Depreciation: Meaning and Features

In accordance with the matching principle, a cornerstone of accrual accounting, the revenues earned during an accounting period must be matched with the expenses incurred to generate those revenues. When a business invests in a long-term fixed asset, such as machinery, vehicles, or buildings, it incurs a significant capital expenditure. The economic benefit from this asset will be derived not just in the year of purchase but over several subsequent accounting periods. Therefore, it would be fundamentally incorrect and misleading to charge the entire cost of the asset as an expense in the year it was acquired. Doing so would drastically understate the profit for that year and overstate the profits for all future years.

To resolve this, the cost of the asset must be spread or allocated systematically over the periods it benefits. Depreciation is precisely this accounting process: it is the systematic allocation of the depreciable cost of a tangible fixed asset over its estimated useful life. It is a process of cost allocation, not asset valuation.

Fixed assets (also known as depreciable assets) inherently lose their value and service potential over time. This decline can be due to physical wear and tear from usage, the mere passage of time, or technological advancements making the asset obsolete. In accounting terms, depreciation represents the portion of the asset's cost that has "expired" or been "used up" in the current accounting period. This expired cost is treated as a non-cash operating expense and is charged to the Profit and Loss Account to ensure the ascertainment of the true profit or loss for the period.

Formal Definitions of Depreciation

The concept of depreciation is formally defined by various professional accounting bodies to ensure consistency and clarity.

• The Institute of Cost and Management Accounting (ICMA), London, provides a concise definition: "Depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time."

• Accounting Standard (AS) 6, issued by The Institute of Chartered Accountants of India (ICAI), offers a more comprehensive definition: “Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change. Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is pre-determined”.

AS-6 further clarifies that the subject of depreciation is 'depreciable assets'. An asset is considered depreciable if it meets the following three criteria:

1. It is expected to be used during more than one accounting period.

2. It has a limited useful life (i.e., it cannot be used indefinitely).

3. It is held by the enterprise for use in the production or supply of goods and services, for rental to others, or for administrative purposes, and not for the purpose of resale in the ordinary course of business.

Examples of depreciable assets include machinery, plant, furniture, buildings, computers, trucks, and equipment.

Features of Depreciation

The core characteristics and fundamental nature of depreciation can be summarised as follows:

1. Decline in Book Value: Depreciation is a reduction in the book value of a fixed asset. The book value is the historical cost of the asset minus all depreciation charged to date (accumulated depreciation). It is crucial to distinguish this from market value. The market value (what the asset could be sold for) may fluctuate and can even increase, but depreciation must still be charged as it represents the allocation of the original cost, not a reflection of current market prices.

2. Multiple Causes: The decline in an asset's value is attributable to several factors, including:

   • Wear and Tear: Physical deterioration due to usage in operations.
   • Effluxion of Time: Loss of value simply due to the passage of time, even if the asset is idle.
   • Obsolescence: Becoming outdated due to technological advancements, changes in market demand, or new legal requirements. For example, a new model of a computer makes the older one less valuable even if it is in perfect physical condition.

3. Continuing Process: Depreciation is not a one-time charge. It is a gradual, continuous, and ongoing process that is recorded in each accounting period throughout the estimated useful life of the asset.

4. Expired Cost: The acquisition of a fixed asset is a capital expenditure. Depreciation is the process of converting this capital expenditure into a revenue expenditure (an expense) over time. The amount of depreciation for a period represents the portion of the asset's cost that has expired or been consumed in generating that period's revenue. This expense is charged to the Profit and Loss Account and must be accounted for before calculating taxable profits.

5. Non-Cash Expense: This is a critical feature. Recording depreciation does not involve any current cash outflow. The cash payment was made when the asset was purchased. Depreciation is a "book entry" that allocates this past expenditure to the periods that benefit from the asset's use. While it reduces reported profit, it does not reduce the cash balance of the business in the current period.

Depreciation and Other Similar Terms

The concept of allocating the cost of a long-term asset over its useful life is fundamental to accounting. While depreciation is the term used for tangible fixed assets, two other terms, depletion and amortisation, are used for other specific categories of assets. Although the underlying assets differ, the accounting principle of matching cost with the periods of benefit remains the same, leading to similar accounting treatments.

Depletion

The term depletion is used exclusively for the allocation of the cost of natural resources. It represents the cost of the portion of the resource that has been physically extracted or used up during a period.

• Applicability: Depletion is associated with "wasting assets" such as mines (containing coal, iron ore, etc.), oil and gas reserves, quarries, and tracts of timber. These assets are physically consumed as they are used.

• Concept: The core idea is the exhaustion of a finite resource. If a business buys a coal mine for ₹10,00,000, the value of that asset decreases with every tonne of coal that is extracted. Depletion is the accounting process that measures and records this reduction in the asset's value corresponding to the quantity of the resource removed.

• Depreciation vs. Depletion: The key distinction lies in the nature of the asset's decline.

  • Depreciation relates to the decline in the service potential of a manufactured asset (like a machine) due to wear and tear or obsolescence. The physical asset remains, but its efficiency decreases.
  • Depletion relates to the decline in the quantity of available resources due to physical extraction. The resource is being consumed and removed.

• Accounting Treatment: Despite the conceptual difference, the accounting treatment is similar. The cost of the natural resource is allocated over the estimated number of units to be extracted (e.g., tonnes of coal, barrels of oil). The depletion expense for a period is calculated based on the units extracted in that period.

Amortisation

The term amortisation refers to the systematic process of writing off the cost of intangible assets over their finite useful life. Intangible assets are long-term assets that lack physical substance but possess economic value.

• Applicability: Amortisation is applied to intangible assets that have a limited period of legal or economic benefit. Common examples include:

  • Patents: Exclusive rights to produce and sell an invention.
  • Copyrights: Exclusive rights to reproduce and sell a creative work (book, music, software).
  • Trademarks: Rights to a symbol or name.
  • Franchises and Licenses: Rights to operate a business or use a property for a specified period.

• Concept: The cost of acquiring an intangible asset is allocated as an expense over the periods it is expected to generate revenue. This process mirrors depreciation. For example, if a business buys a patent for ₹10,00,000 that is legally valid for 10 years, the business will "amortise" or write off ₹1,00,000 of the patent's cost each year.

• Accounting Treatment: The procedure for calculating and recording amortisation is typically identical to the straight-line method of depreciation. The annual amortisation expense is debited to the Profit and Loss Account, and the value of the intangible asset is credited (or an 'Accumulated Amortisation' account is credited).

Causes of and Need for Depreciation

Understanding the underlying factors that cause an asset to lose value is essential to appreciate why providing for depreciation is a necessary and logical business expense.

Causes of Depreciation

The decline in the value and utility of a fixed asset can be attributed to several factors, both internal and external. These are:

1. Wear and Tear due to Use or Passage of Time

   This is the most common cause, referring to the physical deterioration of an asset. It includes:

   • Usage: The operational use of an asset in business causes friction and stress, which reduces its technical capacity and efficiency over time.

   • Passage of Time (Effluxion): An asset deteriorates simply with the passage of time, even if it is not being used, due to exposure to natural elements like weather, rust, and decay.

2. Expiration of Legal Rights

   Some assets derive their value from a legal agreement that is valid for a specific time period. The value diminishes as the expiry date of this legal right approaches. Examples include patents, copyrights, and leasehold properties.

3. Obsolescence

   Obsolescence is a major factor, especially in technologically advanced industries, that makes an asset "out-of-date" long before it is physically worn out. It arises from factors such as:

   • Technological Changes: A new, more efficient model of the asset becomes available.

   • Improvements in Production Methods: A new process makes the old asset redundant.

   • Change in Market Demand: The product manufactured by the asset is no longer popular.

   • Legal Restrictions: A new law or regulation may render the asset unusable.

4. Abnormal Factors

   The usefulness of an asset can decline suddenly due to abnormal factors like accidents, fire, earthquakes, or floods. This loss is permanent but not gradual or continuous like normal depreciation. For example, a car damaged in an accident will fetch a lower price even after repairs.

Need for Providing Depreciation

Charging depreciation is not optional; it is a necessity driven by accounting principles, legal requirements, and sound business practice.

1. To Ascertain True Profit or Loss (Matching of Costs and Revenue)

   Fixed assets are used to generate revenue. The cost of using these assets (depreciation) is an expense of generating that revenue. According to the Matching Principle, this expense must be a charge against the revenue of the corresponding period. Failing to charge depreciation would result in overstating profits.

2. For Tax Considerations

   Depreciation is a deductible cost for tax purposes. As per regulations like the Income Tax Act in India, by charging depreciation, a business can legitimately reduce its taxable income and, therefore, its tax liability.

3. To Show a True and Fair Financial Position

   If depreciation on assets is not provided for, the assets will be overvalued on the Balance Sheet. This would not depict the true and fair financial position of the business. Depreciation ensures that assets are reported at a more realistic book value.

4. To Comply with Law

   Apart from tax regulations, specific laws like the Companies Act in India mandate that businesses provide depreciation on fixed assets. This is a crucial control to ensure that capital is not eroded by being paid out as dividends, ensuring dividends are distributed only from genuine profits.

Factors Affecting the Amount of Depreciation

The determination of the amount of depreciation to be charged in an accounting period is not an arbitrary process. It depends on a careful estimation of four key parameters. The accuracy of the depreciation charge, and consequently the reported profit, hinges on the realistic assessment of these factors.

1. Cost of Asset

The Cost of an Asset, also referred to as its original cost or historical cost, represents the total expenditure incurred to acquire the asset and bring it to its intended location and condition for use. It is a comprehensive figure that goes beyond the basic purchase price.

The formula for the cost of an asset is:

$Cost\ of\ Asset = Purchase\ Price $$\ + \ $$ All\ Necessary\ Costs\ to\ make\ the\ Asset\ Operational$

These necessary costs include, but are not limited to:

• Purchase Price: The invoice price of the asset before any trade discounts.

• Freight and Transportation Costs: The cost of shipping the asset from the supplier to the business premises.

• Transit Insurance: Insurance premium paid to cover the asset against damage during transportation.

• Installation and Commissioning Costs: Expenses incurred on setting up the asset, such as foundation work, electrical wiring, and test runs.

• Registration Costs: Legal fees or government charges required to register the asset, especially for vehicles.

• Initial Overhauling/Repair Costs: In the case of a second-hand asset, any expenditure incurred to bring it into working condition before its first use is capitalized.

2. Estimated Net Residual Value

The Net Residual Value, also known as scrap value or salvage value, is the estimated net realizable value of the asset at the end of its useful life. It is the amount the business expects to recover from the asset's disposal after deducting any anticipated disposal costs.

$Net\ Residual\ Value = Estimated\ $$ Sale\ Value\ $$ of\ Asset\ at\ end\ of\ life$$ \ - \ $$ Estimated\ Disposal\ $$ Costs$

3. Depreciable Cost

The Depreciable Cost is the total amount that will be charged as depreciation expense over the entire useful life of the asset. It is derived by subtracting the net residual value from the total cost of the asset. This ensures that the book value of the asset at the end of its useful life is equal to its scrap value.

$Depreciable\ Cost = Cost\ of\ Asset $$ \ - \ $$ Estimated\ Net\ Residual\ Value$

It is this depreciable cost, not the total cost, that is allocated over the asset's life. This is fundamental to the matching principle, as it ensures that the capital expenditure is properly recovered as an expense over the periods it helps to generate revenue.

4. Estimated Useful Life

The Useful Life of an asset is the estimated period over which it is expected to be economically or commercially usable by the enterprise. It is crucial to note that the useful life is often shorter than the asset's physical life. An asset might still exist physically but may be incapable of producing goods profitably or efficiently.

The useful life can be expressed in various units:

• Time Period: The most common method, expressed in number of years.

• Production Units: The number of units the asset is expected to produce (e.g., in the case of a mine).

• Working Hours: The total number of hours the asset is expected to operate.

Estimating the useful life is a matter of professional judgment and depends on several factors:

• Legal or contractual limits, such as the period of a lease.

• The number of shifts for which the asset is used.

• The company's repair and maintenance policy.

• The rate of technological obsolescence in the industry.

Methods of Calculating Depreciation

Once the depreciable amount (Cost - Residual Value) of an asset is determined, it must be allocated systematically over the asset's useful life. The choice of allocation method is crucial as it should reflect the pattern in which the asset's future economic benefits are expected to be consumed by the enterprise. While numerous methods exist, the two most predominantly used and legally recognized methods in India are the Straight Line Method and the Written Down Value Method.

Straight Line Method (SLM)

This is the simplest and one of the most widely used methods of providing depreciation. The fundamental assumption of this method is that the asset provides a uniform or equal amount of utility during each year of its useful life. Consequently, an equal and constant amount of depreciation is charged as an expense in the Profit & Loss Account every year.

This method is also known as the Fixed Installment Method because the amount of depreciation, or the "installment," remains fixed year after year. The name "straight line" is derived from the fact that if the annual depreciation amount or the book value of the asset is plotted on a graph against time, the result is a straight line sloping downwards.

Formulas and Derivation

The goal of SLM is to write off the asset's depreciable cost evenly over its estimated useful life. The calculation is straightforward.

1. Calculation of Annual Depreciation:

The annual depreciation expense is calculated by dividing the total depreciable cost by the number of years of useful life.

$Annual\ Depreciation = \frac{Cost\ of\ Asset - Estimated\ Net\ Residual\ Value}{Estimated\ Useful\ Life\ of\ the\ Asset}$

2. Calculation of Rate of Depreciation:

Sometimes, a rate of depreciation is applied to the original cost each year. This rate is derived from the annual depreciation amount.

$Rate\ of\ Depreciation\ (\%) = \frac{Annual\ Depreciation\ Amount}{Acquisition\ Cost} \times 100$

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Advantages of Straight Line Method

• Simplicity: It is the easiest method to understand and calculate, making it very popular in practice.

• Full Depreciation: It ensures that the entire depreciable cost of the asset is written off over its useful life, leaving a book value equal to the scrap value at the end.

• Easy Comparison: Since the depreciation expense is the same every year, it makes the comparison of profits from one year to another simpler and more direct.

• Suitability: It is highly suitable for assets whose utility is consistent over time and which do not require significant repairs, such as leasehold buildings, patents, and trademarks.

Limitations of Straight Line Method

• Faulty Assumption of Equal Utility: The core assumption that an asset works with the same efficiency throughout its life is often unrealistic. Most assets are more productive in their early years.

• Increasing Burden on Profits: It is a well-known fact that repair and maintenance expenses for an asset increase as it gets older. Under SLM, the depreciation charge is fixed. Therefore, the total charge against profit (Depreciation + Repairs) becomes progressively heavier in the later years of the asset's life.

Written Down Value (WDV) Method

This method is based on the more realistic assumption that an asset provides greater economic benefits in its earlier years and lesser benefits as it ages. To match this pattern, a higher amount of depreciation is charged in the initial years, and this amount gradually decreases in the subsequent years.

It is also known as the Reducing Balance Method or Diminishing Value Method because depreciation is always calculated as a fixed percentage of the book value (Written Down Value) of the asset at the beginning of each accounting period. Since the book value reduces every year, the depreciation amount also diminishes.

A key feature of this method is that the book value of the asset never becomes zero, unless it is sold or completely written off. This method is widely recognised by tax authorities, including in India, for calculating depreciation for tax purposes.

Formulas and Derivation

The calculation involves applying a fixed rate to a reducing base (the book value). The primary formulas used are:

1. To Calculate Annual Depreciation:

$Depreciation\ for\ a\ Year = Rate\ of\ Depreciation \ $$ \ \times \ $$ \ Book\ Value\ at\ the\ Beginning\ of\ the\ Year$

Where, the Book Value (or Written Down Value) is the remaining value of the asset after deducting accumulated depreciation from its original cost.

$Book\ Value = Original\ Cost - Accumulated\ Depreciation$

2. To Determine the Rate of Depreciation:

If the original cost, scrap value, and useful life of an asset are known, the specific rate required to write down the asset can be calculated. The formula is:

$R = \left(1 - \sqrt[n]{\frac{s}{c}}\right) \times 100$

Where:

• R = Rate of Depreciation (in %)

• n = Estimated useful life of the asset (in years)

• s = Scrap value or residual value at the end of useful life

• c = Original cost of the asset

Derivation of the Depreciation Rate Formula

The formula for the rate of depreciation (R) is derived from the fundamental principle of the WDV method. Let's break down the derivation step-by-step:

Let:

• $C$ = Original Cost of the asset

• $S$ = Scrap Value of the asset

• $n$ = Useful life in years

• $r$ = Rate of depreciation as a decimal (i.e., $\frac{R}{100}$)

The book value at the end of each year is calculated as follows:

End of Year 1:

Depreciation for Year 1 = $C \times r$

Book Value (WDV) at end of Year 1 = $C - (C \times r) = C(1 - r)$

End of Year 2:

Depreciation for Year 2 = (Book Value at start of Year 2) $ \times r = [C(1 - r)] \times r$

Book Value (WDV) at end of Year 2 = $C(1-r) - [C(1-r) \times r] = C(1-r)(1-r) = C(1 - r)^2$

End of Year 3:

Book Value (WDV) at end of Year 3 = $C(1 - r)^3$

Following this pattern, the book value of the asset at the end of its useful life ('n' years) will be:

End of Year n:

Book Value (WDV) at end of Year n = $C(1 - r)^n$

We know that the book value at the end of the asset's useful life is its scrap value, $S$. Therefore, we can set up the equation:

$S = C(1 - r)^n$

Now, we need to solve this equation for 'r':

1. Divide both sides by C:

$\frac{S}{C} = (1 - r)^n$

2. Take the n-th root of both sides to remove the exponent:

$\sqrt[n]{\frac{S}{C}} = 1 - r$

3. Rearrange the equation to isolate 'r':

$r = 1 - \sqrt[n]{\frac{S}{C}}$

Since 'r' is the rate in decimal form, we multiply by 100 to get the percentage rate, R:

$R = \left(1 - \sqrt[n]{\frac{S}{C}}\right) \times 100$

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Advantages of Written Down Value Method

• More Realistic Assumption: It aligns the depreciation charge with the asset's utility pattern, recognizing that assets are more useful in their early years.

• Equal Burden on Profit: This method creates a balanced charge against profits over the asset's life. In early years, high depreciation is combined with low repair costs. In later years, the low depreciation charge is offset by higher repair costs.

• Recognition by Tax Law: The WDV method is the prescribed method for calculating depreciation for tax computation purposes under the Indian Income Tax Act.

• Reduces Obsolescence Impact: By writing off a significant portion of the cost in the early years, the risk of loss from sudden obsolescence is mitigated.

Limitations of Written Down Value Method

• Value Never Becomes Zero: The book value of the asset can never be reduced to zero under this method, as depreciation is always a fraction of the remaining value.

• Complexity in Rate Calculation: Ascertaining a suitable rate of depreciation that will precisely write down the asset to its scrap value over its life is mathematically complex and not as intuitive as SLM.

Comparative Analysis: Straight Line Method vs. Written Down Value Method

The choice between SLM and WDV depends on the nature of the asset and the pattern of its use. The following table and explanations highlight their key differences.

Methods of Recording Depreciation

Once the amount of depreciation for a period has been calculated, it must be recorded in the books of accounts. There are two primary methods for recording depreciation entries, which differ in how the value of the asset is presented in the ledger and the balance sheet. The choice of method affects the presentation of financial statements but does not change the total amount of depreciation charged over the asset's life or the final net profit.

1. Charging Depreciation directly to the Asset Account

This is the simpler and more direct of the two methods. Under this arrangement, the amount of depreciation calculated for the year is directly credited to the concerned Asset Account. This action reduces the book value of the asset in the ledger itself with each passing year. The corresponding debit is made to the Depreciation Account, which is an expense and is later transferred to the Profit and Loss Account at the end of the accounting period.

The main effect of this method is that the Asset Account in the ledger does not show the original cost but rather the written down value (book value) at the end of each period.

Journal Entries

The following journal entries are passed under this method:

(i) For recording the purchase of an asset (in the year of purchase):

(ii) At the end of each accounting year for charging depreciation:

(iii) For transferring depreciation to the Profit and Loss Account:

Balance Sheet Treatment

When this method is used, the fixed asset is shown on the asset side of the Balance Sheet at its net book value (Written Down Value), which is its original cost less all depreciation charged to date. The original cost of the asset and the total accumulated depreciation are not directly visible in the Balance Sheet.

Illustration

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2. Creating a Provision for Depreciation / Accumulated Depreciation Account

This method is considered more informative as it is designed to present a more complete picture of the asset. It achieves this by keeping the Asset Account at its original cost while accumulating the total depreciation charged to date in a separate liability account. This separate account is known as the 'Provision for Depreciation Account' or 'Accumulated Depreciation Account'.

The key characteristics of this method are:

• The Asset Account is maintained at its original historical cost year after year throughout its entire useful life.

• The annual depreciation is credited to the Provision for Depreciation Account instead of the Asset Account. This account has a natural credit balance and represents the total depreciation charged on the asset since it was put to use.

• At the time of sale or disposal of the asset, the accumulated depreciation related to that asset is transferred from the Provision for Depreciation Account to the Asset Account to close it.

Journal Entries

The journal entries under this method are as follows:

(i) For recording the purchase of an asset (same as the first method):

(ii) At the end of each accounting year for providing depreciation:

(iii) For transferring depreciation to the Profit and Loss Account (same as the first method):

Balance Sheet Treatment

Under this method, the asset and its accumulated depreciation are shown separately in the Balance Sheet, providing more information to the users of financial statements. In the balance sheet, the fixed asset continues to appear at its original cost on the asset side. The depreciation charged till that date appears in the Provision for Depreciation account, which can be shown in two ways:

1. The Provision for Depreciation account is shown on the “liabilities side” of the Balance Sheet. This presents the accumulated depreciation as a form of credit balance alongside other liabilities and capital.

2. (More Common) The Provision for Depreciation is shown by way of deduction from the original cost of the concerned asset on the asset side of the Balance Sheet. This method directly shows the written down value (book value) of the asset.

Illustration

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Disposal of Asset

Disposal of an asset refers to the act of selling, scrapping, or removing a fixed asset from use. This can occur either at the end of its useful life or during its useful life due to reasons like obsolescence, inadequacy, or damage. When an asset is disposed of, its value must be removed from the books of accounts, and any resulting profit or loss on the disposal must be calculated and recorded. This profit or loss is a capital gain or loss and is transferred to the Profit and Loss Account.

The accounting treatment for asset disposal depends on whether a 'Provision for Depreciation Account' is maintained or not.

1. When Depreciation is Charged Directly to the Asset Account

In this case, the Asset Account in the ledger is not maintained at its original cost; instead, it already shows the book value (Written Down Value) of the asset. The accounting for disposal is therefore more straightforward.

Accounting Steps

Step 1: Charge Depreciation for the Current Period

If the asset is sold during the year, first calculate and record the depreciation for the period from the start of the accounting year until the date of sale. This entry is the same as the normal depreciation entry.

Step 2: Record the Sale Proceeds

The amount received from the sale is recorded by debiting the Bank/Cash Account and crediting the Asset Account. This entry reduces the book value of the asset in the ledger.

Step 3: Transfer Profit or Loss to Profit and Loss Account

After the above entries, the balance remaining in the Asset Account represents either a profit (credit balance) or a loss (debit balance) on the sale. This balance is transferred to the Profit and Loss Account.

In case of Profit on Sale (Credit balance in Asset A/c):

In case of Loss on Sale (Debit balance in Asset A/c):

2. When a 'Provision for Depreciation Account' is Maintained

In this method, the Asset Account is always shown at its original cost. Therefore, before recording the sale, all accumulated depreciation of the specific asset being sold must be cleared from the books and set off against the asset's cost.

Accounting Steps

Step 1: Transfer Accumulated Depreciation

Debit the Provision for Depreciation Account and credit the Asset Account with the total depreciation charged on the sold asset from the date of purchase to the date of sale. This crucial step brings the Asset Account (for the disposed asset) down from its original cost to its book value.

Step 2 & 3: The subsequent steps of recording the sale proceeds and transferring the profit or loss are the same as in the first method, as the Asset Account now reflects the book value of the asset sold.

3. Use of an 'Asset Disposal Account' (Recommended Method)

To provide a clearer and more complete view of the disposal transaction, a separate temporary account called the 'Asset Disposal Account' is often used. This is especially useful when a Provision for Depreciation Account is maintained or when only a part of an asset is sold. This method consolidates all aspects of the sale—original cost, accumulated depreciation, sale proceeds, and profit/loss—into one single account, leaving the main Asset and Provision for Depreciation accounts undisturbed by the disposal details.

Journal Entries for Asset Disposal Account Method

The following sequence of entries is passed:

(i) Transfer the original cost of the asset being sold to the Asset Disposal Account:

(ii) Transfer the accumulated depreciation of the asset being sold to the Asset Disposal Account:

(iii) Record the sale proceeds:

(iv) Transfer the final balance (Profit or Loss) from the Asset Disposal Account:

At this point, the Asset Disposal account is balanced. If the total of the credit side (Accumulated Depreciation + Sale Proceeds) is greater than the debit side (Original Cost), there is a profit. If the debit side is greater, there is a loss. This balancing figure is then transferred to the Profit and Loss Account.

In case of Profit on Sale (Credit side > Debit side):

The balancing figure is recorded on the debit side of the Asset Disposal Account to close it. The corresponding journal entry is:

In case of Loss on Sale (Debit side > Credit side):

The balancing figure is recorded on the credit side of the Asset Disposal Account to close it. The corresponding journal entry is:

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Effect of any Addition or Extension to the Existing Asset

It is common for a business to incur further expenditure on a fixed asset after it has been put into use. When such an expenditure is made, it is crucial to determine its nature to ensure correct accounting treatment. The primary distinction is between a capital expenditure (which should be added to the cost of the asset) and a revenue expenditure (which should be expensed in the Profit and Loss Account of the current period).

An Addition or Extension is a capital expenditure because it results in a quantifiable increase in the future economic benefits from the existing asset beyond its previously assessed standard of performance. This could be by enhancing its capacity, improving its efficiency, or extending its useful life. The amount incurred on such additions or extensions is capitalised, meaning it is debited to the Asset Account. This is distinct from routine repair and maintenance expenses (e.g., oiling a machine, minor part replacements), which are revenue expenditures necessary to maintain the asset's current working condition and are charged to the Profit and Loss Account in the period they are incurred.

Depreciation of Additions and Extensions

According to accounting principles, the method of depreciating an addition or extension depends on whether it becomes an integral part of the existing asset or maintains a separate identity.

1. Addition Becomes an Integral Part of the Existing Asset

This applies when the addition or extension cannot be physically or functionally separated from the main asset. Its purpose is to enhance the functionality of the existing asset as a whole (e.g., installing a more powerful engine in a truck).

• Depreciation Rule: The cost of the addition or extension should be depreciated over the remaining useful life of the existing asset to which it is attached. The rationale is that the addition will only provide benefits as long as the main asset is in use. The depreciation rate applied is usually the same as that of the original asset.

2. Addition Retains a Separate Identity

This applies when the addition or extension is a distinct component that could be used independently or moved to another asset if the original asset is disposed of (e.g., adding a detachable trailer to a truck, which has its own life and can be used with other trucks).

• Depreciation Rule: The addition or extension should be treated as a new and separate asset. Depreciation should be calculated and provided independently on this addition based on its own estimated useful life and residual value.

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Provisions

In the course of business, it is essential to adhere to the Matching Principle and the Principle of Prudence (or Conservatism) to ensure that financial statements present a true and fair view. The Matching Principle requires that expenses related to revenue earned in a period must be recognized in the same period. The Principle of Prudence dictates that all anticipated losses should be accounted for, but all unrealized gains should be ignored. This leads to the concept of provisions.

A Provision is formally defined as "a liability of uncertain timing or amount". It represents a present obligation arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits. A provision is created for a known liability or a highly probable loss pertaining to the current accounting period, the amount of which can only be estimated with a reasonable degree of accuracy. Crucially, a provision is a charge against profit. This means it is treated as an expense and must be debited to the Profit and Loss Account before arriving at the net profit figure. The creation of provisions is a mandatory accounting practice, not a matter of choice, to ensure profits are not overstated.

Examples of Provisions

Common examples of situations where provisions are necessary include:

• Provision for Depreciation: To account for the known, ongoing loss in the value of fixed assets.

• Provision for Bad and Doubtful Debts: A business that sells on credit knows from experience that a certain percentage of its debtors will likely default. This anticipated loss on current-period sales must be provided for in the same period.

• Provision for Taxation: A company knows it will have to pay income tax on its current year's profits, but the exact tax liability will only be determined after the accounts are finalized and assessed by tax authorities. A provision is made based on an estimate.

• Provision for Discount on Debtors: If a business has a policy of offering cash discounts for prompt payment, it must anticipate that some of its current debtors will avail this discount in the next period. A provision is made for this expected future expense.

• Provision for Repairs and Renewals: To smoothen out the impact of large, periodic repair costs by creating a fund over the years.

Accounting Treatment for Provisions

The accounting treatment for provisions is consistent across different types. The core steps involve recognizing the expense and the corresponding provision.

1. Creation: A provision is created by passing the following journal entry:

2. Presentation in Balance Sheet: The way a provision is shown in the Balance Sheet depends on its nature:

• Provisions related to a specific asset (like Provision for Doubtful Debts or Provision for Depreciation) are typically shown as a deduction from that asset on the Assets side. This presents the asset at its net realizable or net book value.

• Other provisions (like Provision for Taxation or Provision for Repairs) are shown on the Liabilities side, usually under 'Current Liabilities'.

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Reserves

A Reserve represents that portion of profits or surplus which has been set aside by the management for a specific or general purpose, rather than being distributed to the owners (shareholders) as dividends. The fundamental characteristic of a reserve is that it is an appropriation of profit, not a charge against it. This means a reserve is created after the net profit for the period has been calculated. It is a discretionary act of financial prudence, reflecting a decision to reinvest profits back into the business.

Unlike provisions, which are created to cover known liabilities or anticipated losses, reserves are created to strengthen the company's financial position, fund future growth and expansion, meet unforeseen contingencies, or comply with legal requirements. Since reserves are created out of profits, they can only be set aside in years when the business is profitable. The act of creating a reserve reduces the 'distributable profits' available to shareholders. In the Balance Sheet, all reserves are presented on the Liabilities side under the major head 'Shareholders' Funds' and sub-head 'Reserves and Surpluses'.

Purpose of Creating Reserves

The primary motivations for creating reserves include:

• Strengthening Financial Position: A business with substantial reserves is considered financially sound and is better able to withstand unexpected losses or adverse business conditions.

• Funding Business Growth: Retained profits (reserves) are a significant source of internal financing for expansion projects, modernization of assets, or diversification, without having to rely on external debt or equity.

• Meeting Future Contingencies: Reserves provide a cushion to absorb the financial impact of unforeseen events.

• Legal Compliance: Certain laws (like the Companies Act) mandate the creation of specific reserves, such as the Debenture Redemption Reserve.

• Stabilizing Dividend Payments: Reserves like the Dividend Equalisation Reserve can be used to pay dividends in years of low profit, ensuring a stable return for shareholders.

Examples of Reserves

Reserves can be created for a variety of specific or general purposes. Common examples include:

• General Reserve: A reserve not created for any specific purpose, which can be used freely by the management for any legitimate business need.

• Workmen Compensation Fund: To meet potential liability towards workers arising from accidents at the workplace.

• Investment Fluctuation Fund: To absorb any potential decline in the market value of the company's investments.

• Capital Reserve: A special reserve created out of capital profits (e.g., profit on the sale of fixed assets, premium on issue of shares) that is not available for distribution as cash dividends.

• Dividend Equalisation Reserve: To maintain a consistent rate of dividend payment to shareholders over the years, smoothing out the effects of fluctuating annual profits.

• Debenture Redemption Reserve (DRR): A reserve required by law to be created out of profits to ensure that funds are available for the repayment of debentures when they mature.

Difference between Provision and Reserve

Although both provisions and reserves appear on the liabilities side of the Balance Sheet (or as a deduction from assets in the case of some provisions), they are fundamentally different in nature, purpose, and accounting treatment. Understanding this distinction is crucial for interpreting financial statements correctly.

Types of Reserves

Reserves, being an integral part of a company's financial strategy, are classified to reflect their intended purpose and the source of profits from which they are created. The two primary methods of classification are based on purpose (General vs. Specific) and source (Revenue vs. Capital).

Classification Based on Purpose

1. General Reserve

A General Reserve is a reserve for which no specific purpose is designated at the time of its creation. It is a retention of profits to increase the overall financial strength and stability of the business.

• Purpose: To meet future unforeseen contingencies, to fund general business expansion, or to supplement working capital.

• Flexibility: It is also known as a 'free reserve' because the management has complete discretion to utilize it for any legitimate business purpose, including the distribution of dividends during years of inadequate profit.

2. Specific Reserve

A Specific Reserve is a reserve that is created and earmarked for a particular, pre-determined purpose. The funds in this reserve can only be utilized for that specified purpose and not for anything else.

• Purpose: To set aside funds for a known future need or legal requirement.

• Flexibility: It is a restricted reserve with no flexibility in its usage.

• Examples include:

  • Dividend Equalisation Reserve: This reserve is created to maintain a stable rate of dividend for shareholders. In years of high profit, a portion is transferred to this reserve. In years of low profit, funds can be drawn from it to supplement the distributable profit, thus avoiding a sharp fall in the dividend rate.

  • Workmen Compensation Fund: This is created to provide for the company's liability to pay compensation to workers in the event of an accident.

  • Investment Fluctuation Fund: This reserve is set up to cushion the business against a decline in the market value of its investments.

  • Debenture Redemption Reserve (DRR): This is a legally mandatory reserve created by companies that have issued debentures. A portion of profits is transferred to the DRR each year to ensure that sufficient funds are accumulated for the repayment (redemption) of debentures upon their maturity.

Classification Based on Source of Profits

This is a more fundamental classification that distinguishes between reserves created from operating profits and those from non-operating (capital) profits.

1. Revenue Reserves

Revenue Reserves are created out of revenue profits. Revenue profits are those profits that are earned from the normal, regular, day-to-day operating activities of the business (e.g., profit from the sale of goods). These profits are, by their nature, available for distribution as dividends to the owners.

• Source: Net profit from the Profit and Loss Account.

• Examples: General Reserve, Dividend Equalisation Reserve, and all other specific reserves mentioned above (except Capital Reserve) are examples of revenue reserves.

2. Capital Reserves

Capital Reserves are created out of capital profits. Capital profits are profits that do not arise from the regular course of business operations. They are typically one-time or non-recurring gains. As a general rule, capital profits are not legally available for distribution as cash dividends to shareholders.

• Source: Non-operating activities.

• Usage: Capital reserves are typically used for specific purposes as permitted by law, such as writing off capital losses (e.g., discount on issue of shares) or for issuing fully paid bonus shares.

• Examples of capital profits that lead to Capital Reserves include:

  • Premium received on the issue of shares or debentures.

  • Profit on the sale of fixed assets.

  • Profit on the revaluation of assets and liabilities.

  • Profit on redemption of debentures.

  • Profit on reissue of forfeited shares.

  • Profits earned by a company prior to its incorporation.

Importance of Reserves

The practice of creating reserves is a cornerstone of prudent financial management. A business may consider it essential to set up mechanisms to protect itself from the financial consequences of unknown or unforeseen expenses and losses that it may be required to bear in the future. By setting aside a portion of its profits, a business creates a financial buffer or cushion.

Furthermore, creating reserves is a deliberate strategy to conserve business resources. It reduces the amount of profit that can be drawn by the proprietors or distributed as dividends to shareholders, ensuring that funds are retained within the business to meet significant future demands. In essence, reserves represent the reinvestment of profits back into the company. The key reasons for their importance can be summarised as follows:

• Meeting Future Contingencies: Reserves provide a safety net to absorb the shock of unexpected events or losses without destabilizing the business's core operations.

• Strengthening the General Financial Position: A business with substantial reserves is considered financially sound, which enhances its creditworthiness and reputation among lenders, suppliers, and investors.

• Funding Growth and Expansion: Retained profits are a vital source of internal financing for expansion projects, modernization, or diversification, reducing reliance on external debt or equity.

• Redeeming Long-Term Liabilities: Specific reserves, such as a Debenture Redemption Reserve, are created to ensure that funds are systematically accumulated to repay long-term liabilities like debentures when they mature.

• Stabilizing Dividend Payments: Reserves can be used to maintain a consistent dividend payout to shareholders even in years of low profitability, which is attractive to investors.

Secret Reserve

A Secret Reserve, as its name implies, is a reserve whose existence and amount are not disclosed in the Balance Sheet or any other published financial statement. It is a hidden reserve that causes the financial position of the business to be portrayed as less favorable than it actually is. The creation of a secret reserve intentionally understates the company's assets and/or overstates its liabilities, which in turn leads to an understatement of profits.

This practice is generally in direct conflict with the fundamental accounting principle of presenting a 'true and fair view' of the financial statements and the principle of full disclosure. Consequently, the creation of secret reserves is often considered a form of financial manipulation and is not encouraged by accounting standards. However, managements have sometimes justified their creation (within reasonable limits) on the grounds of extreme prudence, arguing that it creates a hidden financial cushion to absorb unexpected future losses, thereby ensuring the company's stability without causing alarm to investors during volatile periods.

Rationale for Creating Secret Reserves

The primary motivations behind the creation of a secret reserve include:

• Stabilizing Reported Profits: By creating a secret reserve in highly profitable years (by overstating expenses), management can later use this hidden buffer in lean years to absorb losses or boost profits, thus presenting a picture of consistent performance.

• Concealing True Financial Strength: Management might wish to hide the company's true profitability to avoid attracting new competitors into the market or to prevent demands for higher wages from employees.

• Extreme Prudence: To create an undisclosed buffer for significant unforeseen future contingencies.

Methods of Creating a Secret Reserve

A secret reserve is not created by a direct entry; instead, it is the result of specific accounting treatments that intentionally misstate asset or liability values. Common methods include:

• Charging Excessive Depreciation: This is a common method where the depreciation charged on fixed assets is significantly higher than a realistic estimate. This not only understates the book value of the assets on the Balance Sheet but also overstates the depreciation expense in the Profit and Loss Account, thereby reducing the reported profit.

• Undervaluation of Inventories/Stock: The closing stock is valued at a price that is deliberately much lower than its actual cost or net realizable value. Since closing stock is credited to the Trading Account, undervaluing it directly reduces the gross profit and, subsequently, the net profit. It also understates the value of current assets on the Balance Sheet.

• Charging a Capital Expenditure to the Profit and Loss Account: An expenditure that should be capitalized (i.e., treated as an asset), such as the cost of a major addition to a building, is instead treated as a revenue expense (e.g., 'Repairs and Maintenance'). This understates the company's assets and overstates its expenses, directly creating a hidden reserve.

• Making Excessive Provision for Doubtful Debts: A provision for doubtful debts is created that is far in excess of the amount realistically expected to be uncollectible. This overstates the expenses in the Profit and Loss Account and understates the net value of sundry debtors on the Balance Sheet.

• Showing a Contingent Liability as an Actual Liability: A contingent liability is a potential obligation that may or may not arise depending on a future event. By treating this potential liability as a definite, actual liability, the company overstates its liabilities and understates its net worth, effectively creating a secret reserve.

Do it yourself (Page No. 229)

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Test Your Understanding - I

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Test Your Understanding - II

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Here is the comparison of depreciation for the first three years under both methods. We will assume the accounting year ends on March 31st each year.

Original Cost of Asset: $\textsf{₹ } \ 1,00,000$

Date of Purchase: July 01, 2014

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1. Depreciation using Original Cost Method (Straight-Line Method - SLM)

Under this method, depreciation is calculated at a fixed percentage on the original cost of the asset.

Annual Depreciation = $10\% \ of \ \textsf{₹ } \ 1,00,000 = \textsf{₹ } \ 10,000$

Year 1 (July 01, 2014 to March 31, 2015):
The asset was used for 9 months in the first year.

Depreciation for 2014-15 = $\textsf{₹ } \ 10,000 \times \frac{9}{12} = \textsf{₹ } \ 7,500$

Year 2 (April 01, 2015 to March 31, 2016):
The asset was used for the full year.

Depreciation for 2015-16 = $\textsf{₹ } \ 10,000$

Year 3 (April 01, 2016 to March 31, 2017):
The asset was used for the full year.

Depreciation for 2016-17 = $\textsf{₹ } \ 10,000$

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2. Depreciation using Written Down Value Method (WDV)

Under this method, depreciation is calculated at a fixed percentage on the book value (Written Down Value) of the asset at the beginning of each year.

Year 1 (July 01, 2014 to March 31, 2015):
Depreciation for 9 months on the original cost.

Depreciation for 2014-15 = $10\% \ of \ \textsf{₹ } \ 1,00,000 \times \frac{9}{12} = \textsf{₹ } \ 7,500$

WDV at end of Year 1 = $\textsf{₹ } \ 1,00,000 - \textsf{₹ } \ 7,500 = \textsf{₹ } \ 92,500$

Year 2 (April 01, 2015 to March 31, 2016):
Depreciation for the full year on the WDV of $\textsf{₹ } \ 92,500$.

Depreciation for 2015-16 = $10\% \ of \ \textsf{₹ } \ 92,500 = \textsf{₹ } \ 9,250$

WDV at end of Year 2 = $\textsf{₹ } \ 92,500 - \textsf{₹ } \ 9,250 = \textsf{₹ } \ 83,250$

Year 3 (April 01, 2016 to March 31, 2017):
Depreciation for the full year on the WDV of $\textsf{₹ } \ 83,250$.

Depreciation for 2016-17 = $10\% \ of \ \textsf{₹ } \ 83,250 = \textsf{₹ } \ 8,325$

WDV at end of Year 3 = $\textsf{₹ } \ 83,250 - \textsf{₹ } \ 8,325 = \textsf{₹ } \ 74,925$

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3. Comparison and Graphical Representation

The depreciation amounts for the three years under both methods are summarized below:

Financial Year	Depreciation by SLM ($\textsf{₹ }$)	Depreciation by WDV ($\textsf{₹ }$)
2014-15 (9 months)	7,500	7,500
2015-16	10,000	9,250
2016-17	10,000	8,325

The graph below visually compares the depreciation amounts computed under both methods over the three years.

Test Your Understanding - III

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