Chapter Overview — Depreciation, Provisions and Reserves
Fixed assets such as machinery, furniture, buildings, and vehicles are used in business over several years. Their value does not remain the same — it decreases over time due to use, wear, and other factors. This decrease is called depreciation. Recording depreciation is essential to show a true picture of the financial position. This chapter also covers provisions and reserves — amounts set aside from profits for specific purposes.
After studying this chapter, you will be able to:
- Define depreciation and explain its causes and need
- Calculate depreciation using the Straight Line Method (SLM) and Written Down Value Method (WDV)
- Pass journal entries for depreciation and disposal of assets
- Distinguish between provisions and reserves
- Explain the types of provisions and reserves
Meaning of Depreciation
Depreciation is the gradual, permanent, and continuing decrease in the value of a fixed asset due to:
- Wear and tear from use
- Passage of time
- Obsolescence (becoming outdated)
- Depletion (for natural resources)
It is important to note that depreciation is a non-cash expense — no cash is paid out when depreciation is recorded. However, it is charged as an expense in the Profit and Loss Account every year to match the cost of the asset against the revenue it helps generate.
Key point: Depreciation applies only to fixed assets — not to current assets like stock or debtors, and not to intangible assets like goodwill (though goodwill is written off, the term "depreciation" is not used for it).
Causes of Depreciation
1. Wear and Tear
Physical deterioration of the asset from constant use. For example, a machine's parts wear out, a vehicle's tyres get worn, furniture gets scratched. The more an asset is used, the faster it wears out.
2. Passage of Time
Even if an asset is not used, its value decreases over time due to the passage of time. Leasehold property, patents, and copyrights lose value as their legal life expires. A building may depreciate simply because it is getting older.
3. Obsolescence
An asset may become obsolete — out of date or no longer useful — even if it is in perfect physical condition. A computer purchased three years ago may still work perfectly but be too slow or incompatible with current software. Obsolescence is caused by:
- Technological advancements
- Changes in market demand
- New and better alternatives becoming available
4. Depletion
This applies to natural resources like mines, oil wells, and forests. As the resource is extracted or used up, the asset's value decreases proportionally. Depletion is similar to depreciation but applies specifically to wasting assets.
Need and Importance of Charging Depreciation
1. To ascertain true profit or loss — Without charging depreciation, profits would be overstated because the cost of using fixed assets would not be accounted for.
2. To show a true and fair view of the financial position — Assets would be shown at an inflated value on the Balance Sheet if depreciation were not deducted.
3. To provide funds for replacement — Depreciation is a non-cash expense that reduces distributable profits, thereby retaining funds in the business for asset replacement.
4. To comply with the matching principle — The cost of using an asset should be matched against the revenue it generates in each accounting period.
5. To comply with legal requirements — The Companies Act requires companies to charge depreciation before declaring dividends.
6. To determine the correct cost of production — Depreciation is part of the cost of using assets to produce goods.
Factors Affecting the Amount of Depreciation
Three factors determine the amount of depreciation charged each year:
1. Cost of the asset — The total cost includes purchase price, freight, installation, and any other expense incurred to bring the asset to a usable condition.
2. Estimated salvage (scrap) value — The estimated resale value of the asset at the end of its useful life. Also called residual value.
3. Estimated useful life — The number of years the asset is expected to be useful to the business.
Methods of Charging Depreciation
There are several methods, but the two most important for CBSE Class 11 are:
1. Straight Line Method (SLM)
Under the Straight Line Method, a fixed and equal amount of depreciation is charged every year over the entire useful life of the asset.
Annual Depreciation = (Cost of Asset - Salvage Value) / Estimated Useful Life
Rate of Depreciation = (Annual Depreciation / Cost of Asset) x 100
Features of SLM
- Same depreciation amount every year
- Easy to understand and calculate
- Asset value reduces to zero or salvage value at the end of useful life
- Also called the Fixed Instalment Method or Original Cost Method
Advantages of SLM
- Simple to understand and easy to calculate
- Depreciation is the same every year — easy to compare
- Suitable for assets with relatively constant use (e.g., furniture, patents)
Disadvantages of SLM
- Ignores the fact that repairs and maintenance increase as the asset ages
- Does not consider the actual use or productivity of the asset
- The charge on Profit and Loss Account increases over time (depreciation stays same but repairs increase)
Worked Example — SLM
Problem: A machine was purchased on 1st April 2022 for Rs 1,00,000. Its estimated useful life is 5 years and salvage value is Rs 10,000. Prepare a Depreciation Schedule under the Straight Line Method.
Annual Depreciation = (1,00,000 - 10,000) / 5 = Rs 18,000 per year
Rate of Depreciation = (18,000 / 1,00,000) x 100 = 18%
| Year | Opening Balance (Rs) | Depreciation (Rs) | Closing Balance (Rs) |
|---|---|---|---|
| 2022-23 | 1,00,000 | 18,000 | 82,000 |
| 2023-24 | 82,000 | 18,000 | 64,000 |
| 2024-25 | 64,000 | 18,000 | 46,000 |
| 2025-26 | 46,000 | 18,000 | 28,000 |
| 2026-27 | 28,000 | 18,000 | 10,000 |
After 5 years, the book value equals the salvage value of Rs 10,000.
Journal Entries under SLM:
| Date | Particulars | L/F | Debit Rs | Credit Rs |
|---|---|---|---|---|
| 1st April 2022 | Machinery A/c Dr. | 1,00,000 | ||
| To Bank A/c | 1,00,000 | |||
| (Being machinery purchased) | ||||
| 31st March 2023 | Depreciation A/c Dr. | 18,000 | ||
| To Machinery A/c | 18,000 | |||
| (Being depreciation charged) | ||||
| 31st March 2023 | Profit and Loss A/c Dr. | 18,000 | ||
| To Depreciation A/c | 18,000 | |||
| (Being depreciation transferred to P&L A/c) |
2. Written Down Value Method (WDV)
Under the Written Down Value Method, depreciation is charged at a fixed percentage on the reducing balance (book value) of the asset each year. Since the book value decreases every year, the amount of depreciation also decreases.
Depreciation for the year = Rate x Book Value at the beginning of the year
Also called the Reducing Balance Method or Diminishing Balance Method.
Features of WDV
- Depreciation amount decreases every year
- Book value never reaches zero (theoretically)
- Higher depreciation in early years, lower in later years
- More realistic for assets that lose value faster in early years
Advantages of WDV
- Higher depreciation in early years matches the higher productivity and lower repair costs of a new asset
- Total charge (depreciation + repairs) remains relatively uniform over the asset's life
- Recognised by the Income Tax Act for most assets
- More realistic for assets like vehicles and machinery that lose value quickly initially
Disadvantages of WDV
- More complex to calculate than SLM
- Asset value never reaches zero — cannot be fully written off
- Difficult to determine the correct rate of depreciation
Worked Example — WDV
Problem: A machine was purchased on 1st April 2022 for Rs 1,00,000. Depreciation is charged at 20% per annum on the Written Down Value method. Prepare a Depreciation Schedule for 5 years.
| Year | Opening Balance (Rs) | Rate | Depreciation (Rs) | Closing Balance (Rs) |
|---|---|---|---|---|
| 2022-23 | 1,00,000 | 20% | 20,000 | 80,000 |
| 2023-24 | 80,000 | 20% | 16,000 | 64,000 |
| 2024-25 | 64,000 | 20% | 12,800 | 51,200 |
| 2025-26 | 51,200 | 20% | 10,240 | 40,960 |
| 2026-27 | 40,960 | 20% | 8,192 | 32,768 |
Notice how the depreciation amount decreases each year while the rate remains the same.
Journal Entries under WDV:
The journal entries are identical in form to SLM — only the amount changes each year:
| Date | Particulars | L/F | Debit Rs | Credit Rs |
|---|---|---|---|---|
| 31st March 2023 | Depreciation A/c Dr. | 20,000 | ||
| To Machinery A/c | 20,000 | |||
| 31st March 2024 | Depreciation A/c Dr. | 16,000 | ||
| To Machinery A/c | 16,000 | |||
| (and so on for each year) |
Comparison: Straight Line Method vs Written Down Value Method
| Basis | Straight Line Method (SLM) | Written Down Value Method (WDV) |
|---|---|---|
| Basis of calculation | Original cost of the asset | Book value (reducing balance) |
| Amount of depreciation | Same every year | Decreases every year |
| Value of asset | Reduces to zero or salvage value | Never reduces to zero |
| Total charge on P&L | Increases over time (depreciation constant + repairs increasing) | Remains relatively uniform (depreciation decreasing + repairs increasing) |
| Simplicity | Simple to calculate | More complex |
| Suitability | Assets with constant use (furniture, patents) | Assets with faster early depreciation (vehicles, machinery) |
| Income Tax recognition | Not commonly used for IT purposes | Recognised by Income Tax Act |
| Impact on P&L | Lower charge in early years | Higher charge in early years |
Provisions
Meaning
A provision is an amount set aside out of current profits to provide for:
- A known liability whose amount cannot be determined precisely (e.g., provision for doubtful debts)
- A known loss whose amount cannot be determined precisely (e.g., provision for discount on debtors)
Key characteristics:
- It is a charge against profits — must be created even if the business incurs a loss
- It reduces distributable profits
- It is created for a specific known purpose
- The exact amount is not known but is estimated
Types of Provisions
1. Provision for Doubtful Debts — Set aside to cover the possibility that some debtors may not pay. Based on past experience and the age of debts.
2. Provision for Discount on Debtors — When a provision for doubtful debts exists, discount is calculated only on the good debts (i.e., Debtors minus Provision for Doubtful Debts).
3. Provision for Repairs and Renewals — For expected repair costs.
Accounting Treatment — Journal Entries for Provisions
Provision for Doubtful Debts:
| Particulars | Debit Rs | Credit Rs |
|---|---|---|
| Profit and Loss A/c Dr. | XXX | |
| To Provision for Doubtful Debts A/c | XXX | |
| (Being provision created for doubtful debts) |
Provision for Discount on Debtors:
| Particulars | Debit Rs | Credit Rs |
|---|---|---|
| Profit and Loss A/c Dr. | XXX | |
| To Provision for Discount on Debtors A/c | XXX | |
| (Being provision created for discount on debtors) |
Important: Both provisions appear on the debit side of the Profit and Loss Account and as deductions from debtors on the Balance Sheet.
Reserves
Meaning
A reserve is an appropriation of profits set aside to:
- Strengthen the financial position of the business
- Meet future contingencies
- Finance expansion or specific future projects
Key characteristics:
- It is an appropriation of profits — can be created only when there are profits
- It does not reduce profit; it is an allocation of profit
- It is shown on the liabilities side of the Balance Sheet under "Reserves and Surplus"
Types of Reserves
1. Revenue Reserve
Created out of revenue profits (normal business income). Two types:
- General Reserve — Created without any specific purpose. Strengthens overall financial position. Also called Contingency Reserve.
- Specific Reserve — Created for a specific purpose, e.g., Dividend Equalisation Reserve, Debenture Redemption Reserve, Workmen Compensation Reserve.
2. Capital Reserve
Created out of capital profits (not from normal business operations). Examples:
- Profit on sale of fixed assets
- Premium on issue of shares or debentures
- Profit on revaluation of assets
Capital reserves are not available for distribution as dividends (unless specified by law).
Accounting Treatment — Journal Entries for Reserves
Creating a General Reserve:
| Particulars | Debit Rs | Credit Rs |
|---|---|---|
| Profit and Loss Appropriation A/c Dr. | XXX | |
| To General Reserve A/c | XXX | |
| (Being general reserve created out of profits) |
Creating a Specific Reserve:
| Particulars | Debit Rs | Credit Rs |
|---|---|---|
| Profit and Loss Appropriation A/c Dr. | XXX | |
| To Dividend Equalisation Reserve A/c | XXX | |
| (Being dividend equalisation reserve created) |
Important: Reserves are shown in the Profit and Loss Appropriation Account (not the P&L Account) and on the liabilities side of the Balance Sheet.
Distinction: Provision vs Reserve
| Basis | Provision | Reserve |
|---|---|---|
| Nature | Charge against profits | Appropriation of profits |
| When created | Must be created even if there is a loss | Can be created only when there are profits |
| Purpose | For a known liability or loss (amount uncertain) | To strengthen financial position or for a specific purpose |
| Effect on profit | Reduces net profit | Does not reduce net profit; only allocates it |
| Placement in P&L | Debited to Profit and Loss Account | Debited to Profit and Loss Appropriation Account |
| Balance Sheet | Shown as deduction from the related asset (or as a liability) | Shown under "Reserves and Surplus" on the liabilities side |
| Compulsion | Mandatory (required by accounting standards) | Discretionary (management decision) |
| Example | Provision for Doubtful Debts | General Reserve |
| Impact on dividends | Must be created before deciding dividends | Created after deciding dividends |
Secret Reserve
A secret reserve is a reserve that is not disclosed in the Balance Sheet. It is created by:
- Charging more depreciation than required
- Undervaluing assets
- Overvaluing liabilities
- Charging capital expenditure to the P&L Account
- Not showing certain income
Purpose: To strengthen the financial position secretly, avoid excessive dividend demands, or hide true profits from competitors.
Legal position: Secret reserves are not permitted under the Companies Act for companies, as they violate the principle of true and fair view. They may be used in sole proprietorships and partnerships but are generally considered unethical.
Common Mistakes to Avoid
1. Confusing cost with purchase price — Cost of an asset includes purchase price + freight + installation + any expense to make the asset usable. Do not forget to add these.
2. Applying WDV rate on the original cost — In the WDV method, the rate is applied on the book value (opening balance), not the original cost.
3. Confusing provision with reserve — A provision is a charge against profits (mandatory). A reserve is an appropriation of profits (discretionary). Their accounting treatment is different.
4. Calculating discount provision on total debtors — Provision for discount on debtors should be calculated on good debts (Debtors - Provision for Doubtful Debts), not on total debtors.
5. Forgetting to transfer depreciation to P&L — After debiting Depreciation A/c and crediting the Asset A/c, the Depreciation A/c must be transferred to the Profit and Loss A/c.
6. Not adjusting for partial year depreciation — If an asset is purchased during the year (not at the beginning), depreciation should be calculated only for the months the asset was in use.
7. Treating sale of asset incorrectly — When an asset is sold, the asset account is credited, and any profit or loss on sale is calculated as: Sale Price - Book Value at the time of sale.
8. Showing reserves on the asset side — Reserves are shown on the liabilities side of the Balance Sheet, not the assets side.
Exam Tips
1. Depreciation numericals are high-weightage — Practise SLM and WDV problems with full schedules and journal entries.
2. Show the Asset Account — Many exam questions ask you to prepare the Machinery Account (or similar) for multiple years. Show opening balance, depreciation, and closing balance for each year.
3. Partial year calculation — If an asset is bought on 1st October, charge only 6 months' depreciation for that year. This is a common exam trick.
4. Provision vs Reserve distinction — A 2-mark or 3-mark question asking for differences is almost guaranteed. Memorise the distinction table.
5. Provision for Doubtful Debts + Discount — These often appear together. Remember: calculate discount on (Debtors - Provision for Doubtful Debts).
6. Disposal of assets — When an asset is sold, prepare the Asset Account showing the sale entry, and calculate profit or loss on sale.
7. Write the formula — Always write the formula you are using before substituting values. This earns method marks even if the calculation goes wrong.
8. Check your arithmetic — Depreciation problems involve multiple years of calculations. A single error cascades. Double-check each year.
Quick Revision Notes
- Depreciation = Gradual permanent decrease in value of fixed assets; causes: wear & tear, time, obsolescence, depletion
- Need for depreciation: True profit, true financial position, replacement fund, matching principle, legal compliance
- SLM: Fixed amount each year = (Cost - Salvage) / Useful Life; simple; asset value reaches zero
- WDV: Fixed rate on reducing balance; decreasing depreciation each year; asset value never reaches zero
- SLM vs WDV: SLM = same depreciation; WDV = decreasing depreciation; SLM suits constant-use assets; WDV suits vehicles/machinery
- Provision = Charge against profits; mandatory; for known liability/loss of uncertain amount; debited to P&L A/c
- Reserve = Appropriation of profits; discretionary; created only when profitable; debited to P&L Appropriation A/c
- Revenue Reserve (from business profits) vs Capital Reserve (from capital profits like sale of fixed assets)
- General Reserve (no specific purpose) vs Specific Reserve (for a defined purpose)
- Secret Reserve = not disclosed in Balance Sheet; not permitted for companies
- Provision for Discount = calculated on good debts (Debtors - Provision for Doubtful Debts)
- Journal entries: Depreciation A/c Dr. to Asset A/c; P&L A/c Dr. to Depreciation A/c; P&L Appropriation A/c Dr. to Reserve A/c
Further Reading
- [Chapter 4 — Recording of Transactions II](/school/cbse/class/11/accountancy/cbse-recording-transactions-2)
- [Chapter 5 — Bank Reconciliation Statement](/school/cbse/class/11/accountancy/cbse-bank-reconciliation-statement)
- [Depreciation, Provisions and Reserves — NCERT Exercise Solutions](/school/cbse/class/11/accountancy/solutions/cbse-depreciation-provisions-reserves-exercise-solutions)
- [All Class 11 Accountancy Solutions](/school/cbse/class/11/accountancy/solutions)
- [Class 11 Accountancy Subject Guide](/school/cbse/class/11/accountancy)