Depreciation, Provisions and Reserves

Introduction

The chapter begins by emphasizing the importance of the matching principle in accounting. This principle requires that the revenue earned during a particular accounting period must be matched with the expenses incurred to earn that revenue within the same period. This ensures the accurate ascertainment of profit or loss for that period. If a cost is incurred whose benefit extends over multiple accounting periods, it is not justified to charge the entire cost as an expense in the year it is incurred. Instead, such costs should be systematically spread over the periods in which the benefits are expected to be received. Depreciation is a prime example of such an expense, as it relates to the allocation of the cost of fixed assets over their useful life. The chapter also introduces the concepts of provisions and reserves, which are important for prudent financial management and accounting. Provisions are amounts set aside to meet known liabilities or anticipated losses, while reserves are portions of profits retained to strengthen the financial position of the business. **Table on page 1 (5×5)** | Depreciation, Provisions and Reserves | | | 7 | | | --- | --- | --- | --- | --- | | | | | 7 | | | Matching principle requires that the revenue of a given period is matched against the expense for the same period. This ensures ascertainment o the correct amount of profit or loss. If some cost i incurred whose benefit extend to more than on LEARNING OBJECTIVES accounting period, it is not justified to charge th After studying this chapter, entire cost as expense in the year in which it i you will be able to : incurred. In fact, such a cost must be spread ove • explain the meaning of the periods in which it provides benefits depreciation and Depreciation, on fixed assets, which is the mai distinguish it from subject matter of the present chapter, deals with suc amortisation and depletion; a situation. Further, it may not always be possibl to ascertain with certainty the amount of som • state the need for charging depreciation particular expense. Recall the principle o and identify its causes; conservatism (prudence) which requires that instea • compute depreciation of ignoring such items of costs, adequate provisio using straight line and must be made and charged against profits of th written down value current period. Moreover, a part of profit may b methods; retained in the business in the form of reserves t • record transactions provide for growth, expansion or meeting certai relating to depreciation specific needs of the business in future. This chapte and disposition of deals with two distinct topics and hence is bein assets; presented in two different sections. First section deal • explain the meaning with depreciation and second section deals wit and purpose of creating provisions and reserves; provisions and reserves. • distinguish between reserves and provisions; SECTION – I • explain the nature of various types of 7.1 Depreciation | | | | | | | | | | | | | LEARNING OBJECTIVES After studying this chapter, you will be able to : • explain the meaning of depreciation and distinguish it from amortisation and depletion; • state the need for charging depreciation and identify its causes; • compute depreciation using straight line and written down value methods; • record transactions relating to depreciation and disposition of assets; • explain the meaning and purpose of creating provisions and reserves; • distinguish between reserves and provisions; • explain the nature of various types of | | | | | | provisions and reserves including secret reserve. | | | | **Table on page 15 (3×5)** | | Basis of Difference | Straight Line Method | Written Down Value Method | | | --- | --- | --- | --- | --- | | | 1. Basis of charging depre- ciation 2. Annual depreciation charge | Original cost Fixed (Constant) year | Book Value (i.e. original cost less depreciation charged till date) Declines year after year Almost equal every year. Recognised It is suitable for assets, which are affected by technological changes and require more repair expenses with passage of time. | | | 3. Total charge against Unequal year after year. Almost equal every year profit and loss account in It increases in later years. respect of depreciation and repairs 4. Recognition by income Not recognised Recognised tax law 5. Suitablity It is suitable for assets in It is suitable for assets which repair charges are which are affected by less, the possibility of technological changes and obsolescence is low and require more repair scrap value depends upon expenses with passage o the time period involved. time. Fig. 7.3 : Comparison of straight line and written down value method 7.8 Methods of Recording Depreciation In the books of account, there are two types of arrangements for recordin depreciation on fixed assets: • Charging depreciation to asset account or • Creating Provision for depreciation/Accumulated depreciation account. 77777.....88888.....11111 CCCCChhhhhaaaaarrrrrgggggiiiiinnnnnggggg DDDDDeeeeeppppprrrrreeeeeccccciiiiiaaaaatttttiiiiiooooonnnnn tttttooooo AAAAAsssssssssseeeeettttt aaaaaccccccccccooooouuuuunnnnnttttt According to this arrangement, depreciation is deducted from the depreciabl cost of the asset (credited to the asset account) and charged (or debited) to prof and loss account. Journal entries under this recording method are as follows 1. For recording purchase of asset (only in the year of purchase) Asset A/c Dr. (with the cost of asset includin installation, freight, etc.) To Bank/Vendor A/c 2. Following two entries are recorded at the end of every year (a) For deducting depreciation amount from the cost of the asset. Depreciation A/c Dr. (with the amount of depreciation To Asset A/c | 3. Total charge against profit and loss account in respect of depreciation and repairs 4. Recognition by income tax law 5. Suitablity | Unequal year after year. It increases in later years. Not recognised It is suitable for assets in which repair charges are less, the possibility of and obsolescence is low scrap value depends upon the time period involved. | Almost equal every year Recognised It is suitable for assets which are affected by technological changes and require more repair expenses with passage o time. | | | | | | | g e it : g ) | **Table on page 18 (10×14)** | | Date | | Particulars | J.F. | Amount ` | Date | | Particulars | | J.F. | | Amounts ` | | | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | | | 2017 Mar. 31 2018 | | Plant | | 54,000 | 2017 Mar. 31 2018 | | Profit and Loss | | | | 54,000 | | | | | | | | | | | | | | | 54,000 | | | Mar. 31 Plant 54,000 Mar. 31 Profit and Loss 54,000 2019 2019 Mar. 31 Plant 54,000 Mar. 31 Profit & Loss 54,000 Workings Notes (1) Calculation of original cost (`) Purchase cost 5,00,000 Add: Installation cost 50,000 Original cost 5,50,000 Salvage value 10,000 Useful life 10 years ` 5,50, 000 −` 10, 000 (2) Depreciation amount = =` 54, 000 p.a. 10 Illustration 2 M/s Mehra and Sons acquired a machine for ` 1,80,000 on October 01, 2016, and spen ` 20,000 for its installation. The firm writes-off depreciation at the rate of 10% on origin cost every year. Record necessary journal entries for the year 2017 and draw up Machin Account and Depreciation Account for first three years given that: (i) The book of accounts closes on March 31 every year; and (ii) The firm charges depreciation to asset account. Solution Books of Mehra and Sons Journal Debit Credit Date Particulars L.F. Amount Amount ` ` 2016 Oct. 01 Machine A/c Dr. 1,80,000 To Bank A/c 1,80,000 (Purchased machine for `1,80,000) | Mar. 31 2019 Mar. 31 | | Plant Plant | | 54,000 | Mar. 31 2019 Mar. 31 | | Profit and Loss Profit & Loss | | | | 54,000 | | | | | | | | 54,000 | | | | | | | 54,000 | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | t al e | | | Date | Particulars | | | | | L.F. | | Debit Amount ` | | Credit Amount ` | | | | | 2016 Oct. 01 | Machine A/c Dr. To Bank A/c (Purchased machine for `1,80,000) | | | | | | | 1,80,000 | | 1,80,000 | | | | | | | | | | | | | | | | | | | | Oct. 01 | Machine A/c Dr. To Bank A/c (Expenses incurred on installation) | | | | | | | 20,000 | | | | | **Table on page 19 (15×13)** | | 2017 Mar. 31 Mar. 31 | Depreciation A/c Dr. To Machine A/c Depreciation charged on machine) | | | | | | 10,000 10,000 | | 10,000 10,000 20,000 20,000 20,000 20,000 | | | | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | | | | Profit and Loss A/c Dr. To Depreciation A/c (Depreciation debited to profit and loss account) | | | | | | | | | | | | 2018 Mar. 31 Depreciation A/c Dr. 20,000 To Machine A/c 20,000 (Depreciation charged on machine) Mar. 31 Profit and Loss A/c Dr. 20,000 To Depreciation A/c 20,000 (Depreciation debited to profit and loss account) 2019 Mar. 31 Depreciation A/c Dr. 20,000 To Machine A/c 20,000 (Depreciation charged on machine) Mar. 31 Profit and Loss A/c Dr. 20,000 To Depreciation A/c 20,000 (Depreciation debited to profit and loss account) Books of M/s Mehra and Sons Machine Account Dr. C Date Particulars J.F. Amount Date Particulars J.F. Amount ` ` 2016 2017 Oct. 01 Bank 1,80,000 Mar. 31 Depreciation 10,000 Oct. 01 Bank 20,000 (for 6 months) (Installation Balance c/d 1,90,000 expenses) Mar. 31 2,00,000 2,00,000 2017 2018 Apr. 01 Balance b/d 1,90,000 Mar. 31 Depreciation 20,000 1,70,000 Balance c/d 1,90,000 1,90,000 | 2018 Mar. 31 Mar. 31 2019 Mar. 31 Mar. 31 | | | | | | | 20,000 20,000 20,000 20,000 | | 20,000 20,000 20,000 20,000 | | | | | | Depreciation A/c Dr. To Machine A/c (Depreciation charged on machine) | | | | | | | | | | | | | | Profit and Loss A/c Dr. To Depreciation A/c (Depreciation debited to profit and loss account) | | | | | | | | | | | | | | Depreciation A/c Dr. To Machine A/c (Depreciation charged on machine) | | | | | | | | | | | | | | Profit and Loss A/c Dr. To Depreciation A/c (Depreciation debited to profit and loss account) | | | | | | | | | | | | | | | | | | | | | | | | r. | | | Date | Particulars | J.F. | Amount ` | Date | | Particulars | | J.F. | | Amount ` | | | | 2016 Oct. 01 Oct. 01 2017 Apr. 01 | Bank Bank (Installation expenses) Balance b/d | | 1,80,000 20,000 | 2017 Mar. 31 Mar. 31 2018 Mar. 31 | | Depreciation (for 6 months) Balance c/d Depreciation Balance c/d | | | | 10,000 1,90,000 | | | | | | | 2,00,000 | | | | | | | 2,00,000 | | | | | | | 1,90,000 | | | | | | | 20,000 1,70,000 | | | | | | | 1,90,000 | | | | | | | 1,90,000 | | | | 2018 Apr. 01 | Balance b/d | | 1,70,000 | 2019 Mar. 31 | | Depreciation Balance c/d | | | | 20,000 1,50,000 | | | | | | | 1,70,000 | | | | | | | 1,70,000 | | | | | | | | | | | | | | | | **Table on page 21 (2×8)** | 2017 Apr. 01 | Balance b/d | | 2,00,000 | 2018 Mar. 31 | Balance c/d | | 2,00,000 | | --- | --- | --- | --- | --- | --- | --- | --- | | | | | 2,00,000 | | | | 2,00,000 | | | | | | | | | | **Table on page 21 (17×11)** | Date Particulars J.F. Amount Date Particulars J.F. Amounts ` ` 2016 2016 Mar. 31 Balance c/d 10,000 Mar. 31 Depreciation 10,000 10,000 10,000 2017 2017 Mar. 31 Balance c/d 30,000 Apr. 01 Balance b/d 10,000 Mar. 31 Depreciation 20,000 30,000 30,000 2018 2018 Mar. 31 Balance c/d 50,000 Apr. 1 Balance b/d 30,000 2017 Mar. 31 Depreciation 20,000 50,000 50,000 Depreciation Account Dr. C Date Particulars J.F. Amount Date Particulars J.F. Amount ` ` 2017 2017 Mar. 31 Provision for 10,000 Mar.31 Profit & Loss 10,000 Deprection 10,000 10,000 2018 2018 Mar. 31 Provision for 20,000 Mar.31 Profit & Loss 20,000 Depreciation 20,000 20,000 2019 2019 Mar. 31 Provision for 20,000 Mar.31 Profit & Loss 20,000 Depreciation 20,000 20,000 | Date | Particulars | J.F. | Amount ` | Date | | Particulars | J.F. | Amounts ` | | | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | | | 2016 Mar. 31 2017 Mar. 31 2018 Mar. 31 | Balance c/d Balance c/d Balance c/d | | 10,000 | 2016 Mar. 31 2017 Apr. 01 Mar. 31 2018 Apr. 1 2017 Mar. 31 | | Depreciation Balance b/d Depreciation Balance b/d Depreciation | | 10,000 | | | | | | | 10,000 | | | | | 10,000 | | | | | | | 30,000 | | | | | 10,000 20,000 | | | | | | | 30,000 | | | | | 30,000 | | | | | | | 50,000 | | | | | 30,000 20,000 | | | | | | | 50,000 | | | | | 50,000 | | | | | | | | | | | | | | | | | | | | | | | | | r. | | | Date | Particulars | J.F. | Amount ` | Date | Particulars | | J.F. | Amount ` | | | | 2017 Mar. 31 2018 Mar. 31 2019 Mar. 31 | Provision for Deprection Provision for Depreciation Provision for Depreciation | | 10,000 | 2017 Mar.31 2018 Mar.31 2019 Mar.31 | Profit & Loss Profit & Loss Profit & Loss | | | 10,000 | | | | | | | 10,000 | | | | | 10,000 | | | | | | | 20,000 | | | | | 20,000 | | | | | | | 20,000 | | | | | 20,000 | | | | | | | 20,000 | | | | | 20,000 | | | | | | | 20,000 | | | | | 20,000 | | | | | | | | | | | | | | | | | | | | | | | | | | **Table on page 22 (8×10)** | Date Particulars J.F. Amount Date Particulars J.F. Amount ` ` 2016 2017 Apr. 01 Bank 2,00,000 Mar. 31 Depreciation 21,0001 Bank 10,000 Balance c/d 1,89,000 2,10,000 2,10,000 2017 2018 Apr. 01 Balance b/d 1,89,000 Mar. 31 Depreciation 18,9002 Balance c/d 1,70,100 1,89,000 1,89,000 2018 2019 Apr. 01 Balance b/d 1,70,100 Mar. 31 Depreciation 17,0103 Balance c/d 1,53,090 1,70,100 1,70,100 2020 Balance b/d 1,53,090 Working Notes 1. Calculation of the amount of depreciation (`) Original cost on 01.04.2016 2,10,000 (i.e. 2,00,000 + 10,000 Less: Depreciation for 2016-17 (21,000) WDV on 01.04.2017 1,89,000 Less: Depreciation for 2017-18 (18,900) WDV on 01.04.2018 1,70,100 Less: Depreciation for 2018-19 (17,010) WDV on 01.04.2017 1,53,090 Illustration 5 M/s Sahani Enterprises acquired a printing machine for ` 40,000 on July 01, 2014 an spent ` 5,000 on its transport and installation. Another machine for ` 35,000 was purchase on January 01, 2016. Depreciation is charged at the rate of 20% on written down valu Prepare Printing Machine account. | Date | Particulars | J.F. | Amount ` | Date | Particulars | J.F. | Amount ` | | | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | | | 2016 Apr. 01 2017 Apr. 01 2018 Apr. 01 2020 | Bank Bank Balance b/d Balance b/d Balance b/d | | 2,00,000 10,000 | 2017 Mar. 31 2018 Mar. 31 2019 Mar. 31 | Depreciation Balance c/d Depreciation Balance c/d Depreciation Balance c/d | | 21,0001 1,89,000 | | | | | | | 2,10,000 | | | | 2,10,000 | | | | | | | 1,89,000 | | | | 18,9002 1,70,100 | | | | | | | 1,89,000 | | | | 1,89,000 | | | | | | | 1,70,100 | | | | 17,0103 1,53,090 | | | | | | | 1,70,100 | | | | 1,70,100 | | | | | | | 1,53,090 | | | | | | | | | | | | | | | | ) d d e. | **Table on page 30 (10×11)** | Illustration 7 On April 01, 2015, following balances appeared in the books of M/s Kanishka Trader Furniture account ` 50,000, Provision for depreciation on furniture ` 22,000. On Octobe 01, 2015 a part of furniture purchased for Rupees 20,000 in April 01, 2011 was sold fo ` 5,000. On the same date a new furniture costing ` 25,000 was purchased. The depreciatio was provided @ 10% p.a. on original cost of the asset and no depreciation was charged o the asset in the year of sale. Prepare furniture account and provision for depreciatio account for the year ending March 31, 2016. Solution Books of Kanishka Traders Furniture Account Dr. C Date Particulars J.F. Amount Date Particulars J.F. Amount ` ` 2015 2015 Apr. 01 Balance b/d 50,000 Oct.01 Bank 5,000 Oct. 01 Bank 25,000 2016 Provision for 8,000 March 31 depreciation 7,0001 Profit and Loss (Loss on sale) Balance c/d 55,000 75,000 75,000 Provision for Depreciation on Furniture Account Dr. C Date Particulars J.F. Amount Date Particular J.F. Amount ` ` 2015 2015 Oct. 01 Furniture 8,000 Apr. 01 Balance b/d 22,000 (Accumulated depreciation on furniture sold) 2016 2016 | | | | | | | | | | s: r r n n n r. | | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | --- | | | Date | Particulars | J.F. | | Amount ` | Date | Particulars | J.F. | Amount ` | | | | 2015 Apr. 01 Oct. 01 | Balance b/d Bank | | | 50,000 25,000 | 2015 Oct.01 2016 March 31 | Bank Provision for depreciation Profit and Loss (Loss on sale) Balance c/d | | 5,000 8,000 7,0001 55,000 | | | | | | | | 75,000 | | | | 75,000 | | | | | | | | | | | | | | | | | | | | | | | | | r. | | | Date | Particulars | | J.F. | Amount ` | Date | Particular | J.F. | Amount ` | | | | 2015 Oct. 01 2016 | Furniture (Accumulated depreciation on furniture sold) | | | 8,000 | 2015 Apr. 01 2016 | Balance b/d | | 22,000 | | | | Mar. 31 | Balance c/d | | | 18,250 | Mar. 31 | Depreciation (` 3,000 + 1,250) | | | | | | | | | | 26,250 | | | | 26,250 | | | | | | | | | | | | | |

• Matching principle ensures expenses are matched with revenues of the same period.
• Costs benefiting multiple periods should be allocated over those periods.
• Depreciation is a systematic allocation of fixed asset cost over its useful life.
• Provisions are for known liabilities or anticipated losses.
• Reserves are retained profits for strengthening financial position.
• 📌 Matching Principle: Accounting principle requiring expenses to be matched with related revenues.
• 📌 Depreciation: Systematic allocation of cost of tangible fixed assets over useful life.
• 📌 Provision: Amount set aside from profits to meet known liabilities or anticipated losses.

Meaning of Depreciation

Depreciation is defined as the gradual and systematic allocation of the cost of a tangible fixed asset over its estimated useful life. It represents the reduction in the value of the asset due to wear and tear, obsolescence, passage of time, or other factors. Depreciation is not a process of asset valuation but a method of cost allocation. It ensures that the cost of the asset is charged as an expense in the profit and loss account over the periods benefiting from the asset's use. This systematic allocation helps in matching the cost with the revenue generated by the asset, adhering to the matching principle. Depreciation applies only to tangible fixed assets such as machinery, buildings, vehicles, and furniture, which have a limited useful life and lose value over time.

• Depreciation is a systematic allocation of asset cost over its useful life.
• It accounts for wear and tear, obsolescence, and passage of time.
• It is an expense, not a valuation of the asset.
• Applies only to tangible fixed assets with limited useful life.
• Ensures matching of cost with revenue generated by the asset.
• 📌 Depreciation: Systematic allocation of cost of tangible fixed asset over useful life.
• 📌 Tangible Fixed Asset: Physical asset used in business operations with limited life.