Class 11 Accountancy Chapter 7: Depreciation, Provisions and Reserves

When a business purchases machinery, how should its cost be distributed across accounting years, and how should expected losses or retained profits be recorded? Applying these concepts correctly helps you determine the period’s profit, calculate the book value of fixed assets and understand the treatment of different items in financial statements.

PW’s Class 11 Commerce online batches for School Preparation offer live and recorded lectures, study material, previous years’ questions, mock tests and doubt-solving support. You can use these learning resources to practise numerical problems, revise accounting entries and improve your application of depreciation, provisions and reserves concepts.

Depreciation, Provisions and Reserves

Meaning of Depreciation

Depreciation is the gradual and permanent decrease in the value of a fixed asset due to use, the passage of time or obsolescence. In accounting, it involves allocating the depreciable cost of an asset over its estimated useful life.

Depreciation is charged to calculate the profit for an accounting period and determine the carrying amount of a fixed asset in the Balance Sheet.

Example: A business purchases machinery for Rs. 1,00,000 and expects to use it for five years. The cost is allocated over its useful life rather than being charged entirely as an expense in the year of purchase.

Causes of Depreciation

The main causes of depreciation are:

• Wear and Tear: Machinery, vehicles and equipment deteriorate through regular use.

• Efflux of Time: Certain assets lose value as time passes, even when they are not actively used.

• Obsolescence: New technology or changes in demand can make existing assets outdated.

• Depletion: Natural resources such as mines and oil reserves reduce as they are extracted. The term depletion is generally used for the gradual exhaustion of natural resources.

Factors Affecting Depreciation

The following factors determine the amount of depreciation charged on an asset:

• Original Cost: The purchase price and other costs necessary to bring the asset into working condition.

• Estimated Residual Value: The expected value of the asset at the end of its useful life.

• Estimated Useful Life: The period for which the asset is expected to be used by the business.

Formula:

Depreciable Amount = Original Cost − Estimated Residual Value

Methods of Calculating Depreciation

The two commonly studied methods of calculating depreciation are the Straight Line Method and the Written Down Value Method.

1. Straight Line Method (SLM)

Under the Straight Line Method, an equal amount of depreciation is charged every year throughout the asset’s estimated useful life, assuming the estimates remain unchanged.

Formula:

Annual Depreciation = (Original Cost − Residual Value) ÷ Useful Life in Years

Example: A machine costs Rs. 1,00,000, has an estimated residual value of Rs. 10,000 and a useful life of five years.

Annual Depreciation = (Rs. 1,00,000 − Rs. 10,000) ÷ 5

Annual Depreciation = Rs. 18,000

Therefore, the annual depreciation charge is Rs. 18,000. At the end of five years, the machine’s carrying amount will be Rs. 10,000, assuming no other adjustments.

2. Written Down Value Method (WDV)

Under the Written Down Value Method, depreciation is calculated at a fixed percentage of the asset’s opening book value every year. As the book value decreases, the depreciation charge also decreases.

Formula:

Annual Depreciation = Opening Book Value × Depreciation Rate ÷ 100

Example: A machine costs Rs. 1,00,000, and depreciation is charged at 10% per annum.

• Year 1: Depreciation = Rs. 1,00,000 × 10% = Rs. 10,000. Closing Book Value = Rs. 90,000.

• Year 2: Depreciation = Rs. 90,000 × 10% = Rs. 9,000. Closing Book Value = Rs. 81,000.

The depreciation charge decreases because the rate is applied to the reduced book value rather than the original cost.

Journal Entries for Depreciation

Depreciation can be recorded using the Direct Asset Credit Method or the Provision for Depreciation Method.

1. Direct Asset Credit Method

Under this method, depreciation is credited directly to the asset account. Therefore, the asset account shows its reduced carrying amount after depreciation is recorded.

Journal Entry:

Depreciation A/c Dr.

To Asset A/c

(Being depreciation charged on the asset)

At the end of the accounting period, depreciation is transferred to the Profit and Loss Account.

Profit and Loss A/c Dr.

To Depreciation A/c

(Being depreciation transferred to the Profit and Loss Account)

2. Provision for Depreciation Method

Under this method, the original cost of the asset remains unchanged in the asset account. Depreciation is accumulated in a separate Provision for Depreciation Account, also known as the Accumulated Depreciation Account.

Journal Entry:

Depreciation A/c Dr.

To Provision for Depreciation A/c

(Being depreciation provided on the asset)

At the end of the accounting period, depreciation is transferred to the Profit and Loss Account.

Profit and Loss A/c Dr.

To Depreciation A/c

(Being depreciation transferred to the Profit and Loss Account)

The asset is presented in the Balance Sheet at its original cost less accumulated depreciation and any applicable impairment loss. The accumulated depreciation balance is adjusted when the asset is disposed of.

Meaning of Provisions

A provision is an amount charged against profit to meet a known liability or expected loss whose exact amount or timing is uncertain.

It ensures that expected obligations and losses are appropriately recognised in the financial statements.

Examples of provisions:

• Provision for Doubtful Debts

• Provision for Taxation

• Provision for Warranty Obligations

Important points about provisions:

• A provision is a charge against profit.

• It is created to meet a liability or expected loss.

• It reduces the profit available for appropriation.

• It is recognised when the applicable accounting requirements are satisfied.

Meaning of Reserves

A reserve is a portion of profit retained in the business instead of being distributed to owners. It can strengthen the financial position of a business, support expansion and help meet future business requirements.

Unlike a provision, a reserve is generally an appropriation of profit rather than a charge against profit for recognising a liability or expected loss.

Examples of reserves:

• General Reserve

• Capital Reserve

• Revenue Reserve

Types of Reserves

1. Revenue Reserve

A revenue reserve is created from profits earned through the normal operations of a business.

Example: General Reserve.

Revenue reserves may be available for dividend distribution or other purposes, subject to applicable legal requirements and the nature of the reserve.

2. Capital Reserve

A capital reserve is created from capital profits rather than ordinary operating profits. It may arise from certain capital transactions, depending on the applicable accounting rules.

Capital reserves are generally not available for routine dividend distribution, subject to applicable legal provisions and the nature of the reserve.

Important Points for Revision

• Depreciation allocates the depreciable cost of a fixed asset over its useful life.

• Wear and tear, efflux of time and obsolescence are common causes of depreciation.

• Under SLM, the annual depreciation charge generally remains constant.

• Under WDV, depreciation is calculated on the opening book value.

• Under the Direct Asset Credit Method, the asset account is credited with depreciation.

• Under the Provision for Depreciation Method, depreciation is credited to a separate accumulated depreciation account.

• A provision is a charge against profit, whereas a reserve is generally an appropriation of profit.

• Revenue reserves arise from revenue profits, while capital reserves arise from capital profits.

• Depreciation reduces accounting profit but does not itself involve a cash payment when the expense is recorded.

Depreciation, provisions and reserves help you understand how businesses account for fixed assets, expected liabilities and retained profits. Revise the SLM and WDV formulas, practise the journal entries and solve numerical questions to strengthen your understanding. PW's Class 11 Accountancy Notes can support your revision, while regular practice helps you apply these concepts accurately in examinations.