Depreciation, Provisions, and Reserves
Depreciation allocates the cost of a fixed asset over its useful life; it is a charge against profit, not a cash payment. The domain also tests the distinction between a provision and a reserve.
Methods and rules
- Straight line: (Cost − Scrap) ÷ Life, an equal amount each year.
- Written down value: a fixed percentage on the opening book value, so the charge falls each year.
- Depreciation runs from the date of purchase or installation; many questions require a pro-rata charge for months.
- Provision: a charge for a known liability or a known fall in value whose amount is uncertain, such as provision for doubtful debts or for depreciation. It is charged against profit.
- Reserve: an appropriation of profit made after profit is computed, such as general reserve or dividend equalisation reserve.
- Secret reserve arises when assets are understated or liabilities overstated; it conflicts with full disclosure.
Worked example
Machinery costs ₹5,00,000, scrap ₹20,000, life 8 years. Straight line = (5,00,000 − 20,000) / 8 = ₹60,000 a year. On written down value at 10%: Year 1 = ₹50,000; Year 2 = 10% of ₹4,50,000 = ₹45,000.
Asset account treatment
Depreciation may be credited directly to the asset account, showing the asset net, or accumulated in a Provision for Depreciation account with the asset carried at cost. Either is acceptable if applied consistently.
Traps
- Charging depreciation on the opening balance while ignoring additions, or charging a full year on a late purchase.
- Computing the provision for doubtful debts on debtors already reduced by bad debts without checking the required order.
- Calling dividend equalisation reserve a provision; it is a reserve.
- Crediting depreciation to Profit and Loss as income - it is always an expense.