Depreciation, Provisions and Reserves

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Accountancy Class XI (Financial Accounting Part I), Chapter 7.

Why one delivery van should not wipe out one year's profit

Kabir runs a courier service and buys a van for ₹6,00,000. The van will earn money for five years. If Kabir charges the whole ₹6,00,000 as an expense in year one, that year shows a huge loss and the next four years look unusually rich. Neither picture is true. The van was used up a little each year, and each year's profit should carry only its own share of that cost.

That share is depreciation. The second half of the chapter deals with a related question: when a firm keeps money back in its books, is it a cost (a provision) or a choice about profit (a reserve)? Getting this one distinction right is worth several marks every year.

What depreciation is, and what causes it

Depreciation is the permanent, continuing and gradual fall in the book value of a fixed asset because of use, passage of time or obsolescence. Four features matter for the exam. It lowers the book value. It is permanent and continuous. It is based on the cost of the asset, not its market value. And it is a non-cash expense: it reduces profit, but no money leaves the business when it is recorded.

Why account for it at all? Four reasons. It matches the cost of the asset with the revenue the asset helps earn. It gives a true and fair picture, because an old machine shown at its full cost would overstate the assets. It is a deductible expense for tax. And the law expects it.

Depreciation, depletion and amortisation. NTA likes to swap these words. The idea is the same (writing off a cost over time) but the asset differs.

Three factors decide the amount

Every depreciation calculation uses three inputs.

The amount that is actually spread over the life is the depreciable cost.

$$\text{Depreciable cost} = \text{Cost of asset} - \text{Net residual value}$$

Worked example: finding the cost and the SLM charge. A firm buys a machine with invoice price ₹3,20,000. It pays freight ₹12,000, transit insurance ₹3,000 and installation ₹15,000. In the first year it also pays ₹8,000 for maintenance. It expects to sell the machine for ₹40,000 after 10 years, paying ₹4,000 to dismantle it. Find the annual depreciation by the straight line method.

Common wrong step. Starting from the invoice price alone (₹3,20,000) and missing freight, insurance and installation, or using ₹40,000 as the residual value. Anything spent to bring the asset to working condition goes into cost, and only the net scrap value is deducted.

Two methods: straight line and written down value

The straight line method (SLM) charges the same amount every year.

$$\text{Annual depreciation (SLM)} = \dfrac{\text{Cost} - \text{Net residual value}}{\text{Estimated useful life}}$$

The written down value method (WDV), also called the reducing balance method, applies a fixed percentage to the book value at the start of each year. Because the book value keeps falling, the charge falls every year too. If the rate is not given, it can be found from the cost $c$, the scrap value $s$ and the life $n$ years.

$$R = \left[1 - \sqrt[n]{\dfrac{s}{c}}\right] \times 100$$

Worked example: SLM and WDV side by side. A machine costs ₹1,00,000, has a life of 5 years and a residual value of ₹10,000. Show the charge and the book value each year under SLM and under WDV at 20%.

SLM charge: (1,00,000 − 10,000) ÷ 5 = ₹18,000 every year. WDV charge: 20% of the opening book value.

SLM brings the book value down to exactly the residual value, ₹10,000. WDV leaves ₹32,768, and it would keep leaving something however long you continued.

Common wrong step. Charging 20% on the original ₹1,00,000 every year. That gives a constant ₹20,000 and is really SLM at 20% on cost. Under WDV the 20% must be applied to the reducing balance. Another slip is to deduct the residual value before applying the WDV rate, which the method does not do.

Pause and predict: under WDV at 10%, will the book value of an asset ever become exactly zero?

Check your answer: no. Each year you remove 10% of what remains, so 90% is always left. The balance shrinks towards zero but never reaches it, which is why a firm using WDV either sells the asset or writes off the last balance at disposal.

Quick check: finding the WDV rate. An asset costs ₹1,00,000. Its scrap value after 4 years is ₹6,250. Find the rate of depreciation under WDV.

Common wrong step. Forgetting the root and using $1 - s/c$, which gives 93.75%.

Which method suits which asset? SLM suits assets with little repair and little obsolescence, such as land, buildings and patents. WDV suits assets that need heavy repairs or become obsolete quickly, such as plant and vehicles.

Beyond the textbook. For the exam: SLM is not recognised by Income Tax law, WDV is. In reality: the Income Tax Act computes depreciation on the written down value of blocks of assets at prescribed rates, which is the idea behind that statement. In company books the Companies Act allows either SLM or WDV. Why it matters: a firm's depreciation in its books and the depreciation allowed for tax can differ.

Recording depreciation: two ways

Method A: charge it to the asset account. Each year the asset account is credited, and the asset appears at its net book value.

Method B: create a Provision for Depreciation Account (also called Accumulated Depreciation). The asset stays at its original cost and the provision account collects the yearly charges. The balance sheet shows the asset at cost less the provision. Method B is more informative because the original cost is still visible.

Worked example: the same asset, both methods. A machine costs ₹1,00,000 and is depreciated at ₹10,000 a year. Show the entries for two years and the balance sheet after year 2.

Method B changes only the credit. In each year, Depreciation A/c Dr 10,000 and To Provision for Depreciation A/c 10,000, with the same transfer to Profit and Loss.

The balance sheet figure is the same. Only the information differs.

Common wrong step. In Method B, crediting the Machinery account anyway. The whole point of the provision is that the asset keeps its original cost.

Beyond the textbook. For the exam: depreciation is a non-cash expense. In reality: charging depreciation does not put any cash aside. The cash stays in the business and gets used, so replacing the machine later needs money from profits or a loan unless the firm deliberately invests funds for it. Why it matters: a question may ask "does recording depreciation reduce cash?" and the answer is no.

Disposal of an asset

When an asset is sold, a single Asset Disposal Account collects everything about it. The original cost goes to its debit. The accumulated depreciation and the sale proceeds go to its credit. The balancing figure is the profit or loss, moved to Profit and Loss.

$$\text{Profit or loss on sale} = \text{Sale proceeds} - (\text{Cost} - \text{Accumulated depreciation})$$

A positive answer is a profit and a negative one is a loss.

Worked example: a machine is sold. A machine costing ₹4,00,000 has accumulated depreciation of ₹1,80,000 and is sold for ₹2,50,000. Pass the entries and find the profit or loss.

Common wrong step. Comparing the sale price with the original cost: 2,50,000 − 4,00,000 looks like a loss of ₹1,50,000. The asset was already written down by ₹1,80,000 in earlier profits, so only the book value of ₹2,20,000 is compared.

Worked example: an asset destroyed by fire. Plant costing ₹2,00,000 with accumulated depreciation of ₹80,000 is destroyed by fire. The insurance company settles the claim at ₹1,00,000. Find the loss.

Common wrong step. Treating the whole book value of ₹1,20,000 as the loss and forgetting the insurance claim.

Additions to an asset. If an addition becomes an integral part of an existing asset, it is depreciated over the remaining useful life of that asset. If it has a separate identity, it is depreciated over its own useful life.

Provisions and reserves: charge or appropriation?

Both are amounts kept back in the books, but the logic is opposite.

A provision is an amount set aside for a known liability or loss whose exact amount cannot yet be measured, such as depreciation, doubtful debts, discount on debtors or taxation. It is debited to the Profit and Loss Account, so it is a charge against profit and reduces profit before it is worked out.

A reserve is a part of profit kept back to strengthen the business or to meet future needs. It is made from profit that has already been calculated, so it is an appropriation of profit. It appears on the liabilities side after capital.

Worked example: charge or appropriation? A firm earns ₹2,00,000 before provision. Debtors are ₹1,20,000 and it makes a 5% provision for doubtful debts. It then transfers ₹50,000 to general reserve. Show the effect on profit and pass the entries.

Common wrong step. Calling the Provision for Doubtful Debts a reserve because "money is kept aside". It is a charge against profit and is made even in a loss year.

Pause and predict: a firm makes a loss this year. Can it still create a provision for doubtful debts? Can it create a general reserve?

Check your answer: it can create the provision, because a provision is a charge and does not depend on profit. It cannot create a general reserve, because a reserve is taken out of profit and there is none.

Kinds of reserves

A capital reserve can be used to write off capital losses or to issue bonus shares, but not to pay a dividend.

A secret reserve is not disclosed on the balance sheet. It is created by understating profit, for example by charging excessive depreciation, undervaluing stock, treating capital expenditure as revenue or making excessive provisions. It hides the true financial position, so joint stock companies may not create one.

Beyond the textbook. For the exam: a secret reserve is built by understating profit or assets, and companies are not allowed to keep one. In reality: accounts are expected to give a true and fair view, and audited company accounts must disclose their reserves. A hidden reserve misleads shareholders and lenders, because it makes a healthy year look weak. Why it matters: every method on the list pushes in the same direction, towards lower profit or lower assets than the facts support, so a question that offers "excessive depreciation" as a cause is right and "insufficient depreciation" is wrong.

Exam traps

Formats and formula sheet

Entries at a glance.

60-second revision

Where this chapter connects

• Previous: Trial Balance and Rectification of Errors covers the capital against revenue error that decides whether a cost is depreciated or expensed.
• Earlier idea reused: Theory Base of Accounting introduced historical cost and the matching principle, which depreciation applies to fixed assets.
• Next: Financial Statements I shows where depreciation, provisions and reserves appear in the Trading and Profit and Loss Account and the Balance Sheet.
• Then: Financial Statements II treats depreciation and provision for doubtful debts as year end adjustments.
• Class XII link: Financial Statements of a Company shows reserves and surplus as a part of shareholders' funds.