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Chapter 7: Depreciation, Provisions and Reserves

Original notes — ready CBSE (NCERT, English Medium) • Class 11 • Accountancy • Book: Financial Accounting — Part I

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Chapter 7: Depreciation, Provisions and Reserves — EG's own notes, in simple words

Book: Financial Accounting — Part I (CBSE, Class 11)  |  Chapter 7  |  Medium: English

Labelled diagram for Chapter 7: Depreciation, Provisions and Reserves

Diagram (labels on the image): Book value over five years under the straight line method (navy) and the written down value method (gold) — same machine, different pattern. Bar labels are rounded to the nearest Rs 1,000; exact figures are in the notes.

Illustration for Chapter 7: Depreciation, Provisions and Reserves

A factory machine with a downward arrow and a calendar — every year of use takes away part of an asset's value.

1. What depreciation is, and why it is charged

A fixed asset — a machine, a building, furniture — gives service for many years, but its value falls with use, age and obsolescence. Depreciation is the fall in the value of a fixed asset due to use, wear and tear, passage of time and obsolescence. It is charged every year so that the cost of the asset is spread over its useful life (matching concept), so that profit is not overstated, and so that the balance sheet shows the asset at its book value rather than its original cost.

Depreciation is not a cash expense and it is not the same as a fall in market price: a machine may still sell well while its book value falls steadily. It applies to tangible fixed assets; land is generally not depreciated because it does not wear out, and wasting assets such as mines are depleted rather than depreciated.

2. Factors and methods

Three factors decide the annual charge: the original cost of the asset (including installation and freight), its estimated scrap (residual) value at the end of its life, and its estimated useful life. Under the straight line method (SLM), an equal amount is charged every year: (Cost − Scrap value) ÷ Useful life. Under the written down value method (WDV), a fixed percentage is charged on the reducing balance each year, so the charge is largest in the first year and falls every year.

Worked example — SLM. A machine costs Rs 1,20,000, scrap value Rs 20,000, useful life 5 years. Annual depreciation = (1,20,000 − 20,000) ÷ 5 = Rs 20,000. Book values: end of year 1 Rs 1,00,000; year 2 Rs 80,000; year 3 Rs 60,000; year 4 Rs 40,000; year 5 Rs 20,000 (the scrap value). Worked example — WDV @ 10%. Same machine ignoring scrap for the WDV computation: year 1 depreciation Rs 12,000, book value Rs 1,08,000; year 2 depreciation Rs 10,800, book value Rs 97,200; year 3 depreciation Rs 9,720, book value Rs 87,480. SLM suits assets whose use is steady (a lease, furniture); WDV suits assets that lose value fastest when new (machinery, vehicles).

3. Disposal of an asset

When an asset is sold, its book value on the date of sale is compared with the sale price. If the price is higher, the difference is a profit on sale (credited to the Profit and Loss Account); if lower, it is a loss on sale (debited). The asset account is closed by transferring its book value to the disposal account, and depreciation is charged up to the date of sale.

Worked example. A machine bought for Rs 80,000 is depreciated at 10% on cost (SLM) — Rs 8,000 a year. After 3 years its book value is Rs 80,000 − Rs 24,000 = Rs 56,000. It is sold for Rs 50,000. Loss on sale = Rs 56,000 − Rs 50,000 = Rs 6,000, debited to the Profit and Loss Account.

4. Provisions and reserves

A provision is an amount set aside out of profit to meet a known liability or a probable loss whose amount cannot be fixed exactly — for example, a provision for doubtful debts, or for discount on debtors. It is a charge against profit: it is made even if there is no profit. A reserve is an amount set aside out of profit (after profit is known) to strengthen the business or meet an unknown future need — for example, a general reserve. It is an appropriation of profit, not a charge, and it can be used to pay dividends.

At a glance — chart / table

ItemPurposeTreatmentNote
ProvisionKnown liability / probable lossCharge against profitMade even in a loss year
ReserveUnknown future need / strengtheningAppropriation of profitMade only out of profit
Provision for doubtful debtsDebtors may not all payDebited to Profit and Loss A/cDeducted from debtors in Balance Sheet

Worked example — provision for doubtful debts. Debtors stand at Rs 50,000 and a provision of 5% is to be made. Provision = 5% × Rs 50,000 = Rs 2,500, debited to the Profit and Loss Account and deducted from debtors in the balance sheet, so debtors appear at Rs 47,500.

What you should learn

  • Define depreciation, state its causes and need, and name the three factors fixing its annual amount.
  • Compute depreciation under the straight line method and the written down value method, and compare the two methods.
  • Explain the two methods of recording depreciation: charging the asset account, and the provision for depreciation account.
  • Work out profit or loss on disposal of an asset, and the effect of an addition or extension to an existing asset.
  • Distinguish provisions from reserves, capital reserves from revenue reserves, and explain what a secret reserve is.

Going further — full coverage of the source chapter

§7.1 Depreciation — introduction. Depreciation is the fall in the value of a fixed asset from use, wear and tear, passage of time and obsolescence. It is a non-cash expense: no money leaves the business when it is charged, yet profit falls and the asset's book value falls.

§7.2 Depreciation and other similar terms. Depletion is the fall in value of wasting assets such as mines and quarries as their contents are extracted. Amortisation is the writing off of intangible assets such as patents and copyrights over their useful life. Depreciation proper applies to tangible fixed assets; land is generally not depreciated because it does not wear out.

§7.3 Causes of depreciation. Use and wear and tear, passage of time even without use, obsolescence (a newer machine or method makes the old one uneconomic), accidents and exhaustion of legal rights (such as a lease ending).

§7.4 Need for depreciation. To spread the asset's cost over its useful life (matching concept), so that each year's profit bears the cost of the asset used in earning it; to show the asset at its book value rather than its original cost; and to retain funds for replacement.

§7.5 Factors affecting the amount of depreciation. Original cost (including installation and freight), estimated scrap or residual value at the end of useful life, and estimated useful life. A change in any factor changes the annual charge.

§7.6 Methods of calculating depreciation amount. Straight line method (SLM): equal charge every year, (Cost − Scrap value) ÷ Useful life. Written down value method (WDV, reducing balance method): a fixed percentage on the reducing book value each year, so the charge is largest in the first year and falls every year.

§7.7 SLM and WDV: a comparative analysis. SLM charges the same amount every year, so book value falls in equal steps and can reach scrap value exactly; it suits assets whose use is steady (furniture, leases). WDV charges most when the asset is new and most useful, so book value falls fast at first and then slowly, and never quite reaches zero; it suits assets that lose value fastest when new (machinery, vehicles). Total depreciation over the asset's life is the same under both methods; only its timing differs.

§7.8 Methods of recording depreciation. First method: depreciation is credited directly to the asset account, so the asset account shows its reducing book value. Second method: depreciation is credited to a Provision for Depreciation Account (accumulated depreciation), so the asset account keeps its original cost and the accumulated depreciation is deducted from it in the balance sheet. The Profit and Loss Account is debited in both methods; only the presentation differs.

§7.9 Disposal of asset. Charge depreciation up to the date of sale, compare book value with sale price: a higher price gives a profit on sale (credited to Profit and Loss Account), a lower price a loss on sale (debited). On disposal through an asset disposal account, the asset's cost and accumulated depreciation are both transferred out and the account closes.

§7.10 Effect of any addition or extension to the existing asset. An addition or extension that increases earning capacity (a new wing on a factory, a motor fitted to a machine) is capitalised: it is added to the asset's cost, and depreciation is then charged on the enhanced value. A mere repair that only maintains capacity is revenue expenditure and is not added to cost.

§7.11 Provisions. A provision is an amount set aside for a known liability or probable loss whose amount cannot be fixed exactly (provision for doubtful debts, for discount on debtors, for tax). It is a charge against profit: it is made even in a loss year.

§7.12 Reserves. A reserve is an amount set aside out of profit for an unknown future need or to strengthen the business (general reserve). It is an appropriation of profit, made only when profit exists, and it can be used to pay dividends. A capital reserve comes from capital profits (profit on sale of a fixed asset, profit on reissue of forfeited shares) and is not available for dividends; a revenue reserve comes from revenue profits and is available for dividends.

§7.13 Secret reserve. A secret reserve is created by deliberately understating assets or overstating liabilities — showing stock below its value, charging excessive depreciation, omitting an asset — so the balance sheet hides part of the firm's strength. It is not shown in the accounts and is discouraged: it misleads readers and can hide mismanagement.

Key Terms / Important Terms

  • Depreciation — The fall in the value of a fixed asset due to use, wear and tear, passage of time or obsolescence.
  • Book value — Original cost minus total depreciation charged so far.
  • Scrap / residual value — The estimated value of an asset at the end of its useful life.
  • Straight line method — Depreciation charged equally every year: (Cost − Scrap) ÷ Useful life.
  • Written down value method — Depreciation charged at a fixed percentage on the reducing book value each year.
  • Provision — An amount set aside for a known liability or probable loss; a charge against profit.
  • Reserve — An amount set aside out of profit for future needs; an appropriation of profit.
  • Depletion — The fall in value of a wasting asset, such as a mine or quarry, as its contents are extracted.
  • Amortisation — Writing off an intangible asset, such as a patent or copyright, over its useful life.
  • Secret reserve — A hidden reserve created by understating assets or overstating liabilities; it is not disclosed in the accounts.

Remember

  • Depreciation spreads cost over useful life; it is a non-cash expense.
  • SLM: equal charge every year. WDV: falling charge every year, on the reducing balance.
  • On disposal: compare sale price with book value — profit if higher, loss if lower.
  • Provision = charge against profit, made even without profit. Reserve = appropriation of profit, made only from profit.
  • Provisions for doubtful debts are deducted from debtors in the balance sheet.
  • Under the provision method the asset account keeps its original cost and accumulated depreciation is shown separately; under the direct method the asset account itself falls each year. The Profit and Loss Account is debited in both methods.

Exam Tip / Common Mistake

Common mistake: charging WDV depreciation on the original cost every year instead of on the reducing balance. Under WDV the base changes: year 2 is charged on year 1's book value, not on cost. Another common slip is forgetting scrap value in SLM — always subtract it before dividing by useful life.

Practice set — try it yourself

  1. A machine costs Rs 2,00,000, scrap value Rs 20,000, life 9 years. Find annual SLM depreciation. Hint: Subtract scrap first, then divide by life.
  2. A machine of Rs 2,00,000 is depreciated at 10% WDV. Find depreciation for years 1 and 2 and the book value after year 2. Hint: Year 2 is charged on the year 1 book value, not on cost.
  3. An asset with book value Rs 40,000 is sold for Rs 46,000. Is there a profit or a loss, and of how much? Hint: Compare sale price with book value.
  4. Give two differences between a provision and a reserve. Hint: Think: known vs unknown need, and charge vs appropriation.
  5. Why is depreciation charged even though no cash leaves the business? Hint: Think about matching cost with the revenue the asset helps to earn.

Questions with Answers

  1. Verify the SLM book values in the notes for the Rs 1,20,000 machine. Answer: Annual depreciation = (1,20,000 − 20,000) ÷ 5 = Rs 20,000. Book values: Rs 1,00,000; Rs 80,000; Rs 60,000; Rs 40,000; Rs 20,000 (scrap value).
  2. Verify the WDV figures in the notes for years 1 to 3 at 10%. Answer: Year 1: 10% × 1,20,000 = Rs 12,000, book value Rs 1,08,000. Year 2: 10% × 1,08,000 = Rs 10,800, book value Rs 97,200. Year 3: 10% × 97,200 = Rs 9,720, book value Rs 87,480.
  3. Verify the disposal loss in the notes. Answer: Book value after 3 years = 80,000 − (3 × 8,000) = Rs 56,000. Sold for Rs 50,000. Loss = 56,000 − 50,000 = Rs 6,000.
  4. A firm has debtors of Rs 80,000 and creates a 5% provision for doubtful debts. Pass the effect in the Profit and Loss Account and the Balance Sheet. Answer: Provision = 5% × 80,000 = Rs 4,000, debited to the Profit and Loss Account and deducted from debtors, so debtors appear at Rs 76,000 in the balance sheet.
  5. A company earns no profit this year but still creates a provision for a pending tax demand. Is this correct? Why? Answer: Yes. A provision is a charge against profit for a known liability; it is made whether or not there is a profit, unlike a reserve, which needs profit to exist.

Extension Questions with Answers

  1. A machine costs Rs 1,00,000 with scrap value Rs 10,000 and a life of 10 years. Find its book value after 2 years under SLM, and under WDV at 10% (ignoring scrap for WDV). Answer: SLM: annual (1,00,000 − 10,000) ÷ 10 = Rs 9,000; after 2 years Rs 1,00,000 − Rs 18,000 = Rs 82,000. WDV: year 1 Rs 10,000, book value Rs 90,000; year 2 Rs 9,000, book value Rs 81,000.
  2. Pass the entry for charging depreciation of Rs 9,000 under the provision method, and state where the asset appears in the balance sheet. Answer: Depreciation A/c … Dr Rs 9,000; To Provision for Depreciation A/c Rs 9,000. The asset appears at cost less accumulated depreciation in the balance sheet.
  3. A machine costing Rs 1,00,000 gets an extension costing Rs 20,000 that increases its capacity. Depreciation is 10% on cost (SLM). What is the annual charge after the extension? Answer: Rs 12,000: the extension is capitalised, so the charge is 10% × (1,00,000 + 20,000) = Rs 12,000.
  4. A firm shows its closing stock at Rs 40,000 although it is worth Rs 50,000. What has it created, and why is it discouraged? Answer: A secret reserve of Rs 10,000. It hides the firm's true strength, misleads readers, and can conceal mismanagement.
  5. Distinguish a capital reserve from a revenue reserve with one example each. Answer: Capital reserve comes from capital profits, such as Rs 30,000 profit on sale of a fixed asset, and is not available for dividends. Revenue reserve comes from revenue profits, such as a general reserve from trading profits, and is available for dividends.

Board-pattern Questions with Answers

  1. State four causes of depreciation. Answer: Use and wear and tear; passage of time; obsolescence; exhaustion of legal rights or accidents.
  2. State the three factors that decide the annual amount of depreciation. Answer: Original cost (including installation and freight); estimated scrap or residual value; estimated useful life.
  3. An asset with a book value of Rs 75,000 is sold for Rs 60,000. Is there a profit or a loss, and of how much? Answer: Loss of Rs 15,000 (75,000 − 60,000), debited to the Profit and Loss Account.
  4. Give three differences between a provision and a reserve. Answer: Provision is for a known liability or probable loss, reserve for an unknown future need. Provision is a charge against profit, reserve an appropriation of profit. Provision is made even in a loss year, reserve only out of profit.
  5. A machine costs Rs 50,000 and is depreciated at 20% on the written down value. Find depreciation for years 1 and 2 and the book value after year 2. Answer: Year 1: 20% × 50,000 = Rs 10,000, book value Rs 40,000. Year 2: 20% × 40,000 = Rs 8,000, book value Rs 32,000.

Recap

Depreciation spreads a fixed asset's cost over its useful life (matching); its amount depends on cost, scrap value and useful life. SLM charges equally every year; WDV charges a percentage of the reducing balance. Recording is either direct to the asset account or through a provision for depreciation account. Disposal compares sale price with book value; additions that raise capacity are capitalised. Provisions are charges for known needs; reserves are appropriations from profit; secret reserves hide strength and are discouraged.