Chapter depreciation-provisions-and-reserves: Depreciation, Provisions and Reserves | Summary

Depletion is the term used in the context of extraction of natural resources like mines and quarries, where the availability of material reduces with extraction. For example, extraction of coal from a mine reduces the mine's value. Though depletion involves exhaustion of economic resources (unlike depreciation which relates to usage of an asset), both result in expiry of service potential and receive similar accounting treatment.

Amortisation refers to the writing-off of the cost of intangible assets such as patents, copyrights, trademarks, franchises, and goodwill over their useful life. The procedure for amortisation is the same as that for depreciation of fixed assets. For instance, if a patent costing Rs. 10,00,000 has a useful life of 10 years, Rs. 1,00,000 is written off each year as amortisation.

The primary cause of depreciation is wear and tear due to use or passage of time, which reduces an asset's technical capacity and may cause physical deterioration even when the asset is not in active use. Another cause is the expiration of legal rights, applicable to assets like patents, copyrights, and leases whose utility ends when the governing agreement expires.

Obsolescence is a significant cause wherein existing assets become out-of-date due to technological changes, improvements in production methods, change in market demand, or legal restrictions. Abnormal factors such as accidents caused by fire, floods, or earthquakes can also cause a permanent decline in asset value, though this is not a continuing process unlike other causes.

Depreciation must be charged to properly match costs and revenue, as fixed assets contribute to earning revenue over multiple periods. It is a charge against revenue of the corresponding period and must be deducted before arriving at net profit as per Generally Accepted Accounting Principles. Depreciation is also a deductible cost for tax purposes, reducing the taxable income of the business.

Charging depreciation ensures a true and fair presentation of the financial position. If depreciation is not provided, assets will be overvalued and the balance sheet will not depict the correct financial position. Additionally, certain legislations, particularly relating to corporate enterprises, indirectly compel businesses to provide depreciation on fixed assets.

The cost of an asset includes its invoice price plus all costs necessary to put it in working condition — freight, transportation, transit insurance, installation, registration, and initial repairs for second-hand assets. The net residual value (also called scrap or salvage value) is the estimated net realisable value at the end of the asset's useful life, after deducting disposal expenses. The depreciable cost is original cost minus net residual value and is the amount to be charged as depreciation over the asset's life.

Useful life is the estimated economic or commercial life of the asset and is typically shorter than physical life. It depends on factors such as usage level, maintenance policy, technological obsolescence, and legal or contractual limits. It can be expressed in years, units of output, or working hours. The accurate estimation of these three factors — cost, residual value, and useful life — determines the amount of depreciation charged each year.

The Straight Line Method (SLM), also called the Fixed Instalment Method, charges a fixed and equal amount of depreciation every year over the useful life of the asset. It is based on the assumption of equal usage throughout the asset's life. The formula is: Depreciation = (Cost - Net Residual Value) / Useful Life. Its advantages include simplicity, uniform annual charge, and ability to depreciate the asset down to zero or scrap value. However, it ignores the increasing repair costs in later years and assumes constant utility, which may not be realistic.

The Written Down Value (WDV) Method, also called the Reducing Balance Method, charges depreciation as a fixed percentage of the book value at the beginning of each year. Since the book value reduces annually, the depreciation amount also declines over time. This method is more realistic as higher depreciation is charged in earlier years when the asset is more productive. It is recognised by the Income Tax Act, ensures nearly equal total charge (depreciation + repairs) across years, and is suitable for assets prone to technological obsolescence. However, it cannot fully write off the asset's cost to zero.

Under SLM, depreciation is calculated on the original cost, resulting in a fixed annual charge. Under WDV, it is calculated on the book value (cost less depreciation to date), resulting in a declining annual charge. SLM is not recognised by Income Tax Law, while WDV is recognised. SLM results in an increasing combined burden of depreciation and repairs over time, while WDV results in an almost equal combined burden each year.

SLM is suitable for assets with low repair costs, low obsolescence risk, and predictable useful life, such as leasehold buildings and patents. WDV is suitable for assets prone to technological changes and increasing repairs, such as plant and machinery and vehicles. The selected method must be applied consistently and changed only under specific circumstances as per AS-6.

Under the first method, depreciation is charged directly to the asset account (credited) and debited to Profit and Loss Account. The fixed asset appears at its net book value on the balance sheet. Under the second method, a separate Provision for Depreciation (or Accumulated Depreciation) Account is maintained. The asset account remains at its original cost throughout its life, and the accumulated depreciation is shown as either a deduction from the asset or on the liabilities side of the balance sheet.

When an asset is disposed of and the provision for depreciation method is in use, the provision balance relating to that asset is first transferred to the asset account before computing profit or loss on disposal. An Asset Disposal Account may also be prepared to consolidate all transactions related to the sale of an asset — original cost, accumulated depreciation, and sale proceeds — enabling clear computation of profit or loss in one account.

When an asset is disposed of during or at the end of its useful life, the sale proceeds are credited to the asset account. The resulting balance — either a debit (loss) or credit (profit) — is transferred to the Profit and Loss Account. If a provision for depreciation account exists, it is first transferred back to the asset account before calculating the gain or loss on sale.

Any addition or extension that becomes an integral part of an existing asset should be depreciated over the remaining useful life of that asset at the same rate. If the addition retains a separate identity and can be used independently after the main asset is disposed of, it should be depreciated separately based on its own useful life. Routine repair and maintenance expenses are treated as revenue expenditure and not capitalised.

A provision is a charge against profit created for a known current liability or expense whose exact amount is uncertain. It must be made even if there are no profits. Common examples include Provision for Doubtful Debts, Provision for Depreciation, Provision for Taxation, Provision for Discount on Debtors, and Provision for Repairs and Renewals. Provisions are debited to the Profit and Loss Account, thereby reducing taxable profits.

In the balance sheet, provisions may be shown either as a deduction from the related asset (e.g., provision for doubtful debts from debtors) or on the liabilities side with current liabilities (e.g., provision for taxes). The accounting treatment for Provision for Doubtful Debts involves first writing off confirmed bad debts, then creating a fresh provision calculated as a percentage of remaining debtors, and adjusting the existing provision balance accordingly.

A reserve is an appropriation of profit (not a charge against it) set aside to strengthen the financial position of the business or to meet future needs. Unlike provisions, reserves can only be created when there are profits. Reserves are shown on the liabilities side of the balance sheet under 'Reserves and Surplus' after capital. Examples include General Reserve, Dividend Equalisation Reserve, Workmen Compensation Fund, Investment Fluctuation Fund, Debenture Redemption Reserve, and Capital Reserve.

Reserves may be classified as General Reserve (for any purpose) or Specific Reserve (for a designated purpose). They are also classified as Revenue Reserves (created from revenue profits available for distribution) and Capital Reserves (created from capital profits not available as dividend, used for writing off capital losses or issuing bonus shares). Capital profits include premium on issue of shares, profit on sale of fixed assets, and profit prior to incorporation.

A provision is a charge against profit while a reserve is an appropriation of profit. Provision is created for a known liability or expense of uncertain amount pertaining to the current period, whereas a reserve is created to strengthen financial position or meet future contingencies. A provision is compulsory (must be made even without profits), while a reserve is generally at management's discretion (cannot be created without profits).

Provision reduces taxable profits as it is deducted before computing net profit, whereas a reserve has no effect on taxable profits. Provision cannot be used for dividend distribution, while a general reserve can. In the balance sheet, provision is shown as deduction from the asset or under current liabilities, while a reserve is shown on the liabilities side after capital.

A secret reserve is one that does not appear in the balance sheet and is not known to outside stakeholders. It is created when total depreciation charged exceeds the total depreciable cost of the asset or through other means such as undervaluation of inventories, charging capital expenditure to profit and loss account, making excessive provision for doubtful debts, or showing contingent liabilities as actual liabilities.

Secret reserves help reduce disclosed profits and tax liability. During lean periods, secret reserves can be merged with profits to show improved performance. While their creation within reasonable limits may be justified on grounds of expediency and prudence, they reduce transparency and may mislead external stakeholders about the actual financial position of the business.

Depreciation is a fundamental accounting concept rooted in the matching principle — ensuring that the cost of fixed assets is systematically allocated over their useful lives rather than being charged entirely in the year of purchase. The chapter establishes that straight line and written down value are the two principal methods of computing depreciation, each suited to different types of assets and business circumstances. Provisions and reserves, while both involving setting aside funds from income, are distinct: provisions are mandatory charges for uncertain current liabilities, whereas reserves are discretionary appropriations of profit to build financial strength.

For board examinations, this chapter is extremely important as it covers numerical problems on both SLM and WDV methods including asset disposal, provision for doubtful debts, and journal entry recording. Students must clearly understand the difference between provisions and reserves, types of reserves, secret reserves, and the accounting treatment of each. Theoretical distinctions such as depreciation vs. amortisation vs. depletion, and SLM vs. WDV, are high-frequency short-answer and essay questions in CBSE Class 11 examinations.