Chapter 7: Depreciation, Provisions and Reserves

Any fixed asset that is acquired by a business is subjected to wear & tear and obsolescence over time. This decrease in monetary value is calculated by a measure in accounting referred to as depreciation.

Depreciation is needed for the following reasons:

1. Determining actual profit or loss: Actual profit and loss can be determined only when all expenditures and losses are added to P & L Account. Assets in business are used to earn revenues; the corresponding cost gets charged as depreciation in P & L Account (Profit & Loss Account).

2. Provide an unbiased view of financial statements: Assets will be shown at inflated values when depreciation does not get charged, so it will lead to the balance sheet not showing a fair view of the financial statements.

3. Cost of production: Production cost includes the depreciation charged on machinery and plant, and other similar assets. When depreciation is not charged, production costs will be uneven, which will reduce the profit.

4. Distribution of dividend from profit: If no depreciation is charged, then overestimation of profit takes place, which causes profit to be distributed as dividends. It results in the movement of capital away from the business.

5. Funds used for asset replacement: Depreciation charged for assets will help in meeting the expense for replacing the asset in future.

6. Tax consideration: The P & L account will reflect less profit if depreciation is charged, which results in paying less taxes for the business.

The major causes of depreciation are listed below:

1. Regular use: Regular use of assets leads to decrement that reduces the value of such assets.

1. Expiry with time: Assets, whether used or not, will show a decline in their effective life with the passage of time. Rain, wind and other Natural forces bring about the deterioration of the asset.
2. Obsolescence: Technological advances will make the current assets obsolete in future

4. Legal rights expiry: An asset’s value becomes zero after its useful life. This is known as depreciation in accounting terms.

1. Accident: The value of an asset can be permanently reduced due to some accident which can include fire, natural calamity etc.

The basic factors affecting the amount of depreciation are as follows:

1. Cost of asset: Depreciation of an asset is directly proportional to the cost of the asset and the cost of a fixed asset is calculated by adding the cost of acquisition, installation, etc. Hence, the cost is an important factor in affecting depreciation.

2. Estimated useful life: Every fixed asset has a useful life till which it can be used for a business. After that, it will not be of any use to the business. Hence, the useful life of an asset is also a factor in determining depreciation.

3. Estimated scrap value: Every asset has a scrap value or salvage value. It is also known as net residual value or as the sale value of the asset arrived at the end of its useful life. If the net residual value is more, it will help in reducing the amount of depreciation and vice versa. Thus, net residual value is also one of the factors affecting the amount of depreciation.

The points of difference between straight-line method and the written down value method are as follows:

In case of assets that require more repairs in the later part of their life, such as cars, machinery, etc., the most preferred method that can be used by management for maintaining a balance on profit and loss account is the written down method.

In this method, in the initial years, depreciation costs are high, and repairs are less, while in the later years, the situation is reversed, and the repair cost increases with lower depreciation costs. This creates a balance without putting a burden on profit.

The following effects can be seen in the P & L account:

1. Reduces net profit by increasing the debit column of the P & L account.

2. Surplus of debit balance occurs over the credit balance due to an increase in the total expenses.

Impact on the balance sheet:

1. It leads to a reduction of book value or the original cost of the asset.

2. It leads to a decrease in the total balance of the asset’s column.

Examples of provision:

1. Provision for taxation
2. Provision for discount on debtors
3. Provision for bad and doubtful debts
4. Provision for depreciation

Examples of reserves:

1. Dividend equalisation reserve
2. Debenture redemption reserve
3. General reserve
4. Capital reserve