Depreciation, Provisions and Reserves

Depreciation means the decline in the value of a fixed asset because of use, passage of time, or obsolescence. In accounting, it is the part of the cost of an asset that has expired and is charged as an expense.

The need for providing depreciation arises because:

- It helps in matching costs with revenue of the same period.
- It shows the true and fair profit or loss of the business.
- It presents the correct value of assets in the balance sheet; otherwise assets will be overvalued.
- It is required for tax purposes.
- Some laws also require depreciation to be provided.

The causes of depreciation are:

- Wear and tear due to use or even by the passage of time.
- Expiration of legal rights, such as patents, copyrights and leases.
- Obsolescence, when a better or newer asset becomes available.
- Abnormal factors, such as fire, flood, earthquake, or accident.

The amount of depreciation depends on three basic factors:

1. Cost of the asset: This includes the purchase price and all expenses needed to bring the asset into use, such as freight, installation and transportation.
2. Estimated net residual value: This is the expected scrap or salvage value at the end of the asset’s useful life, after deducting disposal expenses.
3. Estimated useful life: This is the period for which the asset is expected to be used by the business.

The depreciable cost is:

$\text{Cost of asset} - \text{Net residual value}$

This depreciable cost is spread over the useful life of the asset.

### Straight line method vs Written down value method

- Basis of charging depreciation:
- Straight line method: depreciation is charged on original cost.
- Written down value method: depreciation is charged on book value at the beginning of the year.

- Annual depreciation amount:
- Straight line method: the amount remains fixed/constant every year.
- Written down value method: the amount declines year after year.

- Effect on repairs:
- Straight line method: depreciation stays constant, so total charge of depreciation and repairs becomes higher in later years.
- Written down value method: depreciation falls in later years, so total burden of depreciation and repairs remains almost equal.

- Recognition by income tax law:
- Straight line method: not recognised.
- Written down value method: recognised.

- Suitability:
- Straight line method: suitable where repair charges are low and obsolescence is low, such as leasehold buildings.
- Written down value method: suitable for assets affected by technological change and requiring more repairs, such as plant and machinery and vehicles.

The suitable method is the written down value method because it gives higher depreciation in the earlier years and lower depreciation in later years. Since repair and maintenance expenses rise in later years, this method helps keep the total burden on the Profit and Loss Account more even over time.

If depreciation is not provided:

- Profit and Loss Account: depreciation is a charge against profit, so if it is omitted, profit will be overstated and true profit or loss will not be ascertained.
- Balance Sheet: assets will appear at a value higher than their actual book value, so the balance sheet will not show the true and fair financial position of the business.

### Provision vs Reserve

- Nature:
- Provision is a charge against profit.
- Reserve is an appropriation of profit.

- Purpose:
- Provision is created for a known liability or expense whose amount is uncertain.
- Reserve is created to strengthen the financial position of the business.

- When created:
- Provision is made before calculating net profit.
- Reserve is made after calculating net profit.

- Balance sheet presentation:
- Provision is shown either as a deduction from the related asset or under liabilities.
- Reserve is shown on the liabilities side under Reserves and Surplus.

- Dividend:
- Provision cannot be used for dividend.
- Reserve, especially general reserve, can be used for dividend distribution.

Examples of provisions are:

- Provision for depreciation
- Provision for bad and doubtful debts
- Provision for taxation
- Provision for discount on debtors

Examples of reserves are:

- General reserve
- Workmen compensation fund
- Investment fluctuation fund
- Dividend equalisation reserve

### Revenue reserve vs Capital reserve

- Source:
- Revenue reserve is created out of revenue profits arising from normal business operations.
- Capital reserve is created out of capital profits which do not arise from normal operations.

- Availability for dividend:
- Revenue reserve is generally available for dividend distribution.
- Capital reserve is not available for dividend distribution.

- Purpose:
- Revenue reserve is created to strengthen financial position or meet future needs.
- Capital reserve is created for legal or accounting reasons, such as writing off capital losses or issuing bonus shares.

- Examples:
- Revenue reserve: general reserve, dividend equalisation reserve, etc.
- Capital reserve: premium on issue of shares, profit on sale of fixed assets, etc.

Examples of revenue reserves are:

- General reserve
- Workmen compensation fund
- Investment fluctuation fund
- Dividend equalisation reserve

Examples of capital reserves are:

- Premium on issue of shares or debentures
- Profit on sale of fixed assets
- Profit on redemption of debentures
- Profit on revaluation of fixed assets and liabilities

- General reserve: created for no specified purpose. It is also called a free reserve because management can use it for any purpose.
- Specific reserve: created for a particular purpose and can be used only for that purpose, such as dividend equalisation reserve or workmen compensation fund.

A secret reserve is a reserve that does not appear in the balance sheet. It is not known to outsiders. It may be created by charging higher depreciation than required, undervaluing stock, making excessive provision for doubtful debts, or charging capital expenditure to profit and loss account. It may be used to reduce disclosed profits and tax liability.

Depreciation is the decline in the value of a fixed asset due to use, passage of time, or obsolescence. In accounting, it is the expired part of the cost of an asset charged against the revenue of the accounting period.

### Need for charging depreciation
- To match cost with the revenue of the period.
- To ascertain true profit or loss.
- To show the true and fair financial position.
- For tax compliance.
- Because some laws require it.

### Causes of depreciation
- Wear and tear due to use or passage of time
- Expiration of legal rights
- Obsolescence
- Abnormal factors like fire, flood, earthquake or accident

### Straight line method
Under this method, a fixed amount of depreciation is charged every year on the original cost of the asset. The amount is the same throughout the useful life.

Formula:
$$\text{Depreciation} = \frac{\text{Cost of asset} - \text{Estimated net residual value}}{\text{Estimated useful life}}$$

### Written down value method
Under this method, depreciation is charged on the book value at the beginning of each year. So the amount of depreciation goes on decreasing every year.

### Differences
- Straight line: based on original cost; Written down value: based on book value.
- Straight line: constant depreciation each year; Written down value: decreasing depreciation each year.
- Straight line: repair and depreciation burden rises in later years; Written down value: burden remains almost equal every year.
- Straight line: not recognised by income tax law; Written down value: recognised by income tax law.

### Suitability
- Straight line method is suitable for assets with low repair charges and low obsolescence, such as leasehold buildings.
- Written down value method is suitable for assets like plant, machinery and vehicles, where repair expenses rise and obsolescence is likely.

There are two methods of recording depreciation:

### 1. Charging depreciation to the asset account
- Depreciation is credited to the asset account.
- The asset is shown in the balance sheet at net book value.

Journal entries:
1. On purchase of asset:
- Asset A/c Dr.
- To Bank/Vendor A/c
2. At year-end for depreciation:
- Depreciation A/c Dr.
- To Asset A/c
3. To transfer depreciation to Profit and Loss:
- Profit and Loss A/c Dr.
- To Depreciation A/c

### 2. Creating Provision for Depreciation Account
- Depreciation is accumulated in a separate account called Provision for Depreciation or Accumulated Depreciation.
- The asset remains at original cost in the asset account.

Journal entries:
1. On purchase of asset:
- Asset A/c Dr.
- To Bank/Vendor A/c
2. At year-end:
- Depreciation A/c Dr.
- To Provision for Depreciation A/c
3. To transfer depreciation to Profit and Loss:
- Profit and Loss A/c Dr.
- To Depreciation A/c

In the balance sheet, provision for depreciation may be shown either on the liabilities side or deducted from the related asset.

The amount of depreciation depends mainly on three determinants:

1. Cost of asset: This includes purchase price and all expenses necessary to bring the asset into working condition, such as freight, installation and transportation.
2. Estimated net residual value: The expected value of the asset at the end of its useful life after deducting disposal expenses.
3. Estimated useful life: The period over which the asset is expected to be used by the business.

The depreciable cost is:

$\text{Cost of asset} - \text{Net residual value}$

This amount is spread over the useful life of the asset.

### Types of reserves

A reserve is a part of profit set aside for future needs. The main types are:

#### 1. General reserve
This is created when no specific purpose is mentioned. It is a free reserve and can be used for any business purpose.

#### 2. Specific reserve
This is created for a particular purpose and can be used only for that purpose. Examples:
- Dividend equalisation reserve
- Workmen compensation fund
- Investment fluctuation fund
- Debenture redemption reserve

#### 3. Revenue reserve
Created out of revenue profits from normal business operations. Examples include general reserve and dividend equalisation reserve.

#### 4. Capital reserve
Created out of capital profits such as profit on sale of fixed assets, premium on issue of shares, profit on redemption of debentures, etc. It is not available for dividend distribution.

Provisions are amounts set aside to meet a known liability or expense whose amount is uncertain. They are created on the basis of prudence so that true profit can be calculated.

### How provisions are created
A provision is created by debiting Profit and Loss Account and crediting the relevant provision account.

Journal entry:
- Profit and Loss A/c Dr.
- To Provision for ... A/c

### Accounting treatment for provision for doubtful debts
- Debtors are shown on the assets side.
- Since some debtors may not pay, a Provision for Doubtful Debts is created.
- The provision is usually calculated as a percentage of debtors after deducting bad debts.
- Entry for creating provision:
- Profit and Loss A/c Dr.
- To Provision for Doubtful Debts A/c
- In the balance sheet, the provision is shown as a deduction from Sundry Debtors.

### Calculation
Original cost = ₹5,00,000 + ₹50,000 = ₹5,50,000

Salvage value = ₹10,000

Useful life = 10 years

Annual depreciation:
$$\frac{5,50,000 - 10,000}{10} = \frac{5,40,000}{10} = ₹54,000$$

So, depreciation is ₹54,000 per year.

If depreciation is charged to the asset account, the yearly entries are:
- Depreciation A/c Dr. ₹54,000
- To Plant A/c ₹54,000
- Profit and Loss A/c Dr. ₹54,000
- To Depreciation A/c ₹54,000

The plant account values will be:
- End of Year 1: ₹5,50,000 − ₹54,000 = ₹4,96,000
- End of Year 2: ₹4,96,000 − ₹54,000 = ₹4,42,000
- End of Year 3: ₹4,42,000 − ₹54,000 = ₹3,88,000

### Calculation
Original cost of machine = ₹1,80,000 + ₹20,000 = ₹2,00,000

Depreciation rate = 10% p.a. on original cost

Annual depreciation = 10% of ₹2,00,000 = ₹20,000

Since the machine was purchased on October 01, 2016, depreciation for 2016-17 is for 6 months:
$$₹20,000 \times \frac{6}{12} = ₹10,000$$

Thus:
- 2016-17 depreciation = ₹10,000
- 2017-18 depreciation = ₹20,000
- 2018-19 depreciation = ₹20,000

If a Provision for Depreciation Account is maintained, the machine continues to appear at its original cost of ₹2,00,000, and the provision account accumulates the depreciation amounts.

### Calculation
Original cost of machine = ₹1,08,000 + ₹12,000 = ₹1,20,000

Useful life = 12 years

Net salvage value = ₹12,000

Depreciable cost:
$$1,20,000 - 12,000 = ₹1,08,000$$

Annual depreciation by straight line method:
$$\frac{1,08,000}{12} = ₹9,000$$

Since the machine was bought on July 01, 2010, depreciation for 2010 is for 6 months:
$$9,000 \times \frac{6}{12} = ₹4,500$$

Therefore, the depreciation for the first three years will be:
- 2010: ₹4,500
- 2011: ₹9,000
- 2012: ₹9,000