CBSE Class 11 ACCOUNTANCY Chapter 7

Depreciation, Provisions and Reserves Revision Notes

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Learning Objectives

After studying this lesson, you should be able to:

State the meaning and concept of depreciation.

Explain the need and factors affecting depreciation.
Explain the methods of charging depreciation.
Show the Accounting Treatment of Depreciation.
State the meaning of Provisions and Reserves.
Differentiate between Provisions and Reserves.

Teaching Methods: Teachers are advised to use various examples from daily life in order
to clear the concept of depreciation.
Depreciation Concept: Fixed assets
are held on a long term basis and used to generate
periodic revenue. That portion of assets, which is believed to have been consumed or
expired to earn the revenue, needs to be charged as cost. Such an appropriate proportion
of the cost of fixed assets is called Depreciation.
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 process of converting Raw material into finished products, the fixed assets
depreciate in value over a period of time, i.e. its useful life.

In other words, the process of allocation of the cost of a fixed asset over its useful life is
known as depreciation
According to accounting
standard – 6 (Revised) issued by the ICA

“Depreciation is a measure of wearing out, consumption or other loss of value of a

depreciable asset arising from use, effusion of time or obsolescence through technology
and market changes.

Depreciation is allocated so as to charge a fair proportion of the depreciable in each

accounting period-during the expected useful life of the asset. Depreciation includes
amorization of assets whose useful life is predetermined.
Some Imporant Terms

1. Obsolescence:- When a fixed tangible assets become useless or unwanted due to

new invention.
2. Amorization:- The term amorization is used for writing off intangible assets such
as goodwill, copyright, patents, etc.
3. Depletion:- The term depletion is used in relation to decreasing the value of
wasting assets or natural resources such as mines, oil wells, timber trees & fishing
etc. due to the continue removal or extraction of things.

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Need or objectives of providing Depreciation

1. Ascertaining true profit or loss:

1. The true profit of an enterprise can be ascertained when all cost; 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 expenses 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
consideration. Hence, depreciation must be provided to ascertain the corn- recto
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: Depreciation 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.

Methods of providing depreciation

1. Straight line method

1. This method is also known as ‘original cost method’.

2. Under this method, depreciation is charged at fixed percentage on the original cost
of the asset, throughout its estimated life.
3. Under this method the amount of depreciation is uniform from year to year. That is
why this method is also known as ‘Fixed Installment Method’ or Equal installment
method’.
4. The annual amount of depreciation can be easily calculated by the following
formula:

Annual Depreciation =Original Cost – Estimated scrap valueEstimated Life in

year  =Original Cost – Estimated scrap valueEstimated Life in year  

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For examples: A firm purchases a machine for Rs. 2,25,000 on April 1, 2013. The
expected life of this machine is 5 years. After 5 years the scrap of this machine would be
realized Rs. 25,000. Under straight line method, the amount of depreciation can be
calculated as under:

Annual Depreciation = 2,25,000−25,00052,25,000−25,0005 = Rs. 40,000

Hence Rs. 40,000 will be charged every year as depreciation on this machine.
2. Diminishing balance method: Under this method, depreciation is charged
as a fixed
percentage on the book value of the asset every year. In first year the depreciation will be
charged at the end of the year, on the total cost the asset.

Example: A machine is purchase for Rs. 2,00,000 on April 1. 2009. It is decided to charge
depreciation on this machine @ 10% p.a. The amounts to depreciation for first four years
by using both the methods (Straight line method and Diminishing balance method)

as shown as under:

Year Book Value Dep. @ Book Vlaue Dep. @

10% 10%

2009- 20,000 2,000 20,000 2,000

10

2010- 18,000 (20,000 – 2,000 18,000 (20,000 – 1,800

11 2,000) 2,000)

2011- 16,000 (18,000 – 2,000 16,200 (18,000 – 1,620

12 2,000) 1,800)

2012- 14,000 (16,000 – 2,000 14,580 (16,200 – 1,458

13 2,000) 1,620)

Hence, in Straight Line method, amount of depreciation is same but in Diminishing

Balance Method amount of depreciation goes on decreasing every year. Depreciation can
be recorded by crediting it to the Assets account.
Methods of Recording Depreciation

First Method
In this method
one account is prepared :
(i) Asset A/c

In this case, each year, Depreciation is directly credited to the Asset A/c
with the help of this entry:

Depreciation A/c Dr
To Asset A/c

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 Second Method
In this method two accounts are prepared :

(i) Asset A/c

(ii) Provision for Depreciation A/c

In such case, ever year depreciation is directly credited to provision for Depreciation
A/c. P.F.D. A/c shows the accumulated amount of depreciation to date.

At the time sale of asset, the total accumulated depreciation of concern asset is
transferred to the credit side of asset with the help of following entry.

Accumulated Depreciation A/c or Prov. for Depreciation A/c Dr.

To Asset A/c

Asset Disposal Account

Asset Disposal A/c is opened when an asset (partially or fully) is sold or disposed off. All
entries related to sold asset are recorded in the asset disposal A/c. Methods of recording
the entries in Asset Disposal A/c will depend on a fact whether a provision for
depreciation A/c is maintained or not.

Format of Assets Disposal Account

When provision for Depreciation Account is maintained

To Asset A/c (Original Value) – By Provision for Depreciation A/c –

By Bank A/c –

To Statement of profile – By Statement of profile –

Loss (if loss) – Loss (if Profit) –

When provision for Depreciation Account is not maintained

To Asset A/c (Original Value-Depreciation) – By Bank A/c –

TO Statement of Profile & – By Statement of profile –

Loss (if loss) – Loss (if profit) –

Provisions

Provision is to be made in respect of a liability, which is certain to be incurred, but its

accurate amount is not known.
It is charged in the Profit and loss Account on estimate basis. It Should be clearly
understood that if the amount of a known liability can be determined with
reasonable accuracy, it can not be a provision.

Notes: Provision is a charge against profits. It means provision has to be made

irrespective of business enterprise is earning enough profits or incurring losses.
Examples of Provisions: Provision for Depreciation on assets, Provision for Repairs
and

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Renewals of assets. Provision for Taxation, Provision for Discount on Debtors, Provision
for Bad and Doubtful Debts.

Reserves

Reserves are the amount set aside out of profits. It is an appropriation of profits and
not a charge on the profits.
The amount of profit retained is used in the business when difficult time comes.
Since reserves are neither expenses nor losses, so these are not charged to profit
& loss Account rather these are debited to Profit & Loss Appropriation Account
which is prepared after Profit and Loss Account.
Reserves are also known as ‘Ploughing Back of Profits’.
Reserves are created to strengthening the financial positions of the business
enterprise.
Examples are General Reserves, Dividend Equalization Reserve etc.
If the amount of reserve is invested outside the business then, it is called ‘Reserve
Fund’.
Creation of reserve does not reduce the not profit but only reduced the divisible
profits.

DIFFERENCE BETWEEN PROVISIONS AND RESERVES

Basis Provision Reserve

1. Meaning It is created to meet a known It is created to strengthen the

liability financial position of business
enterprise.

2. Charge or Provisions are charge against Reserve is an appropriation of

Appropriation profits. profit.

3. Objective The object is to provide for It is created to strengthen the

known liability cannot be financial position and to meet
calculated accurately. unforeseen liability

4. Effect on It is debited to the Profit Reserve reduces divisible

Profit & Loss Hence, profit is reduced. profits.
A/c

5. Creation Provisions are to be created Reserve is created out of

even if there are insufficient adequate profits only.
profits.

6 Mode of Provisions are created by It is created through Profit &

creation debiting the Profit & loss Loss Appropriation Account.
account.

7 Investment It cannot be invested outside Reserve can be invested

the business. outside the business.

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 8 Necessity Creation of provision is Its creation is not necessary. It
necessary as per law. is created as a matter of
prudence.

Types of Reserves

Revenue Reserves
General Reserves
Specific Reserves
Capital Reserves

Revenue Reserves
Revenue Reserves are
those reserves which are created by setting aside a par of the net
profit of business. Since reserves represent undistributed profit of the company so they
are available for declaration of dividend and distribution among shareholders. Revenue
Reserves are of two types namely. (1) General Reserves (2) Specific Reserves.

1. General Reserves:- Those reserves which are created out of profit to meet out the
unforseen contigencies is called general Reserves. They are termed as ‘Free
Reserves’ or ‘Contingency Reserves’. Creation of general reserve is optional. It is
an appropriation of profit so it is made only if adequate profit is earned by the
company. They are shown on liability side of the balance sheet under the head,”
Resere and surplus”.
2. Specific Reserves:- These Reserves are created for specific purpose and can be
utilised for that purpose only. Examples:­Divindend Equalization Reserves,
Debentures Redemption Reserve, workmen Compensation fund, Investment
Fluctuation Reserves etc.

Reserve fund:- If reserves are invested in outside securities, it is known as Resere

fund.

Capital Reserves:- The reserves created out of capital profits are known as capital
Reserve. Such reserves, generally are not available for distribution as cash dividend
among the share holders of a company.

Examples:-

1. Profit on sale of fixed assets.

2. Profit on revaluation of assets and liabilities.
3. Securities premium earned on issue of share or debentures.
4. Profit on the purchase of running business.
5. Profit earned on forfeiture of shares.
6. Profit on redemption of debentures.
7. Profit prior to the incorporation of a company.

Capital profits can be used to write off capital losses and to issue fully paid up bonus
shares among the equity share holders. However, company can declare dividend out of
capital profits on the fulfilment of the following conditions.

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1. Articles of Associations of a company permits the declaration of dividend out of
such profile.
2. Capital profits realised in cash.
3. Profile remains after revaluation of assets and liabilities.

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