UNIT -5

DEPRECIATION, PROVISIONS AND RESERVES

DEPRECIATION
A Meaning:
The term "Depreciation" represents loss or diminution or decrease or decline
in the value of a fixed asset. The decline in the value of an asset occurs due to
wear and tear, obsolescence, effluxion of time or permanent fall in market value.
The word "Depreciation" has been derived from the Latin word Depretum'. 'De'
means decline and 'pretum' means price. Therefore, 'Depretum' means decline in
price.
Inevery business, there are certain assets of afixed nature which are required
for the purpose of business operations. Examples of such assets are Building,
Plant and Machinery, Fumiture, Motor Vehicles, Office equipment such as Computer,
Typewriter, Photocopier machine etc. These assets have a definite span of life. After
the expiry of the life assets willlose their usefulness for the business. The fall in the
value and utility of such assets due to expiry of time, constant use and also due to
obsolescence is termed as depreciation. It also arises because of normal wear and
tear.
In accounting, depreciation is the process of allocating the net cost of fixed
assets over its estimated useful life. Net cost of Fixed Assets means Cost Price
less Scrap value or residual value.

Definitions:
The term depreciation' has been defined by different authorities as under:
According to R. N. Carter"Depreciation is the gradual and permanent decrease
in the value of an asset from any cause.
According to William Pickles "Depreciation may be defined as the permanent
and continuing diminution in the quality, quantity or the value of an asset."
According to Spicer &Peglar"Depreciation is the measure of the exhaustion of
the effective life of an asset from any cause during a given period."
fixed
According to J. R. Batliboi" It is amatter of common knowledge that all
diminish in value
assets such as plant, machinery, building, furniture etc. gradually
use in the business."
as they get older and become' worn' out by constant

Special featureslcharacteristics of Depreciation:

Following are the Special features or characteristics of Depreciation:
(0) Depreciation refers to a permanent, gradual and continuous decrease
in the value of a fixed asset and it continues till the end of the useful
life of the asset.
5.2
THEORY AND PRACTICE OF ACCOUNTANCY
(i) Depreciation is a charge against profit (i.e., revenue earned) for a
particular accounting period.
(ii) Depreciation is always computed in a systematic and
since it is not a sudden loss. rational rnanner
(iv) Depreciation is a process of allocation of expired cost and not of
valuation of fixed assets.
(V) Whatever method for calculating depreciation is followed, the exact
amount can never be ascertained. It can simply be estimated.
(i) The decrease in the value of fixed assets on account of
is of a permanent nature. Once the value of an asset is depreciation
reduced due
to depreciation, it cannot be restored to its original cost.
(vi) Depreciation decreases only the book value of the asset.
(vüü) Depreciation has no relation with the market value.
(ix) The term depreciation is used only in respect of tangible fixed assets.
(x) Total amount of depreciation charged cannot exceed the book value of
the asset.
(xi) Depreciation has no relation with the amount spernt for repairs and
maintenance of aparticular asset.
Causes of Depreciation:
The value of an asset mnay decline due to a number of reasons. These are
discussed as under:

(1) Constant Use : Due to the constant use of an asset, wear and tear is caused
and as a results their value decreases. For example, use of machine in a factory.
As on account of constant use, the value of the machine decreases, it willnot fetch
the same price at which it was purchased, if the machine is sold bythe business.
(2) Expiry (Effluxion) of Time: The value of majority of assets decreases with the
passage of time even if they are not being put to use in the business. Natural forces
such as rain, winds, weather etc. contribute to the deterioration of their values. Again,
after purchasing an asset such as Machinery, Motor car, Furniture etc., ifa business
firm wants to dispose them off after say two years, although the assets were not put
to use, they willnot fetch the same price at which these were originally acquiredonly
because some time has expired or elapsed since the assets were purchased.
(3) Expiry of Legal Rights: There are certain assets over which legal right to use
them is acquired for a fixed period. For example,Lease of Land, Mines, Quarry,
Patent right etc. The right to use such asset is generally acquired for a fixed period
by making lump some payment. For instance, ifa lease of land has been obtained
for 20 years for 4,00,000, it will lose 1/20th, i.e., 20,000 of its value each year
whether it is utilised or not. At the end of 20th year total amount paid for acquirtng
the lease right will have to be written off because after the expiry of 20years, he
land will again belong to the original owner.
 DEPRECIATION 5.3

(4) Obsolescence: Due to new inventions and improvement in existing technologies,

the old assets become obsolete (out dated) and may have to be discarded (replaced)
even if the asset can be used. For example,Computers of older versions become
obsolete as and when new versions are invented. Again, in a competitive market it
is not possible for a manufacturing business to survive if it does not move ahead
with time and the improved technology because persisting with the old technology
may prove to be costly.
(5) Accident: Sometimes, assets may be damaged or destroyed on account of
abnormal reasons such as accident, flood, earthquake, fire etc. For example, a
machine may be damaged or destroyed due to fire, flood, earthquake etc. or a
vehicle may be damaged due to accident. insuch a case it willbe necessary to
depreciate the value of such assets accordingly.
(6) Depletion : Depletion means the decrease in the existing quantity. The decrease
in the value of wasting assets such as mines, oil-wellsetc. occurs due to their
constant extraction. Therefore, it will be necessary to provide for depreciation on
such assets on account of such depletion.

Need, importance or objects of providing depreciation:

Depreciation on fixed assets are provided on account of certain necessities
or keeping in view certain objects. Following are the objects or need for providing
depreciation:
(a) To ascertain the true profit or loss: The true profit of a business can be
ascertained only when allcosts incurred for the purpose of earning revenue have
been charged against revenue. As the assets are used in earning revenues, the
depreciation in the value of an asset is charged to Profit and Loss Account in
order to arrive at the true profit any other, such as wages, salary, rent etc. Unless
the depreciation is charged against revenue, true profit or loss of a business
cannot be ascertained
(b) To show the 'true and fair view' of the financial position: If the depreciation
is not charged, the assets will be shown in the Balance Sheet at an amount
which is in excess of their true values. As such, the Balance Sheet will not
present the 'true and fair view' of the financialposition of a business. Therefore,
in order to present the 'true and fair view of the financial position of a business,
it is important to provide for depreciation.
(c) To ascertain the accurate cost of production: As depreciation is also an
item of expenses, the correct cost of production cannot be calculated unless it
is also taken into account. Sale price is determined on the basis of cost of
production and, hence, if the depreciation is not included in cost of production,
the sale price will be fixed at a lower rate and this will lead to reduced profits.
(d) To provide funds for replacement of assets: Depreciation though debited to
Profit & Loss Account, is not paid in cash like other expenses. Hence, the amount
5.4 THEORY AND PRACTICE OF ACCOUNTANCY
of cash equivalent of depreciation is retained in the business
fund for the and is used to
replacement of fxed assets after the expiry of their
(e) To reduce income-tax liability : Depreciation is an estimated
under the income-tax law. If the depreciation is not charged,allowable
usefpruloide
te
by Profit &Loss Account will exceed the actual profits and the net profit expenditure
tax liability will be more than what it should have actually been. result the Shown
as a
to reduce the payment of income-tax liability, it is Therefore, income
necessary to provide in order
() Other Objectives :If the
Profit & Loss Account will exceed
depreciation.
depreciation is not charged, the net profit shown &
the actual profits and as a result:
(0) Employees may demand an increase in wages and
(l) It may also result in extravagance.
bonus.
(I) It may lead to increase in
the prospective entrepreneurs may find competition in that type of business because
this type of business to be profitable and
thereby increase the competition.
Factors to be considered for determining the amount of
Depreciation:
Although it is impossible to calculate the actual amount of
a particular period, following
factors are considered for determiningdepreciation
the
for
amount of
depreciation:
(a) The Cost of the Asset: The cost of a
fixed asset is determined after adding all
expenses incurred for bringing the assets to usable
freight, transit insurance and installation costs etc. condition. Expenses such as
are examples of expenses which are incurred for a particular asset
incured
Condition. For example, a machine is purchased for for bringing the assets to usable
been spent on packing, ? 3,000 as freight and 80,000 and 6,000 have
the cost of the machine will be 1,000 for wages for installation,
(b) Estimated Useful Life of the (80,000+6,000+3,000+1,000)
Asset : Useful life of an asset is
= 90,000.
terms of number of years for which the assets estimated in
can be effectively used for business
operations. For example, if amachine is expected to work for 15
likely to become obsolete after 10 years years but S
of machine with improved on account of availability of a beter type
years for the purpOse of technology, its useful life will be considered as only 10
(c) Estimated Scrap Value :
calculationof depreciation.
from the sale of the asset after Scrap value means the amount which can be
real
estimated sale value of the assettheatexpiry of its useful life. In other
words, I 1S
residual value or break-up value. It isthe end of their useful life. It is also knowi
depreciation to be charged considered while determining the amouie
purchased for 70,000 and? annually on an asset. For example, a machine is
installation. It is estimated that its3,000 are spent on its
useful freight and 2.000for
period it
will life will be 10 endof which
770,000 (i.e.,have scrap years at the
a value of 5,000. Total case will be
70,000 +? 3,000 + 2,000 depreciation in this
5,000).
a
appliesto propeily
However, this Standard
described in (a) and (b) above. evelop
assets
ormaintain the Charging Depreciation:
or
AMethods of Providing or Charging depreciation' refers to s
The term Methods of Providing
calculating the amount of depreciation to be provided
procedure to be followed for methods for providing depreciation. Each oft
aparticular asset. There are various
for different assets depending upon the nature andh
different methods is suitable business organisation. Various
of the asset and also on the size and nature of the
under:
methods of providingdepreciation are as
Instalment Metho
1. Straight Line Method or Original Cost Method or Fixed
2. DiminishingBalance Method or Reducing Instalment or Written Down
Value Method.
3. Annuity Method.
4. Depreciation Fund Method.
5. Insurance Policy Method.
6. Revaluation Method.
7. Depletion Method.
8. Machine Hour Rate Method.
First two methods i.e. Straight Line Method and Written Down Value Meui
providing depreciation are discussed below.
1. Straight Line Method or Fixed lnstalment:
Straight Line Method or Fixed Instalment method is a method of providing
depreciation under which depreciation is charged at a fixed percentage onthe original
orEqual
Cost of the asset. This method is also known as
instalment method. Under this method the amount Original Cost Meunooicular
of depreciation for a
depreciation
 2202/|-704

DEPRECIATION 5.7

asset remains same from year to year. The amount of depreciation is calculated
by deducting the scrap value from the original cost of the asset and then dividing
the remaining balance by the number of years of estimated life. The depreciation
so calculated and charged annually reduces the original cost of the Asset to zero.
or its scrap value, as the case may be at the end of its estimated ife.
In examination problems, where the rate of depreciation is not stated,
the amount of depreciation is calculated by the following formula:
Cost of machine - Scrap value
Yearly Depreciation= Expected life of the asset
For example, if the Original cost of the asset is ? 1,50,000 and its estimated life
be 10 years, the scrap value being ? 10,000. The depreciation to be written
(1,50,000 -10,000) 7 1,40,000
off will be = =714,000 every year
10 10
Merits of Fixed Instalments Method :
(1) Simplicity: Calculation of depreciation under this method is very simple and
as such the method is widely popular.
(2) Equality of Depreciation Burden : Under this method, equal amount of
depreciation is debited to the Profit and Loss Account of each year. Hence, the
burden of depreciation on each year's net profit is equal.
(3) Assets can be completely written off : Under this method, the book value
of an asset can be reduced to zero, which is not possible under some other
methods.
(4) Knowledge of Original Cost and Upto-date depreciation : Under this method,
the original cost of the asset is shown in the Balance Sheet and the upto-date
depreciation is shown as a deduction from it. As such,the information of Original
Cost of the asset and its upto-date depreciation is available at any time.
Demerits:
(1) Difficulty in Computation: When there are different machines having different
life-spans, the computation of depreciation becomes complicated because the
depreciation on each machine is required to be calculated separately.
(2) Unequal charge against income: Amount of expenses on repais go on
increasing year by year as the asset becomes older but as the equal depreciation
ischarged under this method each year, the total burden charged to Profit and Loss
Account in respect of depreciation and repairs put together willnot be equal each
vear. The total burden willbe lesser in earlier years and heavier during the later year.
(3) Undue pressure in later years: It is a well-known fact that the efficiency and
usefulness of a machine is more in the earlier years in comparison to later years.
As such, more depreciation should be charged in earlier year in comparison to the
later years, whereas, depreciation remains constant from to year under this
method.
 DEPRECIATION 5.37

2. Reducing Instalment Method:

Reducing Instalment Method or Diminishing Balance Method of charging
depreciation is a method under which a fixed rate or percentage of depreciation
is charged each year on the diminishing value of the asset till the amount is
reduced to its scrap value. Diminishing value of the asset means the value
appearing in the asset account after charging the depreciation of earlier year. For
example, the original cost of an asset is 20,000 and the rate of depreciation
is 10%, the diminishing value at the end of 1st year will be ( 20,000- 10%
of ? 20,000) 18,000 and the diminishing value after 2nd year will be
( 18,000- 10% of ? 18,000) 16,200.
Under this method, depreciation is calculated on balance of the asset as
appearing at the beginning of each year. For example, depreciation for 2020 will
be calculated on the balance of the asset at the beginning of 2020 and the
depreciation for 2021 will be charged on the balance of the asset at the
beginning of 2021 and so on. Depreciation under this method for the first year
will be 2,000 and for the 2nd year, it will be 1,800. Under this method, as
the value of asset goes on diminishing year after year, the amount of depreciation
charged every year also goes on diminishingalthough the rate of the depreciation
remains fixed. This method is also known as Written down value method' or
'Reducing balance Method'
Merits :
(1) Easy Calculation: It is easy to calculate the depreciation under this method,
even if some new assets are purchased year after year. Different assets are
grouped for the purpose of providing depreciation.
(2) Equal charge against income :In this method, the total burden on Profit &
Loss Account in respect of depreciation and repairs put together remains almost
equal year after year. This is so because in the initial years depreciation is more
in comparison to repair charges whereas, in the later years, as the asset gets
older, the amount of depreciation goes on decreasing while the expenses on
repairs go on increasing, thus keeping the combined charges of depreciation
and repairs almost uniform.
(3) No undue pressure in later years : The efficiency and usefulness of a
machine is more in the earlier years than in later years. Hence, the depreciation
in first few years should be more in comparison to the later years. This is
ensured by adopting the diminishing balance method.
(4) Balance of asset is never written off to zero: This method ensures that
the asset is never reduced to zero so that some depreciation, however small,
is debited to Profit & Loss Account so long as the asset remains in use.
(5) Permitted under Income Tax Laws:This method of providing depreciation
is permissible under Income Tax Laws.
 ACCOUNTANCY
5.38 THEORY AND PRACTICE OF

Demerits:
value of
Asset cannot becompletely written off:Under this method, the to zero
() and useless, cannot be reduced
obsolete
an asset, even if it becomes in the Asset account.
Some balance, however small, will remain
Interest Factor : As with the original cost method, this method
(2)Omission of of interest on the amount
consideration the loss
invested
also does not take into
in the asset.
method, the
Difficulty in determining the rate of depreciation : Under thisgenerally kept
(3) easily decided. The rate is
be
rate of providing depreciation cannot
long time to write an asset down to
its scrap value.
higher because it takes a very earlier.
the rate of depreciation is kept lower, the asset may become obsolete
If
depreciation not possible:
(4)Knowledge of Original Cost and upto-date
assets is not shown in the Balance
Under this method, the original cost of various
such a way that it becomes difficult
Sheet. Sometimes, the assets are grOuped in
of some assets may continue
toknow their specific identity. The residue balance
actually scrapped.
in the Balance Sheet even after they have been
Suitability :
:
This method is very suitable in case of assets which
(a) have a comparatively long life; and
assets become
(b) require considerable repairs in the later years when the
older, such as building, plant, etc.
Meaning of Book value:
Book value of an asset means the value or the amount which appears in
the account of that asset in the ledger. Where the depreciation is charged to
the asset account, the book value is the written down value. Again, where the
depreciation is not charged to the asset account, the book value is equal to the
original cost.

Distinction between Fixed Instalment method and Reducing Instalment

method:

Points of Fixed Instalment Reducing Instalment

distinction Method Method

1. Amount of The amount of depreciation The amount of depreciation

Depreciation remains same for every goes on decreasing every
year. year.
 DEPRECIATION 5.39

Points of Fixed Instalment Reducing Instalment

distinction Method Method

2. Basis of Depreciation is calculated on Depreciation is calculated on

calculation the original cost of the asset. the diminishing balance of
the asset each year.

Book value of the asset is Book value of the asset never

3. Book Value becomes zero under this
reduced to zero under this
method.: method.

Total amount of depreciation Total amount of depreciation

4. Effect on and repairs become almost
Profit and Loss and repairs goes on
increasing each year. equal each year. Therefore,
Therefore, the combined the combined effect on the
Profit and Loss Account is
effect on Profit and Loss
Account is unequal in each almost equal under this
method.
year under this method.

5. Suitability This method is suitable for This method is suitable for

assets of lesser value such assets having longer life and
as patents, furniture and more value such as Building,
fixtures etc. Plant and Machinery etc.

NOTE
depreciation,
It may be noted that the entries for charging
providing depreciation, Disposal of Assets etc. under
various situations under Diminishing Balance System The will
Method.
be the same as in the case of Straight Line
only difference lies in the procedure for calculation of
mount of depreciation