Depreciation, Provisions and Reserves

Depreciation is the gradual, permanent fall in the value of a fixed asset due to use, passage of time or obsolescence. A machine that cost Rs 1,00,000 will not be worth that after five years of work — part of its value has been "used up" in earning revenue. Depreciation spreads the cost of the asset over its useful life.

It is charged only on fixed assets (machinery, building, furniture, vehicles), not on current assets. Land is usually not depreciated (its life is unlimited).

The main causes of depreciation are:

• Wear and tear — physical use in production.
• Passage of time — some assets lose value with time even if unused (and rights like a lease or patent expire).
• Obsolescence — the asset becomes outdated due to new technology or changed demand.
• Depletion — for natural resources (mines, quarries) that get exhausted.

Why provide for depreciation at all? Four reasons:

• To find the true profit — depreciation is an expense of using the asset (the matching concept).
• To show the asset at its true value in the balance sheet (cost less depreciation).
• To provide funds for replacement when the asset wears out.
• To comply with law (the Companies Act requires it).

Two related terms: amortisation (writing off intangible assets like goodwill or patents) and depletion (writing off wasting natural resources). All three share the same idea — spreading an asset's cost over the period it benefits.

Two methods of charging depreciation dominate the syllabus.

1. Straight Line Method (SLM) — also called the fixed instalment method. The same amount is charged every year. The formula is:

Depreciation = (Cost − Scrap value) ÷ Useful life

For example, a machine costing Rs 1,00,000 with scrap value Rs 10,000 and life 5 years gives depreciation = (1,00,000 − 10,000) ÷ 5 = Rs 18,000 every year. Under SLM the asset can be reduced to zero (or scrap) at the end of its life. The annual rate = (annual depreciation ÷ cost) × 100.

2. Written Down Value Method (WDV) — also called the diminishing/reducing balance method. A fixed percentage is charged each year on the reducing book value, so the rupee amount falls year by year. For a machine of Rs 1,00,000 at 10% WDV:

The two differ sharply: SLM charges an equal amount and suits assets that wear evenly (furniture); WDV charges more in early years and suits assets needing heavy repairs later or quick obsolescence (machinery, vehicles, computers). Under WDV the book value never quite reaches zero.

When an asset is sold (disposed of), we compare its book value on the date of sale with the sale price:

• Sale price > book value → profit on sale (credited to P&L).
• Sale price < book value → loss on sale (debited to P&L).

For example, a machine with book value Rs 30,000 sold for Rs 35,000 gives a profit of Rs 5,000; sold for Rs 26,000 gives a loss of Rs 4,000. (Remember to charge depreciation up to the date of sale first.)

Change of method. An entity may change its depreciation method (say SLM to WDV), but consistency demands this be done only for valid reasons and disclosed; usually the change is applied with retrospective effect and any short/excess depreciation adjusted.

Two final, often-confused terms:

A provision is compulsory and reduces profit to show the true position; a reserve is a part of profit set aside voluntarily to make the business stronger. A reserve created for a specific purpose is a specific reserve; one for general strength is a general reserve. Mastering depreciation, provisions and reserves means your fixed assets and profits finally tell the truth — the bridge to preparing final accounts.