Class 11 Accountancy Chapter 7: Depreciation, Provisions and Reserves

Meaning, Need and Causes of Depreciation

Depreciation is the gradual, permanent and continuing fall in the book value of a fixed tangible asset due to usage, passage of time, wear and tear, or obsolescence. It is NOT a cash expense — no money leaves the business when depreciation is charged — yet it is charged to the Profit and Loss Account because of the Matching Concept: the cost of an asset must be spread over the years it helps generate revenue.

Causes of depreciation include: (1) Wear and tear from constant use, (2) Efflux of time — even an unused asset deteriorates with age, (3) Obsolescence — new technology making the old asset outdated, (4) Accidents, and (5) Fall in market price (not usually depreciation in the accounting sense, but a factor). Depreciation is charged only on fixed tangible assets having a limited useful life, such as machinery, furniture, buildings and vehicles — not on land (unlimited life) and not on current assets or investments.

Related terms often confused with depreciation: Depletion (physical shrinkage of natural resources like mines and oil wells), Amortization (writing off intangible assets like patents, goodwill, copyrights), and Dilapidation (damage due to negligence).

Key Terms You Must Know

Depreciation

The systematic allocation of the depreciable cost of a fixed asset over its useful life, representing gradual fall in value due to use, time or obsolescence.

Depletion

Reduction in the value of natural resource assets (mines, quarries, oil wells) due to physical extraction of the resource.

Amortization

Writing off the cost of intangible assets such as patents, trademarks, copyrights and leaseholds over their useful or legal life.

Obsolescence

Loss of value of an asset because a better, more efficient alternative (usually due to new technology) becomes available, even if the old asset still works.

Provision

An amount set aside out of current year's profits to meet a known liability or expected loss of uncertain amount, e.g., Provision for Depreciation, Provision for Doubtful Debts. It is a charge against profit and must be made whether the business earns profit or loss.

Reserve

An amount of profit set aside (appropriated) to strengthen the financial position of the business or meet future unknown contingencies. Unlike a provision, a reserve is an appropriation of profit, made only when there is profit.

Reserve Fund

A reserve that is specifically invested outside the business in easily realisable securities, so that funds are available when actually needed.

Secret Reserve

A reserve that exists but is not disclosed in the Balance Sheet, created by undervaluing assets or overvaluing liabilities — common in banking and insurance companies, but generally prohibited for most companies under the Companies Act.

Straight Line Method vs Written Down Value Method

Step-by-Step: Recording Depreciation and Provision for Depreciation

1. Step 1: Identify Depreciable Cost — Depreciable cost = Original cost of the asset (including installation and freight charges) minus estimated scrap/residual value. This is the total amount to be written off over the asset's useful life.
2. Step 2: Choose the Method — Under SLM: Annual Depreciation = Depreciable Cost ÷ Useful Life in years. Under WDV: Annual Depreciation = Book value at start of year × Rate of depreciation %.
3. Step 3: Pass Journal Entry Without Provision for Depreciation Account — Depreciation A/c Dr. To Asset A/c (to record fall in asset value); then Profit and Loss A/c Dr. To Depreciation A/c (to transfer depreciation to P&L). Here the asset account itself shows the reduced book value every year.
4. Step 4: Pass Journal Entry With Provision for Depreciation Account — Depreciation A/c Dr. To Provision for Depreciation A/c; then Profit and Loss A/c Dr. To Depreciation A/c. The original asset stays at cost price in the Asset Account, while accumulated depreciation builds up separately in the Provision for Depreciation Account (shown as deduction from asset cost in the Balance Sheet).
5. Step 5: Balance Sheet Presentation — Show the asset at cost, less total accumulated Provision for Depreciation, to arrive at net book value. This method keeps historical cost visible and is preferred in modern accounting practice.

Fully Worked Numerical Examples

• Example 1 (Straight Line Method): A machine is purchased on 1st April 2021 for ₹2,00,000. Installation charges are ₹20,000. Estimated scrap value after 5 years is ₹20,000. Calculate annual depreciation under SLM and show the Asset Account for 2 years (books close on 31st March). Step 1: Total cost = 2,00,000 + 20,000 = ₹2,20,000. Step 2: Depreciable cost = 2,20,000 − 20,000 (scrap) = ₹2,00,000. Step 3: Annual depreciation = 2,00,000 ÷ 5 = ₹40,000 per year. Step 4: Asset A/c — Year 1: Opening balance 2,20,000; less depreciation 40,000; closing balance 31-Mar-2022 = ₹1,80,000. Year 2: Opening 1,80,000; less depreciation 40,000; closing balance 31-Mar-2023 = ₹1,40,000. Final answer: Annual depreciation = ₹40,000; book value after 2 years = ₹1,40,000.
• Example 2 (Written Down Value Method): Using the same machine costing ₹2,20,000, calculate depreciation for the first two years at 10% p.a. under WDV. Step 1: Year 1 depreciation = 10% of 2,20,000 = ₹22,000. Book value at end of Year 1 = 2,20,000 − 22,000 = ₹1,98,000. Step 2: Year 2 depreciation = 10% of 1,98,000 = ₹19,800. Book value at end of Year 2 = 1,98,000 − 19,800 = ₹1,78,200. Final answer: Depreciation Year 1 = ₹22,000; Depreciation Year 2 = ₹19,800; closing book value = ₹1,78,200.
• Example 3 (Journal Entries with Provision for Depreciation A/c): A firm purchases furniture on 1 April 2022 for ₹1,00,000, depreciation charged at 10% p.a. SLM using a Provision for Depreciation Account. Pass journal entries for the year ended 31 March 2023. Step 1: Record purchase: Furniture A/c Dr. ₹1,00,000; To Bank A/c ₹1,00,000. Step 2: Charge depreciation: Depreciation A/c Dr. ₹10,000; To Provision for Depreciation A/c ₹10,000 (10% of 1,00,000). Step 3: Transfer to P&L: Profit and Loss A/c Dr. ₹10,000; To Depreciation A/c ₹10,000. Step 4: Balance Sheet shows Furniture at cost ₹1,00,000 less Provision for Depreciation ₹10,000 = Net Block ₹90,000. Final answer: Net book value shown in Balance Sheet = ₹90,000.

Provision vs Reserve — The Most Tested Distinction

Types of Reserves

Reserves are broadly classified into two categories. Revenue Reserves are created from revenue profits (profits earned from normal business operations) and are freely available for distribution as dividend; examples include General Reserve (kept for any future purpose) and Specific Reserve (kept for a particular purpose like Dividend Equalisation Reserve or Workmen Compensation Reserve). Capital Reserves are created from capital profits — profits not earned from normal trading operations, such as profit on sale of fixed assets, premium on issue of shares/debentures, or profit prior to incorporation. Capital reserves are generally NOT available for distribution as cash dividend; they can be used for purposes like writing off capital losses or issuing bonus shares.

A Sinking Fund is a specific type of reserve (often a reserve fund) created by setting aside a fixed sum each year, investing it outside the business, so that a definite amount is available at a future date to replace an asset or repay a liability.

Common Mistakes Students Make

• Confusing depreciation with fall in market value — depreciation is about allocation of cost, not market price fluctuation.
• Charging depreciation on land, which has an unlimited useful life and is therefore not depreciated (unless it is a wasting asset like a mine).
• Forgetting that under WDV method, depreciation is always calculated on the reducing book value, not on the original cost each year.
• Treating 'Provision' and 'Reserve' as interchangeable terms in exam answers — examiners specifically test this distinction.
• Not adjusting for scrap/residual value while calculating depreciable cost under the Straight Line Method.
• Showing Provision for Depreciation as a liability instead of correctly deducting it from the concerned asset's cost in the Balance Sheet.

Board Exam Tip

In CBSE board exams, questions on this chapter often ask you to prepare the Asset Account, Depreciation Account and Provision for Depreciation Account together for 2-3 years — practice this combination repeatedly. Also, a 3-4 mark theory question distinguishing 'Provision and Reserve' or 'Revenue Reserve and Capital Reserve' appears almost every year — memorise the comparison table points with at least one example for each term, since examiners award marks for correct examples too.

Practice Questions with Solutions

• Q: A company purchased machinery for ₹5,00,000 on 1st April 2020. Depreciation is charged at 10% p.a. under the Straight Line Method. Books are closed on 31st March each year. Prepare the Machinery Account for 3 years. A: Step 1: Annual depreciation = 10% of 5,00,000 = ₹50,000 (fixed every year under SLM). Step 2: Year 1 (2020-21): Opening balance 5,00,000; less depreciation 50,000; closing balance = ₹4,50,000. Step 3: Year 2 (2021-22): Opening 4,50,000; less depreciation 50,000; closing balance = ₹4,00,000. Step 4: Year 3 (2022-23): Opening 4,00,000; less depreciation 50,000; closing balance = ₹3,50,000. Final answer: Machinery Account balances at the end of Year 1, 2 and 3 are ₹4,50,000, ₹4,00,000 and ₹3,50,000 respectively.
• Q: Using the Written Down Value Method, calculate depreciation for 2 years on machinery costing ₹8,00,000 at a rate of 15% p.a. A: Step 1: Year 1 depreciation = 15% of 8,00,000 = ₹1,20,000. Book value after Year 1 = 8,00,000 − 1,20,000 = ₹6,80,000. Step 2: Year 2 depreciation = 15% of 6,80,000 = ₹1,02,000. Book value after Year 2 = 6,80,000 − 1,02,000 = ₹5,78,000. Final answer: Depreciation in Year 1 = ₹1,20,000; Depreciation in Year 2 = ₹1,02,000; closing book value = ₹5,78,000.
• Q: Distinguish between Provision and Reserve with one example each. A: Step 1: A Provision is a charge against profit created to meet a known liability or probable loss of an uncertain amount, and must be made compulsorily even if the firm makes a loss — example: Provision for Doubtful Debts. Step 2: A Reserve is an appropriation of profit made to strengthen the financial position of the business or meet future unknown needs, and is created only when there is a profit — example: General Reserve. Step 3: Provisions are shown as deductions from the related asset or under current liabilities, while reserves are shown under 'Reserves and Surplus' on the liabilities side. Final answer: Provision = compulsory charge for a known liability (e.g., Provision for Doubtful Debts); Reserve = voluntary appropriation of profit (e.g., General Reserve).
• Q: A firm bought furniture worth ₹60,000 on 1 April 2021. Depreciation is charged at 10% p.a. on SLM using a Provision for Depreciation Account. Pass journal entries for the year ended 31 March 2022 and show the Balance Sheet extract. A: Step 1: Purchase entry: Furniture A/c Dr. ₹60,000; To Bank A/c ₹60,000. Step 2: Depreciation entry: Depreciation A/c Dr. ₹6,000; To Provision for Depreciation A/c ₹6,000 (10% of 60,000). Step 3: Transfer entry: Profit and Loss A/c Dr. ₹6,000; To Depreciation A/c ₹6,000. Step 4: Balance Sheet extract: Furniture (at cost) ₹60,000 less Provision for Depreciation ₹6,000 = Net Block ₹54,000. Final answer: Net book value of furniture shown in the Balance Sheet = ₹54,000.
• Q: Explain any three causes of depreciation with examples. A: Step 1: Wear and tear — continuous use of machinery in a factory reduces its efficiency and value over time, e.g., a printing press losing precision after years of daily printing. Step 2: Obsolescence — an asset becomes outdated due to new technology even though it is still physically usable, e.g., an old computer replaced by a faster model. Step 3: Efflux of time — assets like a lease or patent automatically lose value as their fixed legal life expires, regardless of use. Final answer: The three causes are wear and tear, obsolescence, and efflux of time, each reducing the useful economic value of the asset.

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