Depreciation, Provision and Reserves:
Depreciation is that portion of the original cost of a fixed asset that is consumed by the business during a certain period of time. The annual charge to profit and loss account/income statement for depreciation is based upon an estimate of how much of the overall economic usefulness of a fixed asset has been used up in that accounting period. Since it is charged as an expense to the profit and loss account/income statement, it leads to a reduction in net profit. In this article, read about depreciation, provision and reserves.
For example, the expense of your car is spread over many years of its use whereas the petrol/diesel it needs is used up within a few days. Hence, the car’s original cost is consumed over a period of time and this concept is called depreciation.
Causes of Depreciation:
The causes of depreciation are many. Following are the few important reasons behind the same, as explained below.
- Wear and Tear: When any fixed assets are used for business (e.g.: motor vehicles, machinery, fixtures and fittings, etc.) they gradually tend to wear out.
- Erosion, Rust, Rot and Decay: Lands may be eroded away due to factors such as wind, rains and other elements of nature. Likewise, the metals used in machinery and tools will rust. Wooden asset may face decay.
- Obsolescence: A lot of technology and machinery is often tagged as out dated since newer, more efficient options are available.
- Inadequacy: This occurs when an asset is abandoned from use due to a business’ increased growth. For example, a van used by a business for deliveries is no more sufficient to accommodate for larger orders.
- The Time Factor: Many assets have a fixed legal life attached. For example: A process or technology that has been patented for a period of ten years has no value on completion of this period.
- Depletion: Exhaustion or reduction in availability of resources due to constant extraction of the raw materials from them is a contributing factor. For example, mines, quarries, oil wells, etc.
From the perspective of accountants, depreciation is not a matter of valuation, but a means of cost allocation. Assets are not depreciated based on a decline in the market value, rather based on the systematic charges to expense. This approach is used sin the value of the asset may fluctuate or change between the time of purchase of assets and the time of sale or disposal. The reasons behind the usage of cost allocation approach are the occurrence of matching of costs with revenue and the difficulty in measurement of fluctuations in fair value.
- For replacement of assets: The amount equivalent to the amount of the depreciation is reserved with the firm. Post expiration of the life of asset, the same fund can be used to for a new asset.
- For determination of true profit or loss: Depreciation is also considered as an expense similar to repairs, maintenance, etc.; which is required to be included in profit and loss account for the purpose of ascertaining the profit or loss of a business accurately.
- For presentation of assets in the balance sheet at their proper value: Depreciation must be charged to the fixed assets o know the true value of assets and for their fair presentation in the balance sheet.
- For determination of accurate cost of production: The cost of production arrived at will be faulty if the depreciation of fixed assets is not included as a part of it. Thus, it is essential for ascertaining the same.
- Straight Line Method
Also known as ‘original cost method’, this method charges depreciation at a fixed percentage on the original cost of the asset, throughout its estimated life. Hence, the amount of depreciation is uniform from year to year. Owing to this it is also known as ‘Fixed Installment Method’ or ‘Equal installment method’. The formula for calculation is:
Annual Depreciation = (Original cost of asset- scrap value)/ Estimated life in years
For instance, a firm purchases machinery for Rs.20,00,000 on April 1, 2017. The expected life of it is 10 years. After 10 years, the scrap of this machine would be Rs. 5,00,000. Under straight line method, the amount of depreciation can be calculated as:
Annual Depreciation = (20,00,000- 5,00,000)/10 = 1,50,000
Hence, Rs. 1,50,000 will be charged every year as depreciation on this machinery.
- Diminishing Balance Method
Under this method, depreciation is charged as a fixed percentage on the book value of the asset every year. For instance, a machine is purchased for Rs.2,00,000 on March 1, 2010. A depreciation of 10% p.a. is charged on this machine. The amount of depreciation for the first four years is as under:
|YEAR||BOOK VALUE||DEPRECIATION @10%|
There is yet another treatment for charging depreciation in which Provision for Depreciation Account is opened in which depreciation is charged, instead of it being charged in the Asset Account. Provision for Depreciation is shown in the liabilities side of Balance Sheet. At the time of sale, the total accumulated depreciation of concerned asset is transferred to the credit side of the asset (Provision of Depreciation A/C Dr. to Asset A/C)
According to Yorston, Smyth and Brown, “Reserve should include amounts set a side out of profits and other surplus which are not intended or necessary to meet any liability, contingency or diminution in the value of assets known to exist at the date of the balance sheet”. Examples of these are: Reserve fund, Contingency fund etc. The amount is debited to profit and loss appropriation account and credited to the respective reserve account. Reserves are also known as ‘Plough Back of Profits’.
Types of Reserves:
1. Revenue Reserve: The part of the profits which is not paid to the proprietor, held back for operations or other requirements, is known as revenue reserve. It can be further classified into two types:
General Reserve: Reserve which is created not for anything specific but for strengthening the financial position of a business is known as general reserve. Examples: reserve fund, contingency fund etc. It is usually created for the following purposes:
- To strengthen the financial position of the business.
- To raise working capital of the business.
- To cater to future contingencies.
- To provide for any unknown liability or loss.
Specific Reserve: Reserve created for any specific purpose is known as specific reserve. For example, dividend equalization fund, debenture sinking fund etc. It cannot be used for other purposes. Specific reserve is also known as special reserve.
2. Capital Reserve: Profit may arise from sources apart from routine business activities. Such profit is known as capital profit. Any reserve created out of such profit is called capital reserve. It is usually utilized for meeting capital losses. “The expression ‘capital reserve’ shall not include any amount regarded as free for distribution through the profit and loss account”. Such profit is earned in the following ways:
- Issue of shares and debentures at a premium.
- Redemption of debenture at a discount.
- Revaluation of assets and liabilities.
- Profit prior to its incorporation.
- Sale of fixed asset.
There are some expenses/losses which pertain to the current accounting period but their amounts are unknown or lack certainty because they are not yet incurred. It is important to make provisions for such items for ascertaining the correct net profit. For example, a businessman selling furniture on credit finds out that some of the debtors of the current year may default and no payments or only partial payments will be realized. It is necessary to consider such an expected loss while calculating true and fair profit/loss as per the principle of Prudence or Conservatism.