Depreciation, Provisions and Reserves

Depreciation : An Introduction

Suppose you have purchased a car. After some time you noticed that if you want to sell this car, its values is less than its cost price. similarly value of all fixed assets is decreased due to passage of time and some other reasons. The reduction in value of fixed assets is known as depreciation

Expenditure on assets of the business like furniture, fixtures and fittings of the shop, motor vans, machines and equipments are neither expenditure on purchase of goods nor expenses.

Expenditure of this nature give service to the business for many years and thus called fixed assets. Would you like to deduct the expenditure on the fixed assets from the profit of any one year ? It would be wrong to do so since their benefit is enjoyed by the business for more than one year. The correct thing will be to distribute their cost over the years of their useful life to the business. The portion of the cost of fixed assets charged each year as expense is known as depreciation.

Learning Objectives

After studying this lesson you will be able to :

• State the meaning and concept of depreciation;
• Explain the causes of depreciation.
• Explain the methods of charging depreciation;
• Show the Accounting Treatment of Depreciation;
• State the meaning of Provision and Reserve;
• Differentiate between Provision and Reserve.

Teachers ae advised to use various examples from daily life in order to clear the concept of depreciation.

'Provison for Depreciation Account' is to be taught through various exercises solved by both the Accounting Treatment of Depreciation, i.e. Charging Depreciation in Asset Account and Charging Depreciation in Provision for Depreciation Account.

Journal entries for creating Provision for Depreciation are also to be explained.

Depreciation : Concept

Business enterprises require fixed assets for their business operations such as furniture and fixtures, office equipments, plant and machinery, motor vehicles, land and building etc. In the rocess of converting Raw material into finished products, the fixed assets depreciate in value over a period of time, i.e. its useful life. Depreciation is a part of the cost of a fixed asset which has expired :

• On account of usage;
• Lapse of time.

In other words, the process of allocation of the cost of a fixed asset over its useful life is known as depreciation

Need or objectives of providing Depreciation :

1. Ascertaining true profit or loss :

1. The true profit of an enterprise can be ascertained when all costs incurred for the purpose of earning revenues have been debited to the profit and loss account.
2. Fall in the value of assets used in business operations is a part of the cost and should be shown in the profit and loss account of concerned accounting period.
3. Keeping this in view, depreciation must be debited to profit & loss account, since loss in value of fixed assets is also an expense like other expenses.

2. Presentation of True and Fair value of assets :

If depreciation is not provided, the value of assets shown in Balance sheet will not present the true and fair value of assets because assets are shown at the cost price but actual value is less than cost price of the assets.

3. To ascertain the accurate cost of the production :

Depreciation is an item of expense, the correct cost of production cannot be calculated unless it is also taken into consideration. Hence, depreciation must be provided to ascertain the correct cost of production.

4. Computation of correct income tax :

1. Income tax of an enterprise is determined after charging all the costs of production.
2. If depreciation is not charged, the profits will be higher and the income tax will also be higher.
3. If depreciation is charged, Tax liability is reduced.

5. Provision of funds and replacement of assets :

Deprecation is a non cash expense. So that amount of depreciation charged to profit and loss accounts is retained in business every year. These funds are available for replacement of the assets when its useful life is over.

CBSE Accountancy Class XI ( By Mr. Aniruddh Maheshwari ) 
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