Chapter 7: Depreciation, Provisions and Reserves
1. Introduction
Businesses use fixed assets such as machinery, buildings, furniture, and vehicles for several years. As these assets are used, their value decreases due to usage, passage of time, technological changes, or other reasons. This decrease in value is called depreciation.
2. Meaning of Depreciation
Depreciation is the gradual and permanent reduction in the value of a fixed asset due to use, passage of time, wear and tear, or obsolescence. It represents the expired portion of the asset’s cost that is charged as an expense during an accounting period.
Example
A machine costing ₹1,00,000 is expected to last for 10 years.
Annual depreciation:
₹1,00,000 ÷ 10 = ₹10,000 per year
Thus, ₹10,000 is treated as an expense every year.
3. Features of Depreciation
- It causes a reduction in the book value of fixed assets.
- It occurs continuously over time.
- It may result from usage, time, or obsolescence.
- It is an expense charged against revenue.
- It is a non-cash expense because no cash is paid when depreciation is recorded.
4. Depreciation, Depletion and Amortisation
| Basis | Depreciation | Depletion | Amortisation |
|---|---|---|---|
| Related to | Tangible fixed assets | Natural resources | Intangible assets |
| Examples | Machinery, Furniture | Mines, Quarries | Patents, Copyrights |
| Cause | Usage and time | Extraction of resources | Expiry of legal rights |
5. Causes of Depreciation
A. Wear and Tear
Assets lose efficiency due to continuous use.
B. Passage of Time
Assets deteriorate even if they are not used.
C. Expiry of Legal Rights
Assets like patents and copyrights lose value after the legal period ends.
D. Obsolescence
Assets become outdated because of new technology or changing market conditions.
E. Abnormal Factors
Losses caused by accidents, fire, floods, earthquakes, etc.
6. Need for Depreciation
1. Matching Cost with Revenue
The cost of an asset should be spread over the years benefiting from its use.
2. Correct Profit Calculation
Without depreciation, profits will be overstated.
3. True Financial Position
Assets should be shown at realistic values in the Balance Sheet.
4. Tax Purposes
Depreciation is generally allowed as a deduction while calculating taxable income.
5. Legal Compliance
Many laws require businesses to provide depreciation.
7. Factors Affecting Depreciation
A. Cost of Asset
Includes:
- Purchase price
- Freight
- Installation charges
- Transportation expenses
- Registration charges
Formula
Cost of Asset = Purchase Price + All Expenses to Make Asset Ready for Use
B. Net Residual (Scrap) Value
Estimated value of the asset at the end of its useful life after disposal expenses.
Formula
Net Residual Value = Estimated Sale Value − Disposal Expenses
C. Depreciable Cost
Formula
Depreciable Cost = Cost of Asset − Net Residual Value
D. Useful Life
The period during which the asset is expected to be economically useful.
8. Methods of Calculating Depreciation
There are two major methods:
- Straight Line Method (SLM)
- Written Down Value Method (WDV)
9. Straight Line Method (SLM)
Under this method, equal depreciation is charged every year.
Formula
Annual Depreciation=Useful LifeCost of Asset−Residual Value
Example
Cost = ₹2,50,000
Residual Value = ₹50,000
Useful Life = 10 years=102,50,000−50,000=₹20,000
Advantages
- Simple and easy.
- Equal annual charge.
- Suitable for assets with consistent use.
Limitations
- Assumes equal usefulness every year.
- Does not consider increasing repair costs in later years.
10. Written Down Value Method (WDV)
Depreciation is charged on the book value of the asset every year.
As book value decreases, depreciation also decreases.
Formula
Depreciation=Book Value×Rate
Example
Cost = ₹2,00,000
Rate = 10%
Year 1 Depreciation:
₹2,00,000 × 10% = ₹20,000
Book Value = ₹1,80,000
Year 2 Depreciation:
₹1,80,000 × 10% = ₹18,000
Book Value = ₹1,62,000
And so on.
11. Advantages of WDV Method
- More realistic because asset utility decreases over time.
- Recognised by Income Tax laws.
- Helps account for obsolescence.
- Suitable for machinery and vehicles.
12. Limitations of WDV Method
- Asset value never becomes exactly zero.
- Suitable depreciation rate is difficult to determine.
13. Difference Between SLM and WDV
| Basis | SLM | WDV |
|---|---|---|
| Basis of Depreciation | Original Cost | Book Value |
| Annual Depreciation | Fixed | Decreasing |
| Repair + Depreciation Cost | Increases over time | Nearly uniform |
| Tax Recognition | Not generally recognised | Recognised |
| Suitable For | Buildings, patents | Machinery, vehicles |
14. Methods of Recording Depreciation
Method 1: Charge Depreciation Directly to Asset Account
Entry
Depreciation A/c Dr.
To Asset A/c
Transfer to Profit & Loss
Profit & Loss A/c Dr.
To Depreciation A/c
Method 2: Provision for Depreciation Method
Entry
Depreciation A/c Dr.
To Provision for Depreciation A/c
Transfer to Profit & Loss
Profit & Loss A/c Dr.
To Depreciation A/c
This method keeps the asset account at original cost.
15. Disposal of Asset
When an asset is sold, discarded, or destroyed, it is said to be disposed of.
Journal Entry for Sale
Bank A/c Dr.
To Asset A/c
Profit on Sale
Asset A/c Dr.
To Profit & Loss A/c
Loss on Sale
Profit & Loss A/c Dr.
To Asset A/c
Quick Revision Points
✅ Depreciation is a non-cash expense.
✅ It applies only to depreciable fixed assets.
✅ Main causes: wear and tear, time, obsolescence.
✅ Depreciable Cost = Cost − Residual Value.
✅ SLM gives equal depreciation every year.
✅ WDV gives decreasing depreciation every year.
✅ Depreciation helps determine true profit and true financial position.
✅ Depreciation can be recorded directly in the asset account or through a provision account.
One-Mark Important Questions
- What is depreciation?
- Why is depreciation called a non-cash expense?
- What is residual value?
- Define obsolescence.
- What is depletion?
- What is amortisation?
- State one advantage of SLM.
- State one advantage of WDV.
- Name two causes of depreciation.
- What is useful life of an asset?
Formula Sheet
Straight Line Method
Depreciation=Useful LifeCost−Residual Value
Rate of Depreciation
Rate=CostAnnual Depreciation×100
Depreciable Cost
Cost of Asset−Residual Value
Questions
Part A: Multiple Choice Questions (MCQs)
1. Depreciation refers to:
a) Increase in asset value
b) Reduction in asset value due to use and time
c) Profit earned on asset
d) Sale of asset
Answer: b
2. Which of the following is a fixed asset?
a) Cash
b) Debtors
c) Building
d) Stock
Answer: c
3. Depreciation is charged because:
a) Assets appreciate in value
b) Assets lose value over time
c) Assets are sold
d) Business earns profit
Answer: b
4. Which factor does NOT affect depreciation?
a) Cost of asset
b) Useful life
c) Residual value
d) Owner’s age
Answer: d
5. Depreciation is a:
a) Capital expenditure
b) Revenue expenditure
c) Loss of asset value
d) Liability
Answer: c
6. Amortisation relates to:
a) Tangible assets
b) Intangible assets
c) Current assets
d) Investments
Answer: b
7. Depletion is generally associated with:
a) Buildings
b) Furniture
c) Natural resources
d) Vehicles
Answer: c
8. Under Straight Line Method, depreciation is:
a) Different every year
b) Equal every year
c) Increasing every year
d) Zero every year
Answer: b
9. Which method is also called Fixed Instalment Method?
a) WDV Method
b) SLM
c) Annuity Method
d) Insurance Policy Method
Answer: b
10. WDV stands for:
a) Written Down Value
b) Withdrawn Depreciation Value
c) Working Depreciation Value
d) Written Double Value
Answer: a
11. Under WDV Method, depreciation is charged on:
a) Original cost only
b) Market value
c) Book value of asset
d) Scrap value
Answer: c
12. Which method gives higher depreciation in the initial years?
a) SLM
b) WDV
c) Both equal
d) None
Answer: b
13. Residual value means:
a) Cost of asset
b) Expected value at the end of useful life
c) Market value today
d) Repair cost
Answer: b
14. Depreciation is charged according to:
a) Matching principle
b) Going concern principle
c) Dual aspect principle
d) Money measurement principle
Answer: a
15. Provision is created for:
a) Known liabilities
b) Unknown liabilities
c) Expected losses
d) Both a and c
Answer: d
16. Reserve is created out of:
a) Sales
b) Capital
c) Profits
d) Loans
Answer: c
17. General Reserve is:
a) Specific reserve
b) Revenue reserve
c) Capital reserve
d) Secret reserve
Answer: b
18. Provision for doubtful debts is an example of:
a) Reserve
b) Provision
c) Capital
d) Asset
Answer: b
19. Depreciation Account is:
a) Personal Account
b) Real Account
c) Nominal Account
d) Capital Account
Answer: c
20. Depreciation appears in:
a) Trading Account
b) Profit and Loss Account
c) Capital Account
d) Cash Book
Answer: b
Part B: Fill in the Blanks
- Depreciation is the __________ reduction in the value of a fixed asset.
Answer: gradual - The amount expected to be realised at the end of useful life is called __________ value.
Answer: residual - Under SLM, depreciation remains __________ every year.
Answer: constant - WDV Method charges depreciation on __________ value.
Answer: book - Depletion is related to __________ resources.
Answer: natural - Amortisation is charged on __________ assets.
Answer: intangible - Depreciation is a __________ expense.
Answer: non-cash - A reserve is created from __________.
Answer: profits - Provision is made for anticipated __________.
Answer: losses - Machinery and buildings are examples of __________ assets.
Answer: fixed - Obsolescence occurs due to __________ changes.
Answer: technological - Depreciation helps determine correct __________.
Answer: profit - General Reserve is a type of __________ reserve.
Answer: revenue - Wear and tear is a major cause of __________.
Answer: depreciation - Depreciation reduces the __________ value of assets.
Answer: book
Part C: True or False
- Depreciation increases the value of assets.
Answer: False - Land generally depreciates.
Answer: False - SLM provides equal depreciation every year.
Answer: True - WDV provides decreasing depreciation every year.
Answer: True - Provision is an appropriation of profit.
Answer: False - Reserve is an appropriation of profit.
Answer: True - Depreciation is a non-cash expense.
Answer: True - Obsolescence may occur due to new technology.
Answer: True - Depreciation should be charged whether profit is earned or not.
Answer: True - Amortisation applies to patents and copyrights.
Answer: True
Part D: Match the Following
| Column A | Column B |
|---|---|
| Depreciation | Tangible Assets |
| Amortisation | Intangible Assets |
| Depletion | Natural Resources |
| SLM | Equal Depreciation |
| WDV | Diminishing Depreciation |
Answers
1 → Tangible Assets
2 → Intangible Assets
3 → Natural Resources
4 → Equal Depreciation
5 → Diminishing Depreciation
Part E: Very Short Answer Questions (1 Mark)
1. What is depreciation?
Answer: Depreciation is the gradual decrease in the value of a fixed asset due to use, passage of time, or obsolescence.
2. Give one example of a depreciable asset.
Answer: Machinery.
3. What is residual value?
Answer: Estimated value of an asset at the end of its useful life.
4. Name any one method of charging depreciation.
Answer: Straight Line Method.
5. What is obsolescence?
Answer: Reduction in usefulness of an asset due to technological advancements.
6. What is a provision?
Answer: An amount set aside to meet known liabilities or expected losses.
7. What is a reserve?
Answer: A portion of profit retained in the business for future needs.
8. Is depreciation a cash expense?
Answer: No.
9. What is depletion?
Answer: Reduction in value of natural resources due to extraction.
10. What is amortisation?
Answer: Systematic write-off of intangible assets.
Part F: Short Answer Questions (3 Marks)
1. State any three causes of depreciation.
Answer:
- Wear and tear
- Passage of time
- Obsolescence
2. Why is depreciation charged?
Answer:
- To ascertain correct profit.
- To show true value of assets.
- To follow matching principle.
3. State any three factors affecting depreciation.
Answer:
- Cost of asset
- Useful life
- Residual value
4. Distinguish between Provision and Reserve.
| Provision | Reserve |
|---|---|
| Charge against profit | Appropriation of profit |
| Compulsory | Optional |
| Made before profit determination | Made after profit determination |
Part G: Long Answer Questions (5 Marks)
1. Explain the need for charging depreciation.
Answer:
- Determines true profit.
- Shows correct asset value.
- Ensures matching of revenue and expenses.
- Helps create funds for replacement.
- Complies with accounting principles.
2. Differentiate between SLM and WDV.
| SLM | WDV |
|---|---|
| Equal depreciation | Unequal depreciation |
| Based on original cost | Based on book value |
| Easy to calculate | Slightly complex |
| Asset value may become zero | Asset value never becomes zero completely |
3. Explain the factors affecting depreciation.
Answer:
- Original cost of asset
- Estimated useful life
- Residual value
- Nature of asset
- Usage of asset
Part H: Numerical Questions with Answers
1.
Machine Cost = ₹50,000
Residual Value = ₹5,000
Useful Life = 5 years
Find annual depreciation under SLM.
Answer:
Depreciation = (50,000 − 5,000) ÷ 5
= ₹9,000 per year
2.
Machine Cost = ₹80,000
Depreciation Rate = 10%
Calculate first year’s depreciation under WDV.
Answer:
Depreciation = 80,000 × 10%
= ₹8,000
Book Value = ₹72,000
3.
Book Value = ₹72,000
Rate = 10%
Find second year’s depreciation.
Answer:
Depreciation = 72,000 × 10%
= ₹7,200
Part I: HOTS Questions
1.
Why should depreciation be charged even if the business incurs a loss?
Answer: Because assets continue to lose value irrespective of profit or loss.
2.
Which method is more suitable for machinery and why?
Answer: WDV Method because machinery generally gives higher efficiency in early years and depreciation is higher initially.
3.
Why is reserve considered a sign of financial strength?
Answer: It provides financial stability and funds for future contingencies and expansion.
Part J: Case Study Questions
Case Study
A company purchased machinery for ₹1,00,000. The estimated life is 10 years and scrap value is ₹10,000.
Questions:
- What is depreciable amount?
Answer: ₹90,000 - Annual depreciation under SLM?
Answer: ₹9,000 - Why should depreciation be charged?
Answer: To ascertain correct profit and asset value. - Which accounting principle supports depreciation?
Answer: Matching Principle.
Quick Revision Formula Sheet
SLM Depreciation
= (Cost − Residual Value) ÷ Useful Life
WDV Depreciation
= Book Value × Rate ÷ 100
Book Value
= Cost − Accumulated Depreciation
Depreciable Amount
= Cost − Residual Value
Provision
= Charge against profit
Reserve
= Appropriation of profit