Depreciation, Provisions and Reserves

Depreciation: meaning, causes and factors

Depreciation is the gradual, permanent fall in the value of a fixed (tangible) asset because of use, passage of time or obsolescence. It is a non-cash expense that spreads the cost of the asset over its useful life (matching principle).

Causes

• Wear and tear from use.
• Passage of time (even if not used, for example a leased building).
• Obsolescence: new technology or a change in demand makes it out of date.
• Expiry of legal rights (lease, patent).
• Accidents.

Need

To find true profit, to show assets at a fair value in the balance sheet, to keep funds for replacement, and because tax and company law require it.

Factors affecting the amount

• Cost of the asset (price + freight + installation).
• Estimated useful life.
• Estimated residual (scrap) value.
• Depreciable cost = cost − residual value.

Depletion and amortisation

Depletion: reduction in the value of natural resources (mines, oil wells, quarries) as the resource is taken out. Depletion = (Cost − residual value) × quantity extracted ÷ total estimated quantity.

Amortisation: writing off the cost of an intangible asset (patent, copyright, software licence, trademark) over its useful or legal life.

All three — depreciation, depletion, amortisation — spread a cost over the period of benefit.

Methods: straight line (SLM) and written down value (WDV)

Straight line method (fixed instalment)

Annual depreciation = (Cost − Residual value) ÷ Useful life. Rate = annual depreciation ÷ cost × 100. Same amount every year; simple; the asset can be written down to its residual value. Suits assets like furniture, leases, patents. But repairs rise in later years, so the total charge (depreciation + repairs) increases.

Written down value method (reducing balance)

Annual depreciation = Rate × Opening book value. Big charge in early years, smaller later; the total of depreciation + repairs stays fairly even. Accepted by income tax law. Book value never becomes zero. Suits plant and machinery, vehicles.

When an asset is bought during the year, depreciation is charged only for the months used (unless told otherwise).

Recording depreciation: asset account or provision account

1. Charging to the asset account

Depreciation A/c Dr; To Asset A/c. Then P&L A/c Dr; To Depreciation A/c. The asset appears at book value (cost less depreciation).

2. Creating provision for depreciation (accumulated depreciation) account

Depreciation A/c Dr; To Provision for Depreciation A/c. The asset account stays at original cost; the provision builds up. In the balance sheet the asset is shown at cost less the provision. Advantage: cost and total depreciation are both visible.

Disposal of an asset

On sale, find book value on the date of sale (cost − depreciation to date, including the part-year up to sale).

• Sale price > book value → profit on sale (credited to P&L).
• Sale price < book value → loss on sale (debited to P&L).

Asset account method: Bank Dr; To Asset A/c (sale), then transfer the balance as profit or loss.

Provision method: open an Asset Disposal A/c. Transfer cost: Asset Disposal A/c Dr; To Asset A/c. Transfer accumulated depreciation: Provision for Depreciation A/c Dr; To Asset Disposal A/c. Sale: Bank Dr; To Asset Disposal A/c. The balance of Asset Disposal A/c is the profit or loss, transferred to P&L.

Provisions and reserves: meaning and differences

Provision: an amount charged against profit to meet a known liability or a fall in asset value whose exact amount is not certain — provision for depreciation, for doubtful debts, for taxation, for repairs.

Reserve: an amount set aside out of profit to strengthen the financial position or meet future needs.

Differences

• Provision is a charge against profit (debited to P&L); reserve is an appropriation of profit (from P&L appropriation / net profit).
• Provision is compulsory for a known liability/loss; reserve is usually by choice (sometimes by law).
• Provision reduces net profit; reserve does not reduce net profit, it reduces the profit available for distribution.
• Provision is shown by deducting from the asset or as a liability; reserve is shown under reserves and surplus (capital side).
• Provision cannot be used to pay dividends; revenue reserves can.

Types of reserves

• Revenue reserve: made out of revenue (trading) profit, can be used for dividends.
  • General reserve: no specific purpose; strengthens the business.
  • Specific reserve: for a named purpose — dividend equalisation reserve, debenture redemption reserve, investment fluctuation reserve.
• Capital reserve: made out of capital profits — premium on issue of shares, profit on sale of fixed assets, profit on reissue of forfeited shares. Usually not available for dividends.
• Secret (hidden) reserve: not shown in the balance sheet; created by undervaluing assets or overvaluing liabilities (e.g. charging excess depreciation). It makes the firm look weaker than it is, and is not allowed for companies beyond law's limits.

Key formulas and definitions

• SLM annual depreciation = (Cost − Residual value) ÷ Useful life
• SLM rate = Annual depreciation ÷ Cost × 100
• WDV depreciation = Rate × Opening book value
• Book value = Cost − Accumulated depreciation
• Profit/loss on sale = Sale price − Book value on date of sale
• Depletion = (Cost − Residual) × Quantity extracted ÷ Total quantity

Worked examples

Common mistakes

• Using cost without adding freight and installation. They are part of the asset's cost.
• In WDV, applying the rate on original cost every year. Apply it on the opening book value.
• Charging a full year's depreciation on an asset bought mid-year (unless the question says so).
• Calling a reserve a charge against profit. A reserve is an appropriation; a provision is a charge.