1. Depreciation — Meaning
Depreciation is the permanent, continuous, and gradual decrease in the value of a tangible fixed asset due to use, wear and tear, efflux of time, or obsolescence. It is a non-cash charge (no actual cash outflow).
Key Characteristics: (1) Permanent decrease (not temporary fluctuation), (2)
Applies to fixed assets only, (3) Non-cash expense, (4) Reduces carrying value of the asset.
2. Causes of Depreciation
- Wear and Tear: Physical deterioration from regular use (machinery, vehicles).
- Efflux of Time: Passage of time reduces value even if not used (e.g., lease, patent expiry).
- Obsolescence: Asset becomes outdated due to improved technology or change in demand.
- Depletion: Exhaustion of natural/wasting resources (mines, oil wells, quarries).
- Accidents: Unexpected damage permanently reduces asset value.
3. Methods of Depreciation
| Basis | Straight Line Method (SLM) / Fixed Instalment | Written Down Value Method (WDV) / Diminishing Balance |
|---|---|---|
| Depreciation amount | Fixed / Same every year | Decreasing every year |
| Calculated on | Original Cost of Asset | Book Value (Written Down Value) each year |
| Book value at end | Reduced to Nil (or scrap value) | Never reaches Zero |
| Total charge | Equal every year | High in early years, lower later |
| Suitable for | Assets with equal utility each year (furniture, leases) | Assets with high repair costs in later years (machinery) |
| Allowed by Income Tax | Not allowed for tax purposes in India | Allowed under Income Tax Act in India |
Formulas
SLM Depreciation = (Cost – Scrap Value) ÷ Useful Life
WDV Depreciation = Book Value at Beginning of Year × Rate%
4. Accounting Treatment of Depreciation
Method 1: Charging Depreciation to Asset Account
- Journal: Depreciation A/c Dr. / Asset A/c Cr.
- Transfer: Profit & Loss A/c Dr. / Depreciation A/c Cr.
- Asset value decreases directly in the ledger.
Method 2: Using Provision for Depreciation Account
- Journal: Depreciation A/c Dr. / Provision for Depreciation A/c Cr.
- Asset remains at COST in the Asset Account.
- Provision for Depreciation accumulates — shown as a deduction from asset in Balance Sheet.
- Book Value = Cost of Asset – Accumulated Provision for Depreciation.
Sale of Asset (with Provision Method): On disposal, the accumulated provision is
reversed, profit/loss on sale is calculated, and all related accounts are cleared through the Asset
Disposal Account.
5. Provisions
A Provision is an amount set aside out of profits to meet a known liability whose amount cannot be determined with certainty. It is created as a charge against profit (reduces profit).
Examples: Provision for Bad Debts (Doubtful Debts), Provision for Discount on
Debtors, Provision for Tax, Provision for Depreciation, Provision for Repairs.
- Provision is a charge against profit (created even if there is no profit).
- Shown on the Liability side of the Balance Sheet OR deducted from the asset.
- Specific purpose — cannot be used freely.
6. Reserves
A Reserve is an appropriation of profit (not a charge). Created out of profits voluntarily or as required by law, to strengthen financial position or meet future contingencies.
| Type of Reserve | Description | Example |
|---|---|---|
| Revenue Reserve | Created from revenue profits for general or specific future use | General Reserve, Dividend Equalisation Reserve |
| Capital Reserve | Created from capital profits – NOT distributable as dividend | Profit on sale of fixed assets, Share Premium |
| Specific Reserve | Created for a specific purpose | Debenture Redemption Reserve, Investment Fluctuation Reserve |
| Secret Reserve | Hidden reserve – value not visible in balance sheet (not permitted for companies) | Excessive depreciation charged |
Key Difference — Provision vs Reserve:
Provision: Charge against profit (created before calculating profit). Reserve: Appropriation of profit (created from profit, after profit is determined).
Provision: Charge against profit (created before calculating profit). Reserve: Appropriation of profit (created from profit, after profit is determined).