Depreciation, Provisions, and Reserves

Depreciation, Provisions, and Reserves

1. Depreciation

Definition:

• Depreciation is the systematic allocation of the cost of a tangible fixed asset over its useful life. It represents the decrease in the asset’s value due to wear and tear, usage, obsolescence, or passage of time.

Need for Depreciation:

• To ascertain the true profit or loss.
• To present a true and fair view of the financial position.
• To provide for the replacement of assets.
• To comply with legal and accounting requirements.

Factors Affecting Depreciation:

• Cost of Asset: Initial purchase price plus any installation and transportation costs.
• Estimated Useful Life: The period over which the asset is expected to be used.
• Residual Value: The estimated scrap or salvage value at the end of its useful life.

Methods of Depreciation:

1. Straight Line Method (SLM): Depreciation is charged evenly over the useful life of the asset.
   • Formula:
     Annual Depreciation = Cost of Asset – Residual Value\Useful Life
     
2. Written Down Value Method (WDV): Depreciation is charged on the reducing balance of the asset each year.
   • Formula:
     
     Depreciation for the Year = Book Value at Beginning of Year * Depreciation

Accounting Treatment of Depreciation:

• Journal Entry:
  Depreciation A/c Dr. To Asset A/c
• Impact on Financial Statements:
  • Profit and Loss Account: Depreciation is shown as an expense.
  • Balance Sheet: Asset is shown at its book value (Cost less Accumulated Depreciation).

Illustration:

• Cost of Asset: ₹1,00,000
• Useful Life: 5 years
• Residual Value: ₹10,000
• Straight Line Method:
  Annual Depreciation = {1,00,000 – 10,000}/{5} = ₹18,000
• Written Down Value Method (Assuming Depreciation Rate of 20%):
  • Year 1:
    Depreciation = 1,00,000 \20% = ₹20,000
    
  • Year 2:
    Depreciation = 80,000 \20% = ₹16,000
    

2. Provisions

Definition:

• A provision is an amount set aside from the profits to cover a known liability or expense, the amount of which cannot be determined with substantial accuracy.

Purpose of Provisions:

• To meet anticipated liabilities.
• To cover potential future expenses.
• To provide for depreciation of assets or diminution in value.

Common Types of Provisions:

• Provision for Doubtful Debts: Set aside to cover potential bad debts.
• Provision for Depreciation: Amount set aside to cover the depreciation of fixed assets.
• Provision for Taxation: Estimated amount of tax liability for the accounting period.

Accounting Treatment of Provisions:

• Journal Entry:
  Expense A/c (e.g., Bad Debts) Dr. To Provision A/c (e.g., Provision for Doubtful Debts)
• Impact on Financial Statements:
  • Profit and Loss Account: Shown as an expense.
  • Balance Sheet: Shown as a liability or deducted from the related asset.

3. Reserves

Definition:

• Reserves are amounts set aside out of profits and other surpluses to meet future liabilities, contingencies, or for specific purposes.

Types of Reserves:

1. Revenue Reserves: Created out of profits from normal business operations.
   • General Reserve: Not earmarked for any specific purpose.
   • Specific Reserve: Created for a specific purpose (e.g., Dividend Equalization Reserve).
2. Capital Reserves: Created out of capital profits (e.g., profit on sale of fixed assets).

Purpose of Reserves:

• To strengthen the financial position.
• To meet unforeseen contingencies.
• To finance expansion and growth.
• To maintain a stable dividend policy.

Distinction Between Provisions and Reserves:

Basis	Provisions	Reserves
Purpose	To cover specific known liabilities or expenses.	To strengthen the financial position and cover unknown liabilities.
Creation	Mandatory as per prudence principle.	Discretionary, created out of profits.
Impact on Profit	Reduces net profit.	Retained out of net profit.
Presentation	Shown as a liability or deducted from assets.	Shown under shareholders’ equity.

Illustration of Reserves:

• General Reserve Creation:
  Profit and Loss Appropriation A/c Dr. To General Reserve A/c

By understanding these concepts, students can effectively manage depreciation, create necessary provisions, and maintain appropriate reserves, ensuring accurate financial reporting and better financial management.