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Depreciation, Provisions and Reserves Matching principle requires that the revenue of a given period is matched against the expenses for the same period. This ensures ascertainment of the correct amount of profit or loss. If some cost is incurred whose benefits extend for more than one accounting period then it is not justified to charge the entire cost as expense in the year in which it is incurred. Rather such a cost must be spread over the periods in which it provides benefits. Depreciation, which is the main subject matter of the present chapter, deals with such a situation. Further, it may not always be possible to ascertain with certainty the amount of some particular expense. Recall that the principle of conservatism (prudence) requires that instead of ignoring such items of expenses, adequate provision must be made and charged against profits of the current period. Moreover, a part of profit may be retained in the business in the form of reserves to provide for growth, expansion or meeting certain specific needs of the business in future. This chapter deals with two distinct topics and hence is being presented in two different sections. First section deals with depreciation and second section deals with provisions and reserves.
Now you are aware that fixed assets are the assets which are used in business for more than one accounting year. Fixed assets (technically referred to as “depreciable assets”) tend to reduce their value once they are put to use. In general, the term “Depreciation” means decline in the value of a fixed assets due to use, passage of time or obsolescence. In other words, if a business enterprise procures a machine and uses it in production process then the value of machine declines with its usage. Even if the machine is not used in production process, we can not expect it to realise the same sales price due to the passage of time or arrival of a new model (obsolescence). It implies that fixed assets are subject to decline in value and this decline is technically referred to as depreciation. As an accounting term, depreciation is that part of the cost of a fixed asset which has expired on account of its usage and/or lapse of time. Hence, depreciation is an expired cost or expense, charged against the revenue of a given accounting period. For example, a machine is purchased for Rs.1,00,000 on April 01, 2005. The useful life of the machine is estimated to be 10 years. It implies that the machine can be used in the production process for next 10 years till March 31, 2015. You understand that by its very nature, Rs. 1,00,000 is a capital expenditure during the year 2005. However, when income statement (Profit and Loss account) is prepared, the entire amount of Rs.1,00,000 can not be charged against the revenue for the year 2005, because of the reason that the capital expenditure amounting to Rs.1,00,000 is expected to derive benefits (or revenue) for 10 years and not one year. Therefore, it is logical to charge only a part of the total cost say Rs.10,000 (one tenth of Rs. 1,00,000) against the revenue for the year 2005. This part represents, the expired cost or loss in the value of machine on account of its use or passage of time and is referred to as ‘Depreciation’. The amount of depreciation, being a charge against profit, is debited to the profit and loss account.
7.1.1 Meaning of Depreciation
Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value. According to Institute of Cost and Management Accounting, London (ICMA) terminology “ The depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time.”
Accounting Standard-6 issued by The Institute of Chartered Accountants of India (ICAI) defines depreciation as “a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change. Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is pre-determined”.
Questions for Practice
1. What is ‘Depreciation’?
2. State briefly the need for providing depreciation.
3. What are the causes of depreciation?
4. Explain basic factors affecting the amount of depreciation.
5. Distinguish between straight line method and written down value method of calculating depreciation.
6. “In case of a long term asset, repair and maintenance expenses are expected to rise in later years than in earlier year”. Which method is suitable for charging depreciation if the management does not want to increase burden on profits and loss account on account of depreciation and repair.
7. What are the effects of depreciation on profit and loss account and balance sheet?
8. Distinguish between ‘provision’ and ‘reserve’ .
9. Give four examples each of ‘provision’ and ‘reserves’.
10. Distinguish between ‘revenue reserve’ and ‘capital reserve’.
11. Give four examples each of ‘revenue reserve’ and ‘capital reserves’.
12. Distinguish between ‘general reserve’ and ‘specific reserve’.
13. Explain the concept of ‘secret reserve’.
1. Explain the concept of depreciation. What is the need for charging depreciation and what are the causes of depreciation?
2. Discuss in detail the straight line method and written down value method
of depreciation. Distinguish between the two and also give situations where they are useful.
3. Describe in detail two methods of recording depreciation. Also give the necessary journal entries.
4. Explain determinants of the amount of depreciation.
5. Name and explain different types of reserves in details.
6. What are ‘provisions’. How are they created? Give accounting treatment in case of provision for doubtful Debts.
Please refer to attached file for NCERT Class 11 Accountancy - Depreciation, Provision and Reserves