Big picture
A machine bought for ₹1,00,000 helps earn revenue for several years, and it wears out over that time. If the whole cost were charged as an expense in the year of purchase, that year's profit would be understated and later years' overstated. Depreciation spreads the cost of a fixed asset over its useful life, matching cost with the revenue it helps earn.
The chapter also covers provisions (amounts set aside for known liabilities or losses whose amount is uncertain) and reserves (profits retained to strengthen the business). Both are applications of conservatism: prepare for losses, keep profits in the business.
Learning goals
Explain the meaning, features, causes and need for depreciation.
Explain the factors that determine the amount of depreciation.
Calculate depreciation by the straight line and written down value methods, and compare them.
Record depreciation by charging it to the asset account or through a provision for depreciation account.
Record the sale of an asset and find the profit or loss.
Explain provisions and reserves, their types and their differences.
Core ideas
1. Meaning, features and causes of depreciation
Depreciation is a decline in the value of a fixed asset due to use, passage of time or obsolescence. It is a non-cash charge, a gradual allocation of the asset's cost over its useful life.
Features: it is a decline in the book value of fixed assets; it continues until the asset's useful life ends; it is an expense (charged against revenue); and it does not involve any cash outflow.
Causes
Cause | Example |
|---|---|
Wear and tear due to use or passage of time | A delivery van becomes less efficient with use |
Expiration of legal rights | A patent or lease valid for 10 years loses value as its term passes |
Obsolescence | A computer becomes outdated because of newer technology |
Abnormal factors | Damage due to an accident, fire or flood |
Depreciation applies to tangible fixed assets; the similar term for intangible assets such as patents is amortisation, and for natural resources such as mines it is depletion.
2. Need for depreciation and factors affecting it
Need: to match costs with revenue (matching concept); to comply with law (the Companies Act and tax laws); to show a true and fair financial position (assets at realistic values); and to retain funds in the business for replacing assets.
Factors determining the amount
Cost of the asset: purchase price plus all costs to bring it into use (freight, installation, registration).
Estimated useful life: the period over which the asset is expected to be used.
Net residual (scrap) value: the expected value at the end of its useful life, net of disposal costs.
Depreciable cost = Cost − Net residual value.
3. Straight line method (SLM)
A fixed amount of depreciation is charged every year.
Annual depreciation = (Cost − Net residual value) ÷ Estimated useful life
Example. A machine is bought for ₹1,00,000 and installed for ₹10,000. Its estimated scrap value is ₹10,000 and its useful life is 5 years.
Cost = 1,00,000 + 10,000 = 1,10,000
Depreciable cost = 1,10,000 - 10,000 = 1,00,000
Annual depreciation = 1,00,000 / 5 = 20,000
Rate on original cost = 20,000 / 1,10,000 x 100 = 18.18%Merits: simple to calculate; the asset can be written down to exactly its residual value. Limitations: ignores that repair costs rise as the asset ages, so the total charge (depreciation + repairs) rises over time; it doesn't reflect the actual pattern of use.
4. Written down value method (WDV)
A fixed percentage is applied to the book value (written down value) at the beginning of each year, so the amount of depreciation falls every year. It is also called the reducing balance method.
Example. A machine costs ₹1,00,000 and is depreciated at 10% per annum on WDV.
Year | Opening WDV | Depreciation (10%) | Closing WDV |
|---|---|---|---|
1 | 1,00,000 | 10,000 | 90,000 |
2 | 90,000 | 9,000 | 81,000 |
3 | 81,000 | 8,100 | 72,900 |
Merits: depreciation is higher in early years when the asset is most efficient, and lower later when repairs are higher, so the total charge is more even; it is accepted by income tax authorities; and it suits assets that become obsolete quickly. Limitations: the asset can never be reduced to zero, and it is harder to calculate the rate.
SLM and WDV compared
Basis | Straight line method | Written down value method |
|---|---|---|
Basis of calculation | Original cost | Book value at the beginning of the year |
Amount each year | Same every year | Decreases every year |
Book value at the end of life | Can become zero or equal to scrap value | Never becomes zero |
Suitable for | Assets with low repair costs and little obsolescence (furniture, leases) | Assets with rising repairs or quick obsolescence (machinery, vehicles, computers) |
Tax acceptance | Not accepted for income tax | Accepted for income tax |
5. Methods of recording depreciation
Method 1: Charging depreciation to the asset account. The asset account is shown at written-down value.
Depreciation A/c Dr, To Asset A/c (charging depreciation)
Profit and Loss A/c Dr, To Depreciation A/c (closing it)
Method 2: Creating a provision for depreciation (accumulated depreciation) account. The asset account stays at original cost; depreciation accumulates in a separate account.
Depreciation A/c Dr, To Provision for Depreciation A/c
Profit and Loss A/c Dr, To Depreciation A/c
In the balance sheet, the asset is shown at cost less accumulated depreciation. This method shows both the original cost and total depreciation so far.
6. Disposal of an asset
When an asset is sold, find its book value on the date of sale and compare it with the sale price.
Example. A machine was bought on 1 April 2022 for ₹2,00,000. Depreciation is 10% p.a. on SLM. It was sold on 30 September 2024 for ₹1,40,000. The accounting year ends on 31 March.
Depreciation 2022-23 (full year) 20,000
Depreciation 2023-24 (full year) 20,000
Depreciation 2024-25 (1 Apr to 30 Sep) 10,000
Total depreciation 50,000
Book value on 30 Sep 2024 = 2,00,000 - 50,000 = 1,50,000
Sale price 1,40,000
Loss on sale 10,000Entries (Method 1): Depreciation A/c Dr ₹10,000, To Machinery A/c (current year's depreciation); Bank A/c Dr ₹1,40,000, To Machinery A/c (sale); Profit and Loss A/c Dr ₹10,000, To Machinery A/c (loss on sale).
Entries (Method 2, using an Asset Disposal Account): transfer the asset's cost (₹2,00,000) to the Asset Disposal A/c, transfer accumulated depreciation (₹50,000, including the current year's ₹10,000) to its credit, credit the sale proceeds (₹1,40,000), and the balance of ₹10,000 is the loss, transferred to the Profit and Loss Account.
7. Provisions
A provision is an amount charged against profit to provide for a known liability or loss whose amount cannot be determined with accuracy.
Example | Purpose |
|---|---|
Provision for doubtful debts | Some debtors may not pay; the expected loss is provided for |
Provision for repairs and renewals | Expected repair costs of fixed assets |
Provision for taxation | Tax on the year's profit, not yet determined exactly |
Provision for depreciation | Accumulated depreciation on fixed assets |
Provision for discount on debtors | Discount expected to be allowed to debtors |
Example. Debtors are ₹50,000. Bad debts of ₹2,000 are to be written off, and a provision for doubtful debts of 5% is to be created on the remaining debtors. Provision = 5% of (50,000 − 2,000) = ₹2,400. Debtors are shown in the balance sheet at 48,000 − 2,400 = ₹45,600.
Provisions are a charge against profit: they are debited to the Profit and Loss Account whether or not there is a profit.
8. Reserves
A reserve is an amount set aside out of profits to strengthen the financial position of the business or meet future contingencies. It is an appropriation of profit, so it can only be made when there is a profit.
Type | Meaning | Examples |
|---|---|---|
Revenue reserve | Created out of revenue profits from normal operations | General reserve (for general strengthening, no specific purpose); specific reserves, such as dividend equalisation reserve, debenture redemption reserve, workmen compensation reserve, investment fluctuation reserve |
Capital reserve | Created out of capital profits that do not arise from normal operations; generally not available for distribution as dividend | Premium on issue of shares or debentures; profit on sale of fixed assets; profit on reissue of forfeited shares; profit prior to incorporation |
Secret reserve | A reserve not disclosed in the balance sheet, created by undervaluing assets or overvaluing liabilities | Charging excessive depreciation |
Importance of reserves: meeting future contingencies; strengthening the financial position; redeeming long-term liabilities such as debentures; and financing expansion from the business's own funds.
9. Provisions and reserves compared
Basis | Provision | Reserve |
|---|---|---|
Nature | A charge against profit | An appropriation of profit |
Purpose | To meet a known liability or loss | To strengthen the financial position |
When created | Created even if there is a loss | Created only out of profit |
Effect on profit | Reduces net profit | Doesn't reduce net profit; reduces profit available for distribution |
Presentation | Deducted from the asset concerned, or shown as a liability | Shown under Reserves and Surplus |
Dividend | Cannot be used for dividend | A revenue reserve can be used for dividend |
A reliable problem-solving routine
Find the asset's cost including all costs to bring it into use.
For SLM, use (cost − scrap) ÷ life, the same each year; for WDV, apply the rate to the opening book value each year.
Charge depreciation for part of a year when the asset is bought or sold during the year.
On sale, find book value on the date of sale, compare it with the sale price, and record profit or loss.
For provisions, calculate on the right base (debtors after bad debts); for reserves, check that there is a profit.
Connections that matter
Theory base: depreciation applies the matching concept; provisions and reserves apply conservatism.
Financial statements: depreciation and provisions are adjustments in final accounts.
Class 12 cash flow statement adds back depreciation as a non-cash charge.
Common mistakes
Charging a full year's depreciation for an asset bought or sold during the year.
Applying the WDV rate to the original cost every year. Apply it to the opening book value.
Leaving installation costs out of the cost of the asset.
Calling a reserve a charge against profit. A reserve is an appropriation; a provision is a charge.
Calculating the provision for doubtful debts before writing off bad debts.
Revision checklist
I can explain the meaning, causes and need for depreciation.
I can calculate depreciation by SLM and WDV and compare the methods.
I can record depreciation with or without a provision account.
I can record the sale of an asset and find the profit or loss.
I can explain provisions, the types of reserves and their differences.