Definition (AS-6): Measure of wearing out, consumption or loss of value of a depreciable asset arising from use, effluxion of time or obsolescence. A non-cash expense.
Applicable to: Fixed Assets (tangible).
Related Terms: Depletion (natural resources – mines), Amortisation (intangible assets – patents, copyrights).
Exam Q (1 mark – 2021 March): Depreciation is charged on? (b) Fixed Assets.
CAUSES OF DEPRECIATION
Wear & tear (use), Expiration of legal rights (patents), Obsolescence (technological change), Abnormal factors (accidents, fire).
NEED / OBJECTIVES OF PROVIDING DEPRECIATION
Matching costs & revenue (true profit), True & fair financial position (asset not overvalued), Tax deduction (IT Act), Retain funds for replacement, Legal compliance (Companies Act).
FACTORS AFFECTING DEPRECIATION
Cost of Asset: Purchase price + all expenses to bring to working condition (freight, installation).
Estimated Net Residual Value (Scrap Value): Realisable value at end of useful life.
Depreciable Cost: Cost – Residual Value.
Estimated Useful Life: Period asset is expected to be used.
METHODS OF CALCULATING DEPRECIATION
Straight Line Method (SLM) / Fixed Instalment Method:
- Formula: Depreciation = (Cost – Scrap Value) / Useful Life.
- Rate: (Annual Depreciation / Cost) × 100.
- Advantages: Simple, equal charge each year, asset can be completely written off.
- Limitations: Assumes equal benefit each year (unrealistic), total charge (depreciation + repairs) increases over time.
- Suitable for: Assets with low repair cost, low obsolescence (buildings, patents).
- Meaning: Depreciation charged at fixed % on book value (WDV) at beginning of year. Amount decreases yearly.
- Formula for Rate: r = [1 – (s/c)^(1/n)] × 100.
- Advantages: More realistic (efficiency declines), total charge (depreciation+repairs) nearly equal year after year, recognised by Income Tax Act.
- Limitations: Asset never becomes zero, difficulty in determining rate.
- Suitable for: Assets with high obsolescence, increasing repair costs (machinery, vehicles).
COMPARISON: SLM vs WDV
| Basis | SLM | WDV |
|---|---|---|
| Basis of charging | Original cost | Book value (WDV) at year start |
| Annual depreciation amount | Fixed & constant | Declines year after year |
| Total charge (depreciation+repairs) | Increases in later years | Almost equal every year |
| Tax recognition | Not recognised | Recognised by Income Tax Act |
METHODS OF RECORDING DEPRECIATION
1. Charging to Asset Account: Depreciation credited directly to Asset A/c. Asset shown at net book value (cost – accumulated depreciation). Simple but original cost not visible.
Entries: Depreciation A/c Dr. → To Asset A/c; P&L A/c Dr. → To Depreciation A/c.
2. Provision for Depreciation / Accumulated Depreciation Account: Depreciation accumulated in separate account. Asset shown at original cost; provision deducted from asset or shown on liabilities side. Maintains historical cost.
Entries: Depreciation A/c Dr. → To Provision for Depreciation A/c; P&L A/c Dr. → To Depreciation A/c.
DISPOSAL OF ASSET
When Provision for Depreciation maintained:
1. Transfer accumulated depreciation: Provision for Depreciation A/c Dr. → To Asset A/c.
2. Record sale proceeds: Bank A/c Dr. → To Asset A/c.
3. Transfer balance of Asset A/c to P&L A/c (profit or loss).
Asset Disposal Account: Special account showing original cost (Dr.) vs accumulated depreciation + sale proceeds (Cr.). Balance transferred to P&L.
PROVISIONS
Meaning: Amount set aside out of profits for a known liability/expense of uncertain amount, relating to current period. A charge against profit (deducted before net profit).
Examples: Provision for Depreciation, Doubtful Debts, Discount on Debtors, Taxation, Repairs & Renewals.
Accounting (Provision for Doubtful Debts): P&L A/c Dr. → To Provision for Doubtful Debts A/c. Shown as deduction from Sundry Debtors in Balance Sheet.
RESERVES
Meaning: Portion of profit set aside for future growth, expansion, or contingencies. An appropriation of profit (after net profit). Not a charge.
Types: General Reserve (free for any purpose) vs Specific Reserve (specific purpose – Dividend Equalisation, Debenture Redemption). Revenue Reserve (from revenue profits, distributable) vs Capital Reserve (from capital profits, not distributable – e.g., profit on sale of fixed asset, premium on issue of shares).
Secret Reserve: Reserve not visible in Balance Sheet. Created by undervaluing assets or overvaluing liabilities.
DIFFERENCES
Provision vs Reserve: Provision is a charge against profit; Reserve is an appropriation. Provision created for known liability/expense; Reserve for strengthening financial position. Provision can be created even if no profit; Reserve only from profits.
Revenue Reserve vs Capital Reserve: Revenue Reserve created from revenue profits (normal business operations), can be used for dividend. Capital Reserve created from capital profits (not from normal operations), cannot be used for dividend.
IMPORTANT EXAM QUESTIONS
1. Write any three needs for charging depreciation (3 marks – 2021 March).
2. Distinguish between SLM and WDV (4 marks – 2019 March).
3. Explain factors affecting depreciation.
4. Differentiate between Provision and Reserve.
5. What is meant by amortisation? Which asset is it related to? (Intangible asset).
6. Write short note on Asset Disposal Account.
7. Difference between Revenue Reserve and Capital Reserve.
8. What is Secret Reserve? How is it created?