Learning Objectives
- Understand the meaning, features, and causes of depreciation
- Learn the methods of calculating depreciation: Straight Line Method and Written Down Value Method
- Differentiate between provisions and reserves
- Understand the accounting treatment of depreciation in the books
- Know the factors affecting the amount of depreciation
Key Concepts
Meaning and Causes of Depreciation
Depreciation is the permanent and gradual decrease in the book value of a fixed asset due to use, wear and tear, efflux of time, obsolescence, or any other cause. It is a non-cash expense charged to the Profit and Loss Account to allocate the cost of an asset over its useful life.
Causes of depreciation include:
- Wear and Tear: Physical deterioration due to regular use of the asset.
- Efflux of Time: Decrease in value simply due to passage of time (e.g., patents, leases).
- Obsolescence: An asset becomes outdated due to technological advancements or changes in market demand.
- Accidents: Physical damage to the asset reducing its useful life or value.
- Depletion: Extraction of natural resources (e.g., mines, quarries) reducing the asset quantity.
Factors Affecting Depreciation
Four factors determine the amount of depreciation: (1) Cost of the Asset (original purchase price plus installation, freight, and other incidental charges), (2) Estimated Useful Life (the period for which the asset is expected to be used), (3) Estimated Scrap/Residual Value (the expected value at the end of useful life), and (4) Method of Depreciation chosen by the business.
Depreciable Cost = Cost of Asset - Estimated Scrap Value
Straight Line Method (SLM) / Fixed Instalment Method
Under SLM, an equal amount of depreciation is charged every year throughout the useful life of the asset.
Annual Depreciation = (Cost - Scrap Value) / Useful Life
Or, if the rate is given: Annual Depreciation = (Cost - Scrap Value) x Rate / 100
Advantages: Simple to calculate, equal charge each year, asset can be depreciated to zero. Disadvantage: Does not account for the fact that repairs increase in later years while depreciation remains constant.
Written Down Value Method (WDV) / Diminishing Balance Method
Under WDV, depreciation is calculated at a fixed percentage on the book value (written down value) of the asset at the beginning of each year. Since the book value decreases each year, the depreciation amount also decreases.
Depreciation = Book Value at the Beginning of the Year x Rate / 100
Advantages: Higher depreciation in early years when the asset is more productive; total charge (depreciation + repairs) remains more or less equal over the years. Disadvantage: The asset can never be fully depreciated to zero.
Comparison of SLM and WDV
Under SLM, depreciation amount is constant; under WDV, it decreases each year. SLM is suitable for assets like furniture and buildings; WDV is suitable for machinery and vehicles that lose value faster initially. SLM can reduce asset value to zero; WDV cannot.
Provisions and Reserves
Provision is an amount set aside out of profits for a known liability or expected expense whose exact amount is uncertain (e.g., Provision for Depreciation, Provision for Doubtful Debts, Provision for Taxation). Creating a provision is mandatory and is a charge against profits.
Reserve is an amount set aside out of profits to strengthen the financial position of the business (e.g., General Reserve, Capital Reserve, Dividend Equalisation Reserve). Creating a reserve is voluntary and represents an appropriation of profits. Reserves are available for distribution as dividends, while provisions are not.
Types of Reserves: Revenue Reserve (from operating profits, can be distributed), Capital Reserve (from capital profits like profit on sale of fixed asset, generally not distributed), General Reserve (for general purposes), and Specific Reserve (for a particular purpose like Dividend Equalisation Reserve).
Summary
Depreciation is the systematic allocation of the cost of a fixed asset over its useful life. It is caused by wear and tear, obsolescence, efflux of time, and other factors. The two primary methods are SLM (equal annual charge) and WDV (decreasing annual charge based on book value). Provisions are mandatory charges against profits for known liabilities with uncertain amounts, while reserves are voluntary appropriations of profits to strengthen financial position. Both provisions and reserves play a vital role in presenting a true and fair view of the financial statements.
Important Terms
- Depreciation
- The gradual and permanent decrease in the book value of a fixed asset due to use, time, or obsolescence.
- Straight Line Method
- A method of depreciation that charges an equal amount each year: (Cost - Scrap Value) / Useful Life.
- Written Down Value Method
- A method that charges depreciation at a fixed rate on the reducing book value of the asset each year.
- Scrap Value (Residual Value)
- The estimated value of an asset at the end of its useful life.
- Provision
- An amount set aside from profits for a known liability whose exact amount is uncertain; it is a charge against profit.
- Reserve
- An amount set aside from profits to strengthen financial position; it is an appropriation of profit.
Quick Revision
- Depreciation is a non-cash expense that allocates asset cost over useful life.
- SLM: constant depreciation each year; WDV: decreasing depreciation each year.
- Depreciable Cost = Cost of Asset - Estimated Scrap Value.
- Under WDV, depreciation is calculated on the opening book value, not original cost.
- Provision is a charge against profit (mandatory); Reserve is an appropriation of profit (voluntary).
- Capital Reserve is from capital profits; Revenue Reserve is from operating profits.
- Land is not depreciated; it generally appreciates in value.
Practice Tips
- Practice numerical problems comparing SLM and WDV for the same asset over 4-5 years.
- Always show the Asset Account, Depreciation Account, and Provision for Depreciation Account in T-format.
- Remember: Provision for Doubtful Debts is based on closing debtors AFTER writing off bad debts.
- Clearly differentiate between provision and reserve in theory questions with examples.