Depreciation and Provisions
Depreciation
Depreciation is the permanent, gradual and continuing reduction in the book value of a fixed asset through use, wear and tear, obsolescence or effluxion of time. It is a non-cash expense charged to the profit and loss account, with a provision for depreciation created and the asset shown net in the balance sheet. Causes: wear and tear, passage of time, obsolescence, depletion and accident. Need: to show true profit, present a true financial position, provide for replacement, and follow the matching concept.
Methods:
- Straight line: (Cost − Scrap value) ÷ Useful life, giving an equal charge every year.
- Diminishing balance (written down value): a fixed percentage applied to the reducing book value, so the charge falls each year.
Provisions and reserves
A provision is a charge against profit for a known liability or a known diminution in the value of an asset where the amount cannot be determined exactly: provision for doubtful debts, for discount on debtors, for taxation, for depreciation. A reserve is an appropriation of profit to strengthen the financial position, either general or specific. A capital reserve arises from capital profits and is not available for dividend; a revenue reserve arises from normal profits. A secret reserve is one not disclosed in the balance sheet.
Worked example
A machine costs ₹1,00,000 with scrap ₹10,000 and a life of 5 years. Straight line = (1,00,000 − 10,000) ÷ 5 = ₹18,000 a year. Diminishing balance at 10%: year 1 = ₹10,000; year 2 = ₹9,000 on the reduced ₹90,000; and so on, the charge declining because the base declines.
Traps
Charging depreciation on market value instead of cost; ignoring scrap value; applying the diminishing rate to the original cost; treating a provision for doubtful debts as a reserve; calling a general reserve a charge against profit.