Depreciation, Provisions and Reserves | CBSE Class 11 Accountancy Notes

This note covers the meaning and features of depreciation, depletion and amortisation, the causes of and need for depreciation, the factors that decide its amount, the straight line and written down value methods, recording depreciation, disposal of assets, additions to assets, provisions, reserves and their types, and secret reserves.

What is depreciation?

The matching principle requires that the revenue of a period is matched against the expenses of the same period. When a cost gives benefits for more than one accounting period, it must be spread over the periods in which it provides benefits. Depreciation on fixed assets deals with this situation.

Fixed assets, technically called depreciable assets, tend to lose value once they are put to use. As an accounting term, depreciation is the part of the cost of a fixed asset which has expired on account of its usage and/or lapse of time. It is an expired cost, debited to the Statement of Profit and Loss.

For example, a machine bought for ₹1,00,000 has a useful life of 10 years. The ₹1,00,000 will give benefits for 10 years, not one, so only a part, say ₹10,000 (one tenth), is charged against the revenue of the first year.

Definition: Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on their market value.

How does AS-6 define it?

Accounting Standard-6 (AS-6), issued by the Institute of Chartered Accountants of India (ICAI), defines depreciation as a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market change. It is allocated so as to charge a fair proportion of the depreciable amount in each accounting period of the asset's expected useful life.

Which assets are depreciable?

Depreciable assets are expected to be used during more than one accounting period, have a limited useful life, and are held for use in production or supply of goods and services, for rental, or for administration, not for sale in the ordinary course of business. Examples are machines, plants, furniture, buildings, computers, trucks and vans.

What are the features of depreciation?

1. It is a decline in the book value of fixed assets.
2. It includes loss of value due to effluxion of time, usage or obsolescence.
3. It is a continuing process.
4. It is an expired cost, so it is deducted before calculating taxable profits. Profit before depreciation and tax of ₹50,000, less depreciation of ₹10,000, gives profit before tax of ₹40,000.
5. It is a non-cash expense: it writes off capital expenditure already incurred.

How is depreciation different from depletion and amortisation?

The terms depletion and amortisation are given similar accounting treatment to depreciation, because each represents the expiry of the usefulness of a different kind of asset.

Depletion

Depletion is used for the extraction of natural resources like mines and quarries. If a mining business buys a coal mine for ₹10,00,000, the value of the mine declines as coal is extracted. Depletion concerns the exhaustion of economic resources, while depreciation relates to the usage of an asset.

Amortisation

Amortisation is the writing off of the cost of intangible assets such as patents, copyright, trade marks, franchises and goodwill, which have utility for a specified period. A patent bought for ₹10,00,000 with a useful life of 10 years is written off over those 10 years.

What causes depreciation, and why must it be charged?

What are the causes of depreciation?

1. Wear and tear due to use or passage of time. Use in business operations reduces the technical capacity of the asset. An asset also deteriorates with time even when unused, especially when exposed to weather, winds and rains.
2. Expiration of legal rights. Assets such as patents, copyrights and leases lose their value when the agreement governing their use ends after a predetermined period.
3. Obsolescence. An existing asset becomes out of date because a better type of asset is available. This arises from technological changes, improvements in production methods, a change in market demand for the asset's output, and legal or other factors.
4. Abnormal factors. Accidents due to fire, earthquake or floods reduce usefulness. A car repaired after an accident will not fetch the same price even if unused.

Note: Accidental loss is permanent, but it is not continuing or gradual.

Why is depreciation charged?

1. Matching of costs and revenue. Depreciation is as much a cost as salary, carriage or postage and stationery, and must be deducted before arriving at net profit.
2. Consideration of tax. Depreciation is a deductible cost for tax purposes, although tax rules for it need not match business practice.
3. True and fair financial position. Without depreciation, assets are overvalued and the balance sheet does not show the correct financial position.
4. Compliance with law. Certain laws indirectly compel some organisations, such as corporate enterprises, to provide depreciation.

Which factors decide the amount of depreciation?

The amount of depreciation depends on three parameters: cost, estimated useful life and probable salvage value.

Cost of the asset

Cost, also called original or historical cost, includes the invoice price and all costs needed to put the asset in working condition: freight and transportation, transit insurance, installation, registration, and commission paid on purchase. For a second-hand asset, it includes the initial repair needed to make it workable.

A photocopy machine bought for ₹50,000, with ₹5,000 spent on transport and installation, has an original cost of ₹55,000.

Net residual value

Net residual value, also called scrap value or salvage value, is the estimated net realisable value of the asset at the end of its useful life, after deducting disposal expenses.

Net residual value = Expected sale value − Disposal expenses

A machine costing ₹50,000 with a 10-year life is expected to sell for ₹6,000 at the end, with disposal expenses of ₹1,000. Its net residual value is ₹5,000.

Depreciable cost

Depreciable cost = Cost − Net residual value

In the same example, depreciable cost is ₹50,000 − ₹5,000 = ₹45,000, charged over 10 years. Total depreciation over the useful life must equal the depreciable cost; if less is charged, the capital expenditure is under-recovered, which violates proper matching.

Estimated useful life

Useful life is the estimated economic or commercial life of the asset, not its physical life. A machine may be in good physical condition after 5 years but no longer produce profitably, so its useful life is 5 years. Useful life is normally shorter than physical life, and may be expressed in years, units of output or working hours.

It depends on legal or contractual limits (such as the period of a lease), the number of shifts worked, the repair and maintenance policy, technological obsolescence, innovation in production methods, and legal or other restrictions.

How does the straight line method work?

Two methods are mandated by law and enforced by professional practice in India: the straight line and written down value methods. The choice depends on the type of asset, the nature of its use and the circumstances of the business. Under AS-6, the chosen method should be applied consistently.

What is the straight line method?

The straight line method assumes equal usage of the asset over its useful life, so a fixed and equal amount is charged every year. The yearly charge reduces the original cost to the scrap value by the end of the useful life. It is also called the fixed instalment method, because the amount stays constant.

Annual depreciation = (Cost − Net residual value) ÷ Useful life

Rate of depreciation = (Annual depreciation ÷ Cost) × 100

Worked example 1. An asset costs ₹2,50,000. Its useful life is 10 years and its net residual value is estimated at ₹50,000. Find the annual depreciation and the rate of depreciation under the straight line method.

Working: (₹2,50,000 − ₹50,000) ÷ 10 = ₹20,000. Rate = ₹20,000 ÷ ₹2,50,000 × 100 = 8%.

Answer: Annual depreciation is ₹20,000 and the rate is 8% per annum.

A line graph with "depreciation (₹)" on the vertical axis, from 0 to 25,000, and "Year" on the horizontal axis, marked 2001, 2002 and 2003. Each year is plotted at 20,000, and the points form a flat horizontal line: the same charge every year.

See Fig. 7.1 in your NCERT textbook

What are its advantages?

1. It is simple, easy to understand and apply.
2. The asset can be depreciated up to its net scrap value or zero, so the full depreciable cost is spread over the useful life.
3. The same amount is charged every year, so profits of different years are easy to compare.
4. It suits assets whose use is consistent from year to year, such as leasehold buildings.

What are its limitations?

It rests on the faulty assumption that the asset gives the same utility every year. As the asset ages, repair costs rise, so the total charge of depreciation and repairs keeps increasing from year to year.

How does the written down value method work?

Under the written down value method, a predetermined percentage is applied to the book value of the asset at the beginning of every accounting period. Because the book value keeps falling, it is also called the reducing balance method; because the charge falls every year, it is also called the diminishing value method.

The method assumes that the benefit from an asset diminishes as it becomes old. A fixed percentage of a shrinking balance means larger charges in the earlier years than in later years.

For example, an asset costs ₹2,00,000 and is depreciated at 10% per annum on written down value.

A line graph titled "Depreciation using WDV Method", with "depreciation (₹)" on the vertical axis from 0 to 25,000 and "Year" on the horizontal axis marked 2001, 2002 and 2003. Three points are joined by a line sloping gently downwards: a smaller charge each year.

See Fig. 7.2 in your NCERT textbook

How is the rate found?

R = [1 − ⁿ√(s ÷ c)] × 100

Here R is the rate of depreciation, n the expected useful life, s the scrap value and c the cost of the asset. For a truck costing ₹9,00,000 with a net salvage value of ₹50,000 after 16 years, R = (1 − 0.8347) × 100 ≈ 16.5%.

What are its advantages?

• It rests on the more realistic assumption that benefits diminish with time, so higher depreciation falls in the early years when utility is higher.
• The burden of depreciation and repairs together is almost equal every year.
• The Income Tax Act accepts this method for tax purposes.
• Because much of the cost is written off early, loss due to obsolescence is reduced.

What are its limitations?

The depreciable cost cannot be fully written off, so the value of the asset can never be zero. It is also difficult to ascertain a suitable rate.

How do the straight line and written down value methods differ?

The key difference is the basis of the charge: original cost under the straight line method, and net book value at the start of the year under the written down value method. Since repair expenses usually rise in later years, the combined charge of depreciation and repairs rises under the straight line method but stays similar under the written down value method.

Which assets suit each method?

The straight line method suits assets such as buildings, patents and trade marks. The written down value method suits assets such as plant and machinery and vehicles.

How is depreciation recorded in the books?

There are two arrangements for recording depreciation on fixed assets: charging depreciation to the asset account, or creating a provision for depreciation account, also called an accumulated depreciation account.

Charging depreciation to the asset account

Here depreciation is credited to the asset account and debited to the profit and loss account.

In the balance sheet, the asset appears at its net book value (cost less depreciation charged till date), not at its original cost.

Book value = Original cost − Depreciation charged till date

Worked example 2. M/s Singhania and Bros. bought a plant for ₹5,00,000 on April 01 and spent ₹50,000 on its installation. Its salvage value after a useful life of 10 years is ₹10,000. Books close on March 31, the straight line method is used, and depreciation is charged to the asset account. Find the yearly depreciation and the plant balance for three years.

Working: original cost = ₹5,00,000 + ₹50,000 = ₹5,50,000. Depreciation = (₹5,50,000 − ₹10,000) ÷ 10 = ₹54,000 a year.

Answer: ₹54,000 is charged each year, and the plant balance falls to ₹4,96,000, ₹4,42,000 and ₹3,88,000 at the end of the three years.

What happens when an asset is bought during the year?

In the year of purchase, depreciation is charged for the months the asset is actually used.

Worked example 3. M/s Mehra and Sons bought a machine for ₹1,80,000 on October 01, 2016 and spent ₹20,000 on installation. Depreciation is 10% a year on original cost, charged to the asset account. Books close on March 31.

Working: original cost = ₹2,00,000; full-year depreciation = 10% of ₹2,00,000 = ₹20,000. In 2016-17 the machine is used for 6 months, so depreciation = ₹20,000 × 6/12 = ₹10,000.

Answer: depreciation is ₹10,000 for 2016-17 and ₹20,000 for each later year; the machine balance is ₹1,50,000 on March 31, 2019.

Creating a provision for depreciation account

Here depreciation is accumulated in a separate account, and the asset account is not disturbed. The asset continues to appear at its original cost year after year over its whole life.

At each year end, Depreciation A/c is debited and Provision for depreciation A/c credited, and Depreciation A/c is then closed to Profit and Loss A/c. In the balance sheet, the provision is shown on the liabilities side, or deducted from the cost of the asset on the assets side.

With the Mehra and Sons data, the machine account would stay at ₹2,00,000, and the provision balance would grow to ₹10,000, ₹30,000 and ₹50,000 over the three years.

How is the disposal of an asset recorded?

An asset may be disposed of at the end of its useful life, or during it because of obsolescence or another abnormal factor. When it is sold as scrap, the amount realised is credited to the asset account and the balance is transferred to profit and loss.

Profit or loss on sale = Sale proceeds − Book value

Worked example 4. R.S. Limited bought a vehicle for ₹4,00,000. Its salvage value after 4 years is estimated at ₹40,000. Depreciation is on the straight line basis, and the vehicle is sold for ₹50,000 at the end of the fourth year.

Working: depreciation = (₹4,00,000 − ₹40,000) ÷ 4 = ₹90,000 a year. Book value after four years = ₹4,00,000 − ₹3,60,000 = ₹40,000.

Answer: profit on sale = ₹50,000 − ₹40,000 = ₹10,000, credited to the profit and loss account.

If a provision account is kept, the vehicle stays at ₹4,00,000 and the provision reaches ₹3,60,000. That balance is transferred to the vehicle account before the sale is recorded.

What is an asset disposal account?

An asset disposal account brings together, under one head, the original cost of the asset sold, its accumulated depreciation, the sale price, the value of any parts retained, and the resulting profit or loss. It is generally used when a part of the asset is sold and a provision for depreciation account exists. The entries are:

1. Asset Disposal A/c Dr. To Asset A/c, with the original cost of the asset sold.
2. Provision for Depreciation A/c Dr. To Asset Disposal A/c, with the accumulated depreciation on that asset.
3. Bank A/c Dr. To Asset Disposal A/c, with the net sale proceeds.
4. For a debit balance (loss): Profit and Loss A/c Dr. To Asset Disposal A/c.
5. For a credit balance (profit): Asset Disposal A/c Dr. To Profit and Loss A/c.

Worked example 5. On March 31, 2017, Karan Enterprises had machinery (gross value) of ₹6,00,000 and a provision for depreciation of ₹2,50,000. A machine bought for ₹1,00,000 on November 01, 2013, with accumulated depreciation of ₹60,000, was sold on April 01, 2017 for ₹35,000.

Working: book value = ₹1,00,000 − ₹60,000 = ₹40,000. Loss = ₹40,000 − ₹35,000 = ₹5,000.

Answer: the machinery disposal account shows a loss of ₹5,000, and the machinery account falls to ₹5,00,000.

How is an asset lost by accident treated?

Worked example 6. On January 01, 2012, Jain & Sons bought a second-hand plant for ₹2,00,000, spent ₹10,000 on overhauling and ₹5,000 on transport and installation. Depreciation is 20% on written down value, and books close on December 31. The plant was destroyed by fire on July 31, 2015, and an insurance claim of ₹50,000 was admitted.

Working: cost = ₹2,15,000. Depreciation: 2012 ₹43,000; 2013 ₹34,400; 2014 ₹27,520; 2015 (7 months on ₹1,10,080) ₹12,843. Accumulated depreciation = ₹1,17,763, so book value = ₹97,237.

Answer: loss on disposal = ₹97,237 − ₹50,000 = ₹47,237, debited to the profit and loss account.

How are additions and extensions to an existing asset treated?

An existing asset may need additions or extensions to make it suitable for operations. The amount spent is capitalised and written off as depreciation over the life of the asset. It is separate from usual repair and maintenance expenses. AS-6 (Revised) says that:

• an addition that becomes an integral part of the existing asset should be depreciated over the useful life of that asset, and may be depreciated at the rate applied to the existing asset; and
• an addition that keeps a separate identity and can be used after the existing asset is disposed of should be depreciated on the basis of its own useful life.

The cost of a modification is capitalised, but routine repair expenses are treated as revenue expenditure.

Worked example 7. M/s Nishit Printing Press bought a printing machine for ₹6,80,000 on April 01, 2015, depreciated at 20% on original cost by the straight line method. On April 01, 2017, a modification costing ₹70,000 was made, and an important component was replaced for ₹20,000 due to excessive wear and tear. Routine maintenance was ₹5,000. Find the depreciation for the year ending March 31, 2018.

Working: provision on April 01, 2017 = 20% of ₹6,80,000 × 2 = ₹2,72,000. Depreciation for 2017-18 = 20% of ₹6,80,000 (₹1,36,000) + 20% of ₹90,000, that is ₹70,000 + ₹20,000 (₹18,000) = ₹1,54,000.

Answer: depreciation is ₹1,54,000; the machinery account shows ₹7,70,000 and the provision account ₹4,26,000 at the year end.

What is a provision, and how is it created?

Some expenses and losses relate to the current period, but their amount is not known with certainty because they are not yet incurred. A provision is made for them so that true net profit is found, following the principle of prudence or conservatism. A trader selling on credit knows some debtors will not pay, so creates a provision for doubtful debts.

Examples are provisions for depreciation, bad and doubtful debts, taxation, discount on debtors, and repairs and renewals.

A provision is a charge against revenue of the current period, created by debiting the profit and loss account. In the balance sheet it is shown either as a deduction from the concerned asset (doubtful debts from sundry debtors), or on the liabilities side with current liabilities (provision for taxes).

How is a provision for doubtful debts created?

Good debtors are those from whom collection is certain. Bad debts are a certain loss, as collection is not possible. Doubtful debts are those who may pay, but full collection is not certain.

The provision is usually a percentage of sundry debtors after writing off all known bad debts. The entry is Profit and Loss A/c Dr. To Provision for doubtful debts A/c.

Worked example 8. On March 31, 2014, Trehan Traders had sundry debtors of ₹68,000. Bad debts of ₹8,000 had proved bad but were not recorded. A provision of 10% of debtors is to be maintained.

Working: debtors after bad debts = ₹68,000 − ₹8,000 = ₹60,000. Provision = 10% of ₹60,000 = ₹6,000.

Answer: bad debts of ₹8,000 are written off and charged to profit and loss, and a provision of ₹6,000 is created.

What is a reserve, and how does it differ from a provision?

A part of the profit may be retained in the business to meet a future contingency, strengthen the financial position, or redeem a long-term liability like debentures. A reserve is an appropriation of profit made to strengthen the financial position of the business. It is not a charge against profit, but it reduces the profit available for distribution among the owners.

A reserve is shown under Reserves and Surplus on the liabilities side of the balance sheet, after capital. Examples are general reserve, workmen compensation fund, investment fluctuation fund, capital reserve, dividend equalisation reserve and reserve for redemption of debentures.

What are the types of reserves?

General and specific reserves

A general reserve is one whose purpose is not specified. It is also called a free reserve, because management can use it for any purpose. It strengthens the financial position of the business.

A specific reserve is created for a specific purpose and can be used only for that purpose. Examples:

1. Dividend equalisation reserve: created to stabilise the dividend rate; it is built up in years of high profit and used in years of low profit.
2. Workmen compensation fund: created to provide for claims of workers due to accidents and similar events.
3. Investment fluctuation fund: created to meet a decline in the value of investments due to market fluctuations.
4. Debenture redemption reserve: created to provide funds for redeeming debentures.

Revenue and capital reserves

Reserves are also classified by the nature of the profit they come from. Revenue reserves come from revenue profits of normal operating activities; all four specific reserves above, and the general reserve, are revenue reserves.

Capital reserves come from capital profits, such as premium on issue of shares or debentures, profit on sale of fixed assets, profit on revaluation of fixed assets and liabilities, profit on redemption of debentures, profits prior to incorporation, and profit on reissue of forfeited shares.

What is a secret reserve?

A secret reserve is a reserve that does not appear in the balance sheet. It is called secret because it is not known to outside stakeholders. It may help to reduce the disclosed profits and also the tax liability. In lean periods, it can be merged with profits to show improved results.

Management may create a secret reserve by charging higher depreciation than required, so that total depreciation charged is higher than the total depreciable cost. It can also be created by:

• undervaluation of inventories (stock);
• charging capital expenditure to the profit and loss account;
• making excessive provision for doubtful debts; and
• showing contingent liabilities as actual liabilities.

Creating secret reserves within reasonable limits is justified on grounds of expediency, prudence and preventing competition from other firms.

Glossary

• Depreciation — the part of the cost of a fixed asset that has expired through use and/or lapse of time; a permanent, continuing and gradual shrinkage in its book value.
• Depreciable cost — the cost of an asset less its net residual value; the total amount charged as depreciation over the asset's useful life.
• Net residual value — the estimated net sale value of an asset at the end of its useful life after disposal expenses; also called scrap or salvage value.
• Useful life — the estimated economic or commercial life of an asset, normally shorter than its physical life.
• Depletion — the decline in value of natural resources such as mines and quarries as material is extracted from them.
• Amortisation — the periodic writing off of the cost of intangible assets such as patents, copyrights, trade marks, franchises and goodwill.
• Straight line method — a method charging a fixed, equal amount of depreciation every year on original cost; also called the fixed instalment method.
• Written down value method — a method charging a fixed percentage on the book value at the start of each year, so the charge falls every year.
• Asset disposal account — an account bringing together the cost, accumulated depreciation and sale proceeds of an asset sold, to show profit or loss on disposal.
• Provision — an amount charged against profit for a known liability or expense of the current period whose amount is not certain.
• Reserve — an appropriation of profit retained in the business to strengthen its financial position or meet future needs.
• Secret reserve — a reserve that does not appear in the balance sheet, created for example by charging more depreciation than required.

Common errors and misconceptions

• Misconception: Depreciation is the fall in the market value of an asset. Correct: Depreciation is based on the cost of the asset consumed, not its market value, and it is charged even when market value is higher than book value.
• Misconception: If an asset is well maintained, depreciation need not be charged. Correct: Depreciation must still be charged, because it is an expired cost that has to be matched against revenue.
• Misconception: Depletion is the term used for intangible assets. Correct: Depletion is used for natural resources such as mines; writing off intangible assets such as patents is amortisation.
• Misconception: The written down value method writes the asset down to zero. Correct: Under this method the depreciable cost cannot be fully written off, and the asset's value can never become zero.
• Misconception: Creating a reserve reduces taxable profit. Correct: A reserve is created from profit after tax and has no effect on taxable profit; a provision, being a charge, reduces it.
• Misconception: Capital reserves are normally created out of free or distributable profits. Correct: They are created mainly out of capital profits, which do not arise from normal operations and are not available for dividend.
• Misconception: Dividend equalisation reserve is a general reserve. Correct: It is a specific reserve, created and used only to keep the rate of dividend stable.

Exam-style questions with model answers

Q1. What is depreciation? State any two of its features. [2 marks]

1. Depreciation is the part of the cost of a fixed asset that has expired on account of its usage and/or lapse of time; it is a permanent, continuing and gradual shrinkage in book value.
2. Features: it is a continuing process, and it is a non-cash expense involving no cash outflow.

Q2. On July 01, 2010, Ashok Ltd. bought a machine for ₹1,08,000 and spent ₹12,000 on installation. Its life is 12 years and its salvage value ₹12,000. Depreciation is by the straight line method and accounts close on December 31. Find the annual depreciation and the machine balance on January 01, 2013. [4 marks]

1. Original cost = ₹1,08,000 + ₹12,000 = ₹1,20,000.
2. Annual depreciation = (₹1,20,000 − ₹12,000) ÷ 12 = ₹9,000.
3. 2010 (6 months, July to December) = ₹9,000 × 6/12 = ₹4,500; 2011 = ₹9,000; 2012 = ₹9,000.
4. Total depreciation to December 31, 2012 = ₹22,500.
5. Balance of machine account on January 01, 2013 = ₹1,20,000 − ₹22,500 = ₹97,500.

Q3. Distinguish between the straight line method and the written down value method on five bases. [5 marks]

1. Basis of charging: straight line uses the original cost; written down value uses the book value, that is, original cost less depreciation charged till date.
2. Annual charge: fixed and constant every year under straight line; highest in the first year and declining every year under written down value.
3. Total charge for depreciation and repairs: unequal and rising in later years under straight line; almost equal every year under written down value.
4. Recognition by income tax law: straight line is not recognised; written down value is recognised.
5. Suitability: straight line suits assets with low repair charges and low possibility of obsolescence, such as patents and trade marks; written down value suits assets affected by technological change that need more repairs over time, such as plant and machinery and vehicles.

Q4. On April 01, 2010, Bajrang Marbles bought a machine for ₹1,80,000, spending ₹10,000 on carriage and ₹10,000 on installation. Its working life is 10 years and scrap value ₹20,000. Using the straight line method, with accounts closed on March 31, find the machine balance after four years if depreciation is charged to the asset account, and the provision balance if a provision for depreciation account is kept. [5 marks]

1. Original cost = ₹1,80,000 + ₹10,000 + ₹10,000 = ₹2,00,000, as carriage and installation form part of cost.
2. Annual depreciation = (₹2,00,000 − ₹20,000) ÷ 10 = ₹18,000.
3. Depreciation for four years (2010-11 to 2013-14) = ₹18,000 × 4 = ₹72,000.
4. Charging depreciation to the asset account: Machine A/c is credited with ₹18,000 each year, so its balance on April 01, 2014 is ₹2,00,000 − ₹72,000 = ₹1,28,000.
5. Keeping a provision account: Provision for Depreciation A/c is credited with ₹18,000 each year, so its balance on April 01, 2014 is ₹72,000, while the machine account stays at ₹2,00,000.
6. Both give the same net book value of ₹1,28,000; only the presentation differs.

Q5. Distinguish between a provision and a reserve. [6 marks]

1. Basic nature: a provision is a charge against profit; a reserve is an appropriation of profit, made after net profit is calculated.
2. Purpose: a provision is made for a known liability or expense of the current period whose amount is not certain; a reserve strengthens the financial position, and some reserves are mandatory under law.
3. Presentation: a provision is deducted from the related asset or shown with current liabilities; a reserve is shown on the liabilities side after capital.
4. Effect on taxable profits: a provision reduces taxable profits; a reserve comes from profit after tax and has no effect on them.
5. Element of compulsion: a provision is necessary under the prudence concept and must be made even without profits; a reserve is generally at management's discretion and cannot be created without profits, though law requires some, such as Debenture Redemption Reserve.
6. Use for dividend: a provision cannot be used for dividend distribution; a general reserve can.

Q6. What is a secret reserve? State three ways of creating it. [3 marks]

1. A secret reserve is a reserve that does not appear in the balance sheet and is not known to outside stakeholders; it reduces disclosed profits and can reduce tax liability.
2. It can be created by charging higher depreciation than required.
3. It can be created by undervaluing inventories or by charging capital expenditure to the profit and loss account.
4. It can also be created by making excessive provision for doubtful debts, or by showing contingent liabilities as actual liabilities.

Key takeaways

• Depreciation is the expired part of the cost of a fixed asset, charged against revenue so that costs are matched with the revenue they help earn.
• Depreciation is based on cost, not market value, and is a non-cash expense that must be deducted before taxable profit is calculated.
• The amount of depreciation depends on cost, estimated useful life and net residual value; depreciable cost equals cost less net residual value.
• The straight line method charges an equal amount on original cost each year, while the written down value method charges a fixed percentage on a falling book value.
• Depreciation is recorded either by crediting the asset account or by accumulating it in a provision for depreciation account, which keeps the asset at original cost.
• An asset disposal account brings together the cost, accumulated depreciation and sale proceeds of an asset sold, and shows the profit or loss on disposal.
• A provision is a charge against profit for a known but uncertain liability, while a reserve is an appropriation of profit that strengthens the business.
• Reserves may be general or specific, and revenue or capital; a secret reserve does not appear in the balance sheet.

Test yourself

Is depreciation a cash expense?

No. Depreciation is a non-cash expense. It involves no cash outflow, because it writes off capital expenditure that has already been incurred.

What are the three factors that decide the amount of depreciation?

The cost of the asset, its estimated useful life, and its probable salvage value, also called net residual value.

A machine is expected to sell for ₹6,000 at the end of its life, with disposal expenses of ₹1,000. What is its net residual value?

Net residual value is ₹6,000 − ₹1,000 = ₹5,000, because disposal expenses are deducted from the expected sale value.

Where is the provision for depreciation shown in the balance sheet?

Either on the liabilities side, or as a deduction from the original cost of the asset on the assets side.

Give the journal entry for creating a provision for doubtful debts.

Profit and Loss A/c Dr. To Provision for doubtful debts A/c, with the amount of the provision required.

Which reserve is created to maintain a stable rate of dividend?

The dividend equalisation reserve. Amounts are transferred to it in years of high profit and used in years of low profit.