value Method:

 Easy to calculate the amount of depreciation
 It is approved by the Income Tax Act.
 Rational method as it takes into account the efficiency and utility of an asset.
 The combined amount of depreciation and maintenance charge remains the same
throughout the working life of the asset.
 Suitable for those assets which have long life.

Disadvantages Written Down Value Method:

 The value of the asset cannot be completely written off.
 It does not take into consideration the loss of interest on the investment made in an
asset.
 The rate of depreciation cannot be fixed easily.
 No provision is made for purchasing a new asset when the present asset in use becomes
obsolete or useless.
 It is very difficult to identify individual assets if there are frequent additions.

Difference between straight line method and written down value method:
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We will learn to prepare the following:

1. Asset A/c & Depreciation A/c
2. Asset A/c & Provision for Depreciation A/c
3. Asset A/c &/ Provision for Depreciation +Asset Disposal A/c

Methods of Recording Depreciation:

1. By Charging to Asset A/c:
Under this method,
a) Asset A/c &
b) Depreciation A/c
are maintained. The depreciation is directly credited to ‘Asset A/c’ because ‘Provision
for Depreciation A/c’ is not maintained.

2. By Creating provision for depreciation A/c:

Under this method an
 a) Asset A/c &
b) Provision for Depreciation A/c
are maintained. The depreciation is credited to ‘Provision for depreciation A/c’ instead of
‘Asset A/c and hence, ‘Asset A/c’ always appears in the ledger at its original cost. The
balance on the credit side of the ‘Provision for Depreciation A/c’ shows the total amount
accumulated till date. However, when the asset is sold or discarded the total accumulated
depreciation for that asset is transferred to the credit side of the ‘Asset A/c’.

3. By Creating Asset disposal A/c:

When part of the asset is sold or disposed off, it is appropriate to open a new account
called ‘Asset Disposal A/c’. It provides a complete and clear view of all the transactions
involved in the sale of an asset and shows the profit or loss on sale of the asset. The
method of recording entries in ‘Asset Disposal A/c’ will depend on the fact whether
‘Provision for Depreciation A/c’ is maintained or not.

PROVISIONS & RESERVE

Provisions:
There are certain expenses/losses which are related to the current accounting period but
amount of which is not known with certainty because they are not yet incurred. It is
necessary to make provision for such items for ascertaining true net profit/loss according
to the principle of Prudence or Conservatism.
Examples of provisions are:
• Provision for depreciation;
• Provision for bad and doubtful debts;
• Provision for taxation;
• Provision for discount on debtors;
• Provision for repairs and renewals

Reserves:
A part of the profit may be set aside & retained in the business to provide for certain
future needs like growth & expansion or to meet future contingencies such as workmen
compensation. Unlike provisions, reserves are the appropriations of profit to strengthen
the financial position of the business. Reserve is not a charge against profit as it is not
meant to cover any known liability or expected loss in future. However, retention of
profits in the form of reserves reduces the amount of profits available for distribution
among the owners of the business. It is shown under the head Reserves and Surpluses on
the liabilities side of the balance sheet after capital.
Examples of reserves are:
• General reserve;
• Workmen compensation fund;
• Investment fluctuation fund;
• Capital reserve;
• Dividend equalisation reserve;
• Reserve for redemption of debenture.
Difference between Provisions & Reserve:
Provision Reserve
It is charge against profit. It is an appropriation of profit.
It is made for strengthening the financial
It is created to meet a specific liability /
position of the business. Some reserves are
contingencies
also mandatory under law.
It is recorded on the debit side of Profit & It is recorded on the credit side of the
Loss A/c Profit & Loss Appropriation A/c
It can be shown either (i) by way of deduction
from the item on the assets side for which it is It is shown on the liabilities side after
created,/(ii) in the liabilities side along with capital.
the current liabilities.
It cannot be utilized for dividend distribution. It can be utilized for dividend distribution.
It is never invested outside the business. It can be invested outside the business.
It reduces net profits. It reduces only divisible profit.

Types of Reserves:
A reserve is created by retention of profit of the business can be for either a general or a
specific purpose.
1. General Reserve: When the purpose for which reserve is created is not specified, it is
called General Reserve. It is also termed as free reserve because the management can
freely utilise it for any purpose. General reserve strengthens the financial position of the
business.
2. Specific Reserve: Specific reserve is the reserve, which is created for some specific
purpose and can be utilised only for that purpose.
Examples of specific reserves are given below:
(i) Dividend Equalisation Reserve: This reserve is created to stabilise or maintain
dividend rate. In the year of high profit, amount is transferred to Dividend Equalisation
reserve. In the year of low profit, this reserve amount is used to maintain the rate of
dividend.
(ii) Workmen Compensation Fund: It is created to provide for claims of the workers
due to accident, etc.
(iii) Investment Fluctuation Fund: It is created to make for decline in the value of
investment due to market fluctuations.
(iv) Debenture Redemption Reserve: It is created to provide funds for redemption of
debentures.
Reserves are also classified as revenue & capital reserves according to the nature of the
profit out of which they are created.

(a) Revenue Reserves: Revenue reserves are created from revenue profits which arise out
of the normal operating activities of the business & are otherwise freely available for
distribution as dividend.
Examples of revenue reserves are:
• General reserve;
• Workmen compensation fund;
• Investment fluctuation fund;
• Dividend equalisation reserve;
• Debenture redemption reserve;

(b) Capital Reserves: Capital reserves are created out of capital profits which do not
arise from the normal operating activities. Such reserves are not available for distribution
as dividend. These reserves can be used for writing off capital losses or issue of bonus
shares in case of a company.
Examples of capital profits, which are treated as capital reserves, whether transferred as
such or not, are:
• Premium on issue of shares or debenture.
• Profit on sale of fixed assets.
• Profit on redemption of debentures.
• Profit on revaluation of fixed asset & liabilities.
• Profits prior to incorporation.
• Profit on reissue of forfeited shares

Difference between capital reserve and revenue reserve

Revenue Reserve Capital Reserve
It is formed out of revenue profit It is formed out of capital profit which is a gain
which is earned from normal activities from other than normal activities of business
of business operations. operations, such as sale of fixed assets.
It can be used for distribution of
It cannot be used for distribution of dividend.
dividend.
It is created for increasing the It is created for the purpose of the Companies
financial position of the business. Act.