Chapter-7

Depreciation ,Provisions &reserves

 Meaning of depreciation
• It is a permanent continuing and gradual
shrinkage in book value of fixed assets.
• It is based on cost of asset not on market
value.
• According to ICMA, LONDON ,The depreciation
is diminution in intrinsic value of asset due to
use and/or lapse of time.
• Depreciation has significant effect in
determining and presenting the financial
position of the firm.
• Eg of depreciable assets are:
I. Machine
II. Plant
III. Furniture
IV. Buildings etc…
 Features of depreciation
• Decline in book value of assets
• Includes loss due to effluxion on time.
• Continuing process.
• As it is expired cost ,so it must be deducted
before calculating taxable profit.
• It is a non cash expense.
 Similar terms
• Depletion : extraction of natural resources
that reduces the availability of quantity of
material.
• Amortization : writing off cost of intangible
assets.
 Causes of depreciation
• Wear &tear due to use or passage of time
Detoriation arising from the use in business
operations.
• Expiration of legal rights: assets lose their value after
completion of predetermined period
• Obsolescence : technological changes, improvement
in production methods, changing demand conditions.
• Abnormal factors: accidents due to fire, earthquake
etc
 Need for depreciation

• Matching cost and revenue: it is a charge

against revenue for corresponding period and
must be deducted before arriving net profit.
• Consideration of tax :it is a deductable cost
before calculating tax.
• True and fair financial position :the asset will be
over valued if depreciation is not calculated
• Compliance with law: it has become
compulsory by law to corporate
 Factors affecting depreciation
• Cost of asset: cost of asset include invoice price and
other costs. It also includes
freight,transportation,insurance, installation cost etc..
• Estimated residual value :also known as scrap value or
salvage value is the net realisable value of asset it is
calculated after deducting the expenses necessary for
disposal of asset.
• depreciable cost: It is the cost of asset – net residual
value.
• Estimated useful life :estimated economic or commercial
use of asset is called estimated useful life.
 Methods of calculating depreciation
• Straight line method
• Written down value method
• Annuity method
• Depreciation fund method
• insurance policy method
• Sum of years method
• Double declining method
 Selection of appropriate method
• Type of asset
• Nature and use of asset
• Circumstances of company
 Straight line method
• Earliest method of depreciation
• Assumption of equal usage of asset over the
useful life.
• Also called fixed installment method, fixed
percentage method, original cost method.
• Formula: depreciation= cost of asset-net
residual value/useful life of asset.
• Rate of depreciation= amount of
depreciation/accquistion cost *100.
 advantages
• Simple and easy to understand.
• Depreciated up to scrap value.
• Every year same amount is charged as
depreciation.
• Use of asset is consistent.
 limitations
• Faulty assumption of same amount.
• Work efficiency of asset decreases and
maintenance charges increases.
 Written down value method
• Charged on book value of asset
• Also known reducing balance method or
diminishing balance method.
• The amount of depreciation reduces year after
year.
 advantages
• Realistic assumption
• Accepted by income tax authorities.
• Loss due to obsolesce is reduced
• Suitable for fixed asset last for long time.
LIMITATIONS:
• The value will not become zero.
• Difficult to ascertain rate of depreciation.
 difference
Straight line method
• Original cost
• Fixed amount throughout
the year
• Total charge increases every
year
• Not recognized by income
tax authorities.
• Suitable for less repair
charges
Written down value
• Book value
• Declines year after year
• Almost equal every year
• Recognized by income tax
authorities.
• Suitable for asset which are
affected by technology
 Method for recording transaction
Charging depreciation to asset account

• Purchase of asset entry

• Asset a/c dr
• to cash/vendor/bank
• Deducting depreciation from asset
• Depreciation a/c dr
• to asset a/c
• Transfer of depreciation to p&l account
• P&l a/c dr
• to depreciation a/c
• Balance sheet treatment
• Asset balance appear as net book value.
 Creating provision for
depreciation/accumulated depreciation account

• Purchase of asset entry

• Asset a/c dr
• to cash/vendor/bank
• Depreciation to provision of depreciation
• Depreciation a/c dr
• to provision of depreciation a/c
• Transfer of depreciation to p&l account
• P&l a/c dr
• to depreciation a/c
• Balance sheet treatment
• Asset balance remain original cost less provission of depreciation
• Or
• Provision for depreciation on liability side.