Depreciation, Provisions and

Reserves
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Chapter Objectives
Understand the concept of depreciation
Identify the causes of depreciation
Explain the meaning of depreciation accounting
Compute depreciation according to different
methods of providing depreciation
Explain the role of depreciation policy
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Depreciation
Depreciation is defined as the gradual decrease
in the value of an asset.
Causes of depreciation are:
Wear and tear
Exhaustion
Obsolescence
Efflux of time
Accidents
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Features of Depreciation
It is applicable to all fixed assets except some
assets like land and antique.
It is a charge against profits and true profit of a
business can only be computed after charging
depreciation.
It differs from maintenance expenses, which
are incurred for keeping the machines in a
workable state.
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Depreciation Accounting
Depreciation accounting is concerned with
distributing the cost of a tangible asset over its
estimated useful life.
Objectives of depreciation accounting are:
To determine true profit of business
To provide true financial position of business
To provide funds for the purchase of new assets
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Fixation of Depreciation Amount
Depreciation amount of a particular asset is
computed and is charged to the profit and loss
account.
Depreciation amount in respect to a particular
asset depends upon the following factors:
Cost of asset
Estimated scrap value
Estimated useful life
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Methods of Recording Depreciation
To record the depreciation in the books of
account, two methods are used:
Using Provision for Depreciation account
Without using Provision for Depreciation account
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Methods of Recording Depreciation
(contd.)
Using Provision for Depreciation account:
The Provision for Depreciation account is credited with the
depreciation amount chargeable in a year.
The Asset account provides the original cost of asset.
The Provision for Depreciation account is transferred to the
Asset account, when the asset is sold.
Without using Provision for Depreciation account:
The Depreciation account is debited with the depreciation
amount chargeable in a year and the same amount is
credited to the Asset account.
The Depreciation account is transferred to the Profit and
Loss account.
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Methods of Recording Depreciation
(contd.)
In both the methods, when the asset is sold:
On profit, the balance of Asset account is
transferred to the Profit and Loss account.
On loss, the amount realized on account of sale is
transferred to the Asset account.
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Methods for Providing Depreciation
The methods used for computing depreciation
are classified into three categories:
Uniform charge methods
Declining charge or accelerated depreciation
methods
Other methods
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Uniform Charge Methods
In these methods a uniform depreciation
amount is charged every year.
The various uniform charge methods are:
Fixed installment method: It is also known as
Straight Line Method (SLM). It provides a fixed
amount of depreciation every year. In this,
depreciation is computed by dividing the
difference of original cost of asset and estimated
scrap value by the estimated life of the asset in
years.
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Uniform Charge Methods (contd.)
Depletion method: It is also known as productive
output method. In this, depreciation depends upon
the actual cost of the asset and actual and estimated
quantities of output to be produced using the asset.
Machine hour rate method: It is also known as
service hours method. In this, depreciation depends
upon the running time of the asset. Depreciation is
computed by dividing the difference of asset and
scrap value by the life of the asset in hours.
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Declining Charge Depreciation
Methods
In these methods, the depreciation amount to
be charged decreases with the expected life of
the asset.
The various declining charge depreciation
methods are:
Diminishing balance method: Depreciation is
computed on the book value of the asset.
Depreciation rate is obtained using the formula:
1 n ((net residual value/acquisition cost)

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Declining Charge Depreciation
Methods (contd.)
Sum of years digits method: It is similar to the
diminishing balance method. Depreciation is
computed as the product of remaining life of asset
divided by the sum of n digits, where n is the
estimated life of asset in year, and original cost.
Double declining balance method: It is also
similar to the diminishing balance method, but the
depreciation rate is double the rate computed using
the straight line method.
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Other Methods
Group depreciation method: In this, the
homogeneous assets having similar average life are
grouped together under a common summary account.
The depreciation rate is computed from the expected
average life and the scrap values of assets of a group.
Inventory system depreciation: In this, depreciation
is computed for the assets whose expected life cannot
be determined. Depreciation amount is computed by
subtracting the cost of asset at the end of the
accounting period from the total cost of the asset
available at the beginning and purchased during the
accounting period.
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Other Methods (contd.)
Annuity method: In this, depreciation is computed by
considering the cost of asset and the interest on the
actual cost of the asset that the business would have
earned if the amount have been invested in some
investment.
Depreciation fund method: In this, the depreciation
amount is invested in some securities. This helps in the
business to gather funds for the purchase of new
assets.
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Other Methods (contd.)
Insurance policy method: In this, the business takes
an insurance policy for a particular amount and pays a
fixed amount of premium every year. At the end of the
duration of insurance policy, the insurance company
pays the insured amount, which is used by the business
to buy new assets.
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Depreciation Policy
Objectives of depreciation policy:
To recover the amount invested in purchasing an
asset before the expiry of the economic life of the
asset.
To ensure that a uniform rate of return on
investment is achieved.
To generate funds for purchasing of new asset after
the expiry of an old asset.
To determine correct profit and loss information of
the business.
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Depreciation Policy (contd.)
Aspects that should be considered while
developing the depreciation policy:
An appropriate method for computing depreciation
should be selected depending upon the nature of
assets and objectives of the management.
The provisions for depreciation should be
periodically reviewed.
The depreciation policy should be evaluated in the
context of tax, price level changes and
Government regulations.
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Provision
Provision is the amount that is set aside from the
profits of the business for providing:
Depreciation, renewals and decrease in the value of
assets.
An known liability, which cannot be determined.
It is a charge against profits and is created by
debiting the Profit and Loss account.
It cannot be distributed as profits.
Examples: Provision for bad debts, provision for
repairs and renewals and provision for discount.
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Reserve
Reserve is the portion of earnings and receipts
of a business that is kept aside for a specific
purpose other than a provision for depreciation.
It is an appropriation of profits that ultimately
results to an increase in the funds of the
proprietor.
It can be distributed as profits, if required.
It is shown on the liability side of the Balance
Sheet under the heading Reserves and Surplus.
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Reserve Funds
Reserve funds are the reserves that are kept for
investment outside the business.
Types of reserve funds:
Revenue reserves: They are created out of revenue
profits of the business.
Capital reserves: They are created out of capital
profits of the business.
Secret reserves: They are the reserves that are not
shown on the Balance Sheet.
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Summary
In this chapter, you have:
Understood the concept of depreciation
Identified the causes of depreciation
Explained the meaning of depreciation accounting
Computed depreciation according to different
methods of providing depreciation
Explained the role of depreciation policy