Depreciation, Provisions and Reserves
Class 11 Accountancy · Financial Accounting Part I · Chapter 7
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Summary
This chapter deals with depreciation in its first section and with provisions and reserves in its second. Depreciation is the systematic allocation of the cost of a fixed asset over its useful life, following the matching principle so that only the part of the cost consumed in a period is charged against that period's revenue. It is distinguished from depletion, which relates to natural resources, and amortisation, which relates to intangible assets. The causes of depreciation include wear and tear from use or passage of time, expiration of legal rights, obsolescence and abnormal factors. Charging depreciation is needed to match costs with revenue, for tax purposes, to show a true and fair financial position, and to comply with law. The amount of depreciation depends on the cost of the asset, its estimated net residual value and its estimated useful life. The two common methods of calculating depreciation are the straight line method, which charges a fixed amount each year on the original cost, and the written down value (diminishing balance) method, which charges a fixed percentage on the reducing book value. Provisions are amounts set aside to meet known liabilities of uncertain amount, such as a provision for doubtful debts, while reserves are appropriations of profit to strengthen the financial position. Reserves include revenue reserves and capital reserves, and undisclosed reserves are called secret reserves.
Meaning, features and causes of depreciationDepreciation, depletion and amortisationFactors affecting the amount of depreciationStraight line and written down value methodsProvisions and reserves
Key terms
Depreciation
The systematic allocation of the depreciable cost of a fixed asset over its useful life.
Written Down Value Method
A method that charges depreciation at a fixed percentage on the reducing book value of the asset each year.
Straight Line Method
A method that charges an equal amount of depreciation each year based on the original cost of the asset.
Obsolescence
A cause of depreciation where an asset becomes outdated due to new technology or changes in demand.
Provision
An amount set aside out of profits to meet a known liability whose amount cannot be determined with certainty, such as a provision for doubtful debts.
Reserve
An appropriation of profit retained in the business to strengthen its financial position; it may be a revenue or capital reserve.
Extra questions & answers
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Depreciation is the systematic allocation of the cost of a fixed asset over its: