CBSE Class 11 Accountancy Depreciation Provisions And Reserves Notes

“Depreciation is gradual and permanent decrease in the value of an asset from any cause.” – Carter

Introduction:

Every fixed asset loses its value due to use or other reasons. This decline in the value of asset is known as depreciation

. Meaning of Depreciation:

Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets.

Features of Depreciation:

(1) It is decline in the book value of fixed assets.

(2) It is a continuing process.

(3) It includes loss of value due to efflux ion of time, usage or obsolescence.

(4) It is an expired cost and must be deducted before calculating taxable profit.

Causes of Depreciation:

(1) Wear and tear due to use or passage of time.

(2) Obsolescence.

(3) Expiration of legal rights.

(4) Abnormal factors.

Need or Objectives of Depreciation:

(1) To ascertain the true profit or loss.

(2) For consideration of tax.

(3) To ascertain the true and fair financial position.

(4) Compliance with legal provisions. 

Factors or Basis for providing Depreciation:

(1) Cost of asset.

(2) Estimated net residual value.

(3) Depreciable cost.

(4) Estimated useful life.

Methods of calculating Depreciation:

(1) Straight line method (Fixed installment method):

This method is based on the assumption of equal usage of time over asset‟s entire useful life. According to this method a fixed and equal amount is charged as depreciation in every accounting period during the life time of an asset. Depreciation amount can be calculated by the following formula:

(2) Written Down value method(Diminishing balance method):

In this method depreciation is charged on the book value of tha asset. The amount of depreciation reduces year after year.

Difference between Straight line method and written down value method:

Methods of recording Depreciation:

(1) When depreciation is charged to asset account:

In this method depreciation is deducted from the asset value and charged (debited) to profit and loss account. Journal entries for recording under this method are as follows.

(a) For purchase of an asset

           Asset A/c Dr.

               To Bank/ vendor A/c

                            (With the cost of an asset including installation expenses, freight etc.)

(b) Following entries are recorded at the end of each year

            (i) Depreciation A/c Dr.

                    To Asset A/c

                    (With an amount of depreciation)

(ii) Profit and loss A/c Dr.

            To Depreciation A/c

                       (With an amount of depreciation)

(2) When provision for depreciation/Accumulated depreciation account is maintained:

Following journal entries are recorded at the end of each year.

Depreciation means the gradual decrease in the book value of a fixed asset over time because of regular usage, wear and tear, or passage of time, until it is no longer usable. This process spans the estimated productive lifespan of the asset. Once an asset goes past this functional life, using it further is typically no longer economical for the business.

Causes of Depreciation

• Constant Usage: Operating fixed assets, such as vehicles or machinery, over extended periods naturally causes physical wear and tear.
• Effluxion of Time: Exposure to natural elements or natural disasters can lead to degradation, such as the erosion of land or the rusting of metal machinery parts over time.
• Obsolescence: Technological advancements can make existing machinery obsolete, requiring businesses to discard and replace them with modern alternatives.

Need for Depreciation

• Presenting a Fair View: It ensures financial statements reflect realistic asset values instead of inflated historical costs. Since market values fall over time, recording this decline is essential to determine precise net profits or losses.
• Retention of Funds: Accounting for depreciation helps retain cash within the enterprise. Without it, profits might be overstated, leading to excessive dividend distributions to shareholders.
• Matching Cost and Revenue: It spreads the asset's cost over its useful life, matching the expense of deterioration against the revenue generated, rather than treating the purchase cost as a single one-time expense.
• Asset Replacement: It allows businesses to accumulate funds over time to replace worn-out machinery when its useful life ends.
• Tax Savings: Recording depreciation reduces taxable income. Ignoring it leads to overstated profits and higher tax liabilities, so proper accounting helps prevent unnecessary tax payments.

Importance of Depreciation

• Determining Accurate Profits: A business can only calculate its actual net profit or loss by matching all expenses incurred to generate revenue, including depreciation, against that revenue.
• Reflecting True Financial Position: Without depreciation, fixed assets appear on the balance sheet at values higher than their actual worth, misrepresenting the company's true financial health.
• Preventing Excess Tax Payments: Failing to debit depreciation to the Profit and Loss Account artificially inflates the net profit, resulting in higher tax outlays.

Factors Affecting Depreciation

• Acquisition Cost: The total purchase cost of the asset, which is directly proportional to the amount of depreciation charged.
• Estimated Useful Life: The period over which the asset is expected to be functional, which determines how the cost is distributed.
• Estimated Scrap Value: The residual value expected at the end of the asset's useful life, which reduces the depreciable base.

Methods of Calculating Depreciation

• Straight-Line Method
• Written-Down Value Method

Meaning of Reserve

Reserves are funds set aside from net profits and accumulated surpluses to strengthen the financial position and address future unforeseen contingencies. Essentially, they help a business handle unexpected losses or unknown liabilities.

Types of Reserves

• Revenue Reserves: These are created out of profits generated from normal business operations. Instead of being distributed as dividends to owners or shareholders, they are retained to fund ongoing operations or expansion.
• Capital Reserves: These are built from capital profits (non-operational gains). They are used to prepare the organization for capital-intensive events like business expansion, funding new ventures, or writing off capital losses.

Meaning of Provision

A provision represents an amount retained from profits to cover a known liability or anticipated loss, the exact value of which cannot be estimated with absolute accuracy.

Features of Provision

• It is established to cover a specific, anticipated liability.
• Although the obligation is certain, its exact financial value cannot be calculated with absolute precision.
• It is treated as a charge against profit, thereby directly reducing the net profit of the financial year in which it is established.

Difference Between Provisions and Reserves

Difference Between Revenue Reserve and Capital Reserve

Difference Between General Reserve and Specific Reserve