Depreciation, Provisions and Reserves
Depreciation is the systematic allocation of the depreciable cost of a fixed asset over its useful life. The exam asks for both methods, for the journal treatment, and for the distinction between a provision and a reserve.
Methods and rules
- Straight-line method: (Cost − residual value) ÷ useful life, charged equally each year.
- Written-down-value method: a fixed percentage on the opening book value, so the charge falls each year.
- Depreciation is a non-cash expense; it is debited to profit and loss and credited to the asset account or to provision for depreciation.
- Causes include wear and tear, obsolescence, passage of time and depletion.
Provision versus reserve
A provision is a charge against profit for a known liability or expected loss, such as provision for doubtful debts. A reserve is an appropriation of profit, such as general reserve. A provision for doubtful debts is calculated on debtors after deducting bad debts and is shown as a deduction from debtors.
Worked example
A machine costs ₹5,00,000, has a residual value of ₹50,000 and a life of five years. SLM depreciation = (5,00,000 − 50,000) ÷ 5 = ₹90,000 a year. Under WDV at 10%, year 1 = ₹50,000; year 2 = ₹45,000; book value after two years = ₹4,05,000.
Traps
- Ignoring residual value under SLM.
- Charging a full year's depreciation on an asset bought during the year.
- Treating a reserve as a charge against profit.
- Forgetting that depreciation is added back in a cash flow statement.