Depreciation, Provisions and Reserves

• Introduction to Depreciation

  • Meaning and Definition
    • Permanent, gradual, and continuous decrease in the book value of fixed assets
  • Causes of Depreciation
    • Wear and tear due to actual use
    • Efflux of time
    • Obsolescence due to new technology or style
    • Accidents or abnormal factors
  • Need and Objectives
    • Ascertaining true net profit
    • Showing true financial position
    • Replacement of assets
    • Legal compliance (Companies Act/Income Tax Act)

• Methods of Charging Depreciation

  • Straight Line Method (SLM)
    • Features: Equal amount of depreciation every year
    • Formula: $(Cost - Scrap Value) / Estimated Life$
    • Also known as: Fixed Installment Method or Original Cost Method
  • Diminishing Balance Method (WDV)
    • Features: Depreciation charged on the Written Down Value (Reducing balance)
    • Amount of depreciation decreases every year
    • Also known as: Written Down Value Method or Reducing Installment Method

• Accounting Treatment of Depreciation

  • Recording Depreciation
    • Without maintaining Provision for Depreciation Account
      • Charging to asset account and transferring to Profit & Loss A/c
    • With maintaining Provision for Depreciation Account (Accumulated Depreciation)
      • Asset remains at original cost in ledger
      • Depreciation accumulated in a separate provision account
  • Disposal / Sale of Asset
    • Calculation of profit or loss on sale

• Provisions

  • Meaning and Definition
    • Amount retained to provide for a known liability whose amount cannot be determined with substantial accuracy
  • Examples
    • Provision for Bad and Doubtful Debts
    • Provision for Discount on Debtors
    • Provision for Depreciation
    • Provision for Taxation
  • Characteristics
    • Created out of known profits (Charge against profit)
    • Created for a future known liability or loss

• Reserves

  • Meaning and Definition
    • Amount set aside out of profits to strengthen the financial position or meet unknown future contingencies
  • Types of Reserves
    • General Reserve (Revenue Reserve for general purposes)
    • Specific Reserve (Created for a specific purpose, e.g., Dividend Equalization Reserve)
    • Secret Reserve (Not explicitly shown on the balance sheet)
  • Reserves vs Provisions
    • Basis of difference: Purpose, compulsion, usage for dividend distribution, and appearance on balance sheet