Depreciation, Provisions and Reserves Class 11 Notes

Depreciation is a systematic allocation of the cost of a tangible or intangible fixed asset, other than land, over its useful life. It is an expense of the period in which the benefit is consumed, and it continues for as long as the asset is held, whether or not the business measures profit on a cash basis.

• Wear and tear: the physical use of the asset in production or transport.
• Efflux of time: even an unused machine loses value simply as it ages and becomes obsolete.
• Obsolescence: technological change makes a machine outdated, or its design goes out of fashion.
• Other causes: accidental damage, exhaustion of the natural resources in a mine, and legal or contractual limits on the use of an asset.
• Factors affecting the amount: cost of the asset, estimated scrap or residual value, estimated useful life, and the method of depreciation adopted.

The rationalised syllabus retains exactly two methods and excludes any change of method during the life of an asset, so there is no compounding adjustment to learn. Each method produces a different book value each year from the same cost and the same scrap value.

• Straight line method: an equal charge each year, so the total of the charges equals cost less scrap value exactly, and the asset reaches scrap value at the end of its life.
• Written down value method: a fixed percentage of the declining book value, so the total of the charges is normally less than cost less scrap value and the book value falls quickly at first.
• Advantages of SLM: equal charge each year, simple to calculate, suitable where the benefit from the asset is uniform over its life, and it makes the charge match the expense.
• Advantages of WDV: a heavier charge in the early years when the asset is most productive, it reflects the true fall in market value more closely, and it provides a larger reserve for a larger replacement.
• SLM is preferred where the asset gives equal benefit over its life, and WDV where the benefit is greater in the earlier years.

Having calculated the charge, the question is where to put it. There are two treatments, and they produce different balance sheet figures for the same asset, so the method must be stated in the answer.

• Charging depreciation directly to the asset account: the asset account is reduced each year, so the balance sheet shows the net book value in a single line and no separate provision appears.
• Creating a provision for depreciation, also called accumulated depreciation: a separate account accumulates the charges, and the balance sheet shows the original cost on the asset side and the accumulated provision as a deduction.
• The charge itself is debited to depreciation in the profit and loss account in both methods, so the expense is identical and only the presentation differs.
• The provision for depreciation account is credited for each year's charge and debited on disposal, and it is a contra asset, never a liability to the business.

On disposal, the asset leaves the business, the accumulated depreciation on it is written off, and the resulting profit or loss is transferred to the profit and loss account. Three figures decide whether the result is a gain or a loss, and getting all three right is the whole of the question.

• Book value on the date of disposal: the original cost less the accumulated depreciation charged up to that date.
• Cash received from the buyer: the sale proceeds, which may be for cash or in part payment.
• Profit on disposal: proceeds greater than book value. Loss on disposal: proceeds less than book value.
• If the asset is sold for exactly its book value there is neither profit nor loss, and the entry simply removes the cost and the accumulated depreciation.

A provision is created for a known liability whose amount is uncertain, so it is a liability. A reserve is an appropriation of profit, retained inside the business for a purpose, so it is not a liability to anyone and is part of capital. This single distinction organises the whole of the section.

• Provision: a charge against profit for a liability that is outstanding and unascertained in amount, such as provision for doubtful debts, outstanding expenses and provision for tax.
• Reserve: a deliberate appropriation of profit, made after the profit and loss appropriation account, and never a charge against the cost of running the business.
• Provisions are created before the appropriation of profit; reserves can be created only out of profit.
• A provision reduces profit, a reserve does not reduce the profit earned; it only distributes it.

The rationalised syllabus asks for five types of reserve, and each is defined by what it is for and by where the money originally came from.

• General reserve: a reserve kept for no particular purpose, created out of general profits, used to meet unforeseen losses or to declare dividends.
• Specific reserve: a reserve created for a defined purpose, such as a reserve for dividend, a reserve for tax or a reserve for buildings, so that profit is not tied up in a particular object.
• Secret reserve: a reserve concealed from the financial statements, created by showing assets at a lower figure than cost or by making excessive provisions. It is undisclosed and retained entirely within the business.
• Revenue reserve: a reserve created out of revenue profits of an operating nature, such as general reserve, reserve for dividend, reserve for buildings and secret reserve.
• Capital reserve: a reserve created out of capital profits, that is, a gain on the sale of a fixed asset or a long-term investment. It cannot be distributed as dividend, because it did not arise from revenue.