Chapter 4: Depreciation, Provisions and Reserves
Depreciation
Depreciation is the permanent, continuous, and gradual shrinkage in the book value of a fixed tangible asset due to its use, wear and tear, passage of time, or obsolescence.
Need and Factors Affecting Depreciation
- Need: To ascertain the true profit/loss, to show the true financial position, and to accumulate funds for the replacement of the asset.
- Factors: Cost of the Asset, Estimated Useful Life, and Estimated Residual (Scrap) Value.
Methods of Calculating Depreciation
- Straight Line Method (SLM): Also known as Original Cost Method. An equal amount of depreciation is charged every year. \[ \text{Depreciation} = \frac{\text{Cost of Asset} - \text{Scrap Value}}{\text{Estimated Useful Life}} \]
- Written Down Value Method (WDV): Also known as Diminishing Balance Method. Depreciation is charged at a fixed rate on the reducing balance (book value) of the asset every year.
Recording Depreciation
Depreciation can be recorded in two ways:
- Charging to Asset Account: The Asset account is directly credited (reduced).
- Creating Provision for Depreciation Account: The Asset remains at its original cost, and depreciation is accumulated in a separate “Provision for Depreciation” (or Accumulated Depreciation) account.
Disposal of Asset
When an asset is sold or discarded, an Asset Disposal Account can be prepared to calculate the profit or loss on the sale of that asset.
Provisions and Reserves
Provision
A Provision is an amount set aside out of current profits to meet a known liability or a decrease in the value of an asset, the amount of which cannot be determined with substantial accuracy (e.g., Provision for Doubtful Debts, Provision for Depreciation). It is a charge against profit.
Reserve
A Reserve is an amount set aside out of profits to strengthen the financial position of the business or to meet unforeseen contingencies. It is an appropriation of profit.
Competency-Based Questions
Q1. A transport company purchased 10 trucks at ₹25,000 each on April 1, 2021. The firm charges depreciation at 10% p.a. on the original cost. However, a major accident occurred on October 1, 2023, destroying 2 trucks completely, and the insurance company paid ₹30,000 as compensation. State the book value of the remaining trucks on March 31, 2024.
Solution: Total cost of remaining 8 trucks = 8 × 25,000 = ₹2,00,000. Under SLM (Original Cost Method), depreciation is 10% on cost. Per year depreciation for 8 trucks = ₹20,000. From April 1, 2021, to March 31, 2024, is 3 full years. Total accumulated depreciation for 8 trucks = 3 × 20,000 = ₹60,000. Book Value of remaining trucks = 2,00,000 - 60,000 = ₹1,40,000.
Q2. An enterprise decides not to charge depreciation on a machine, claiming that its market value has increased over the year. Discuss the validity of this decision based on accounting principles.
Solution: The decision is invalid. Depreciation is a process of allocation of cost, not of valuation. Regardless of the market value, depreciation must be charged to match the cost of the asset consumed over its useful life against the revenue generated, adhering to the Matching Concept and Going Concern Concept.
Q3. An asset was purchased for ₹5,00,000 and depreciated under WDV at 10%. Why does the depreciation amount decrease every year under this method?
Solution: Under the Written Down Value (WDV) method, depreciation is calculated on the reducing balance (book value) of the asset, not the original cost. Since the book value reduces each year after deducting the previous year’s depreciation, the base on which the 10% is calculated becomes smaller, hence the depreciation amount decreases.
Q4. A firm sets aside 5% of its profit to meet a pending court case related to employee compensation, though the final judgment is unknown. Is this a Provision or a Reserve? Justify.
Solution: It is a Provision. It is created to meet a known liability (the pending court case) whose amount cannot be determined with substantial accuracy. It is a charge against profit necessary to show the true profit/loss.