Depreciation, Provisions and Reserves

Meaning and Definition

In simple classroom terms, depreciation is the permanent and gradual decrease in the value of a fixed asset. It isn't about the market price going up or down; it's about the asset getting older or outdated.

Formal Definition: Depreciation is the systematic allocation of the cost of a tangible fixed asset over its useful life.

Key Features of Depreciation

• Continuous Process: It happens every year, not just once.
• Non-Cash Expense: No money actually leaves the bank account; it is an accounting entry.
• Applicable to Tangible Assets: Applies to machinery, vehicles, furniture. (Note: Land usually does not depreciate).

Causes of Depreciation

• Wear and Tear: Physical decay due to constant use.
• Effluxion of Time: Loss of value simply because time passes (e.g., lease expiration).
• Obsolescence: When new technology makes the old one useless (e.g., 4G to 5G).
• Depletion: Specifically for natural resources like coal mines.

Factors Determining Depreciation

• Cost of Asset: Total price paid including installation.
• Estimated Useful Life: Years the business expects to use the asset.
• Estimated Scrap Value: The residual/junk value at the end.
• Method of Depreciation: SLM vs WDV.

Examples

• A printing press bought for $10,000 worth $2,000 after 5 years. Depreciation = $8,000.
• High-end servers becoming obsolete due to faster replacements.

A. Straight Line Method (SLM)

Also called the "Original Cost Method." The same amount of depreciation is charged every year.

Example: Machine costs $1,000, scrap $100, life 9 years.
Annual Dep = $(1,000 - 100) / 9 = $100$ per year.

B. Written Down Value Method (WDV)

Also called the "Reducing Balance Method." Depreciation is charged as a percentage of the current book value.

Example: Machine costs $10,000 at 10% WDV.
Year 1: $1,000 (Value becomes $9,000).
Year 2: 10% of $9,000 = $900.

Depreciation can be recorded by charging it directly to the Asset Account or by creating a separate Provision for Depreciation Account.

Common Journal Entries

1. To record depreciation:
   Depreciation A/c ............ Dr
      To Asset A/c

2. To transfer to Profit & Loss:
   Profit & Loss A/c ........... Dr
      To Depreciation A/c
        

Provisions

An amount set aside for a known liability, though the exact amount is uncertain.

• Nature: Charge against profit (mandatory).
• Examples: Provision for Doubtful Debts, Provision for Taxation.

Reserves

Profits kept aside for unknown future needs or financial strengthening.

• Nature: Appropriation of profit (done only if profit exists).
• Examples: General Reserve, Dividend Equalization Reserve.

Difference Table

Secret Reserves

Reserves not disclosed in the balance sheet. Created by:

• Understating Assets: Showing a building at $1M when worth $1.5M.
• Overstating Liabilities: Showing a loan as $50k when it's actually $40k.

Key Formulas

Numerical Problem

Question: Machinery cost $50,000, Scrap $5,000, Life 5 years. Calculate dep. for 3 years using SLM and WDV (20%).

Solution (a) SLM:
Annual Dep = (50,000 - 5,000) / 5 = $9,000.
Total for 3 years = $9,000 × 3 = $27,000.

Solution (b) WDV at 20%:
Year 1: 50,000 × 20% = $10,000 (Value: $40,000)
Year 2: 40,000 × 20% = $8,000 (Value: $32,000)
Year 3: 32,000 × 20% = $6,400 (Value: $25,600)
Total for 3 years = 10,000 + 8,000 + 6,400 = $24,400.

• ERP Software (SAP, Oracle): Automates depreciation based on commissioning dates.
• Tally Prime/QuickBooks: Uses "Depreciation Schedules" for automated monthly posting.
• IFRS/GAAP Standards: IAS 16 ensures global comparability of financial reporting.

Scenario: NovaLogistics invested $500,000 in electric trucks. They chose WDV because battery degradation is fastest in early years.

Action: They created a Provision for Doubtful Debts of $10,000 as a charge against profit due to struggling clients.

Strategy: They sold land for a profit and moved it to a Capital Reserve for a 2025 sorting machine.

Tactics: They undervalued their warehouse by $50,000 to create a Secret Reserve, preventing hostile takeovers by appearing less profitable.

1. Depreciation is a process of: (b) Allocation of cost
2. Which of the following does NOT depreciate? (c) Land
3. In SLM, the amount of depreciation remains: (c) Constant every year
4. WDV is also known as: (b) Reducing Balance Method
5. A provision is created for: (b) Known liabilities of uncertain amount
6. Revenue Reserves are created from: (b) Regular business profits
7. A Secret Reserve is created by: (b) Undervaluing assets
8. Depreciation due to new technology is called: (c) Obsolescence
9. Which of these is a 'Charge against Profit'? (c) Provision for Tax
10. The scrap value of an asset is also known as: (c) Residual value

1. Q: Distinguish between Depreciation and Amortization.
   Ans: Depreciation is for tangible assets (machinery); Amortization is for intangible assets (patents).
2. Q: Why is WDV considered more scientific than SLM?
   Ans: It recognizes higher value loss in early years and balances the total burden (Depreciation + Repairs) over the asset's life.
3. Q: What is the difference between a Provision and a Reserve?
   Ans: Provision is for a known liability (charge against profit); Reserve is for general growth (appropriation of profit).
4. Q: Explain "Effluxion of Time".
   Ans: Value loss based on the expiry of a fixed period, such as a 10-year operation license.
5. Q: Can a company create a reserve if it makes a loss?
   Ans: No, reserves are appropriations of profit. However, provisions must be created even during a loss.
6. Q: What are objectives of a Secret Reserve?
   Ans: Hide strength from competitors and prevent shareholders from demanding excessive dividends.
7. Q: Explain Capital Reserve with an example.
   Ans: Created from non-operational profits. Example: Selling land for $100k bought at $60k; $40k goes to Capital Reserve.
8. Q: How is depreciation treated in the Balance Sheet?
   Ans: Subtracted from Asset value or shown as "Accumulated Depreciation".
9. Q: Calculate SLM Dep: Cost $20k, Scrap $2k, Life 4 yrs.
   Ans: (20,000 - 2,000) / 4 = $4,500 per year.
10. Q: What happens if depreciation is not charged?
    Ans: Assets and Net Profit will be overstated, and the Balance Sheet will not show a "true and fair view".

• Causes of Depreciation: Remember "W.O.E.D" (Wear & Tear, Obsolescence, Effluxion of Time, Depletion).
• Factors of Depreciation: Remember "C.L.S.M" (Cost, Life, Scrap Value, Method).
• Provision vs Reserve: Remember "K.U." (Provision → Known liability; Reserve → Unknown/General).