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Depreciation, Provisions and Reserves

NCERT Class 11 · Accountancy Based on NCERT Class 11 Accountancy textbook · Free CBSE study kit

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Chapter Notes

Overview
This chapter explains the concept of depreciation as the allocation of the cost of a fixed asset over its useful life, in accordance with the matching principle. It covers the causes, need, factors affecting, and methods of calculating depreciation, including straight line and written down value methods, along with their recording and disposal of assets. The second section introduces provisions and reserves, emphasizing the prudence principle and the distinction between them. The one big idea is that depreciation is not a valuation exercise but a systematic cost allocation to ensure true and fair profit and financial position.
Key Concepts (14)
Depreciation
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. It 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.
e.g. A machine purchased for ₹1,00,000 with a useful life of 10 years and no scrap value will be depreciated by ₹10,000 each year.
Depreciable Assets
Assets that are expected to be used during more than one accounting period, have a limited useful life, and are held for use in production, supply of goods/services, rental, or administration, not for sale in the ordinary course of business.
e.g. Machinery, buildings, furniture, computers, vehicles.
Depreciable Amount
The historical cost (or other amount substituted for historical cost) of a depreciable asset less its estimated salvage value.
e.g. If a machine costs ₹1,00,000 and its salvage value is ₹10,000, the depreciable amount is ₹90,000.
Useful Life
Either the period over which a depreciable asset is expected to be used by the enterprise, or the number of production or similar units expected to be obtained from the use of the asset by the enterprise.
e.g. A machine expected to be used for 10 years has a useful life of 10 years.
Cost of Asset
The total cost spent in connection with its acquisition, installation and commissioning as well as for addition or improvement of the depreciable asset.
e.g. Purchase price ₹50,000 + transportation ₹5,000 = cost ₹55,000.
Net Residual Value (Scrap Value/Salvage Value)
The estimated net realisable value of the asset at the end of its useful life, after deducting disposal expenses.
e.g. Machine expected to sell for ₹6,000 with disposal cost ₹1,000 gives net residual value ₹5,000.
Depletion
The term used in the context of extraction of natural resources like mines, quarries, etc., representing the reduction in the quantity of the material or asset.
e.g. A coal mine purchased for ₹10,00,000 loses value as coal is extracted.
Amortisation
The writing-off of the cost of intangible assets like patents, copyrights, trademarks, franchises, goodwill which have utility for a specified period of time.
e.g. A patent costing ₹10,00,000 with a 10-year useful life is amortised at ₹1,00,000 per year.
Wear and Tear
Deterioration and consequent diminution in an asset's value arising from its use in business operations or simply from the passage of time due to exposure to nature.
e.g. A delivery van loses value as it is driven and also as it ages.
Obsolescence
The fact of being 'out-of-date' due to technological changes, improvements in production methods, change in market demand, or legal restrictions.
e.g. A machine becomes outdated when a newer, more efficient model is introduced.
Straight Line Method (Fixed Installment Method)
A method of depreciation where a fixed and equal amount is charged as depreciation in every accounting period during the lifetime of an asset, based on the assumption of equal usage.
e.g. Asset cost ₹2,50,000, life 10 years, scrap ₹50,000 → annual depreciation ₹20,000.
Written Down Value Method (Reducing Balance Method)
A method of depreciation where depreciation is charged on the book value of the asset at the beginning of each accounting period, resulting in a declining amount year after year.
e.g. Asset cost ₹2,00,000, rate 10% p.a. → Year 1 depreciation ₹20,000, Year 2 depreciation ₹18,000.
Provision for Depreciation Account (Accumulated Depreciation Account)
A separate account used to accumulate the depreciation provided on an asset, allowing the asset account to continue at its original cost.
e.g. Depreciation of ₹10,000 is credited to Provision for Depreciation A/c instead of crediting the Asset A/c.
Disposal of Asset
The sale or removal of a fixed asset at the end or during its useful life, with the profit or loss on sale transferred to the Profit and Loss Account.
e.g. A vehicle purchased for ₹4,00,000, depreciated for 4 years, sold for ₹50,000.
Formulas & Equations (3)
Depreciation = (Cost of asset - Estimated net residual value) / Estimated useful life of the asset
Reads as: Depreciation equals cost of asset minus estimated net residual value, divided by estimated useful life of the asset
Variables: Cost of asset: total acquisition cost (₹); Estimated net residual value: estimated sale value minus disposal expenses (₹); Estimated useful life: number of years or units of output
Use when: Calculating annual depreciation under the Straight Line Method
⚠ Students forget to subtract the net residual value before dividing by useful life, or they use the original cost instead of the depreciable amount.
Rate of Depreciation (SLM) = (Annual depreciation amount / Acquisition cost) × 100
Reads as: Rate of depreciation under straight line method equals annual depreciation amount divided by acquisition cost, multiplied by 100
Variables: Annual depreciation amount (₹); Acquisition cost (₹)
Use when: Finding the percentage rate of depreciation under the Straight Line Method
⚠ Students sometimes use the depreciable amount instead of acquisition cost in the denominator.
r = [1 - (s/c)^(1/n)] × 100
Reads as: Rate of depreciation under written down value method equals 1 minus the nth root of scrap value divided by cost, all multiplied by 100
Variables: r = rate of depreciation (%); n = expected useful life (years); s = scrap value (₹); c = cost of asset (₹)
Use when: Calculating the rate of depreciation under the Written Down Value Method when cost, scrap value, and useful life are known
⚠ Students forget to take the nth root or incorrectly apply the formula, often using simple division instead.
How It Works
Recording Depreciation by Charging to Asset Account
  1. Step 1: Record purchase of asset — Debit Asset A/c, Credit Bank/Vendor A/c (with cost including installation, freight, etc.)
  2. Step 2: At end of each year — Debit Depreciation A/c, Credit Asset A/c (with amount of depreciation)
  3. Step 3: Transfer depreciation to Profit and Loss — Debit Profit & Loss A/c, Credit Depreciation A/c
  4. Step 4: In Balance Sheet, show asset at net book value (cost less depreciation charged till date)
💡 The asset account is directly reduced each year, so its balance shows the net book value, not the original cost.
Recording Depreciation by Creating Provision for Depreciation Account
  1. Step 1: Record purchase of asset — Debit Asset A/c, Credit Bank/Vendor A/c
  2. Step 2: At end of each year — Debit Depreciation A/c, Credit Provision for Depreciation A/c
  3. Step 3: Transfer depreciation to Profit and Loss — Debit Profit & Loss A/c, Credit Depreciation A/c
  4. Step 4: In Balance Sheet, asset appears at original cost; Provision for Depreciation is shown either on liabilities side or as deduction from the asset's cost.
💡 The asset account always shows original cost; accumulated depreciation is kept in a separate account.
Disposal of Asset (when depreciation charged to asset account)
  1. Step 1: Record sale of asset as scrap — Debit Bank A/c, Credit Asset A/c (with amount realised)
  2. Step 2: Transfer balance of asset account to Profit and Loss — If credit balance (profit): Debit Asset A/c, Credit Profit & Loss A/c; If debit balance (loss): Debit Profit & Loss A/c, Credit Asset A/c
💡 If a Provision for Depreciation account exists, first transfer its balance to the Asset account by debiting Provision for Depreciation A/c and crediting Asset A/c, then proceed with sale entry.
Exam Traps — Don't Make These Mistakes
⚠ Confusing depreciation with decline in market value
✗ Depreciation is the decline in the market value of a fixed asset.
→ Depreciation is based on the cost of the asset consumed, not its market value. It is an allocation of cost, not a valuation.
✓ Depreciation is the allocation of the depreciable amount of a fixed asset over its useful life, based on its cost, not market value.
⚠ Forgetting to deduct scrap value in SLM formula
✗ Depreciation = Cost of asset / Estimated useful life
→ The formula must subtract the estimated net residual value from the cost to get the depreciable amount before dividing by useful life.
✓ Depreciation = (Cost of asset - Estimated net residual value) / Estimated useful life
⚠ Applying full year depreciation for asset purchased mid-year
✗ Depreciation for the first year is calculated on the full annual amount regardless of purchase date.
→ Depreciation should be charged only for the period the asset was used, e.g., if purchased on Oct 1, only 6 months' depreciation is charged for that year.
✓ Depreciation for the year of purchase is calculated proportionately for the number of months the asset was in use.
⚠ Mistaking depletion for depreciation
✗ Depletion is the same as depreciation, used for all fixed assets.
→ Depletion is specifically used for natural resources like mines and quarries, not for all fixed assets.
✓ Depletion refers to the reduction in the quantity of natural resources (e.g., coal mine) due to extraction, while depreciation applies to tangible fixed assets.
⚠ Thinking depreciation provides a fund for replacement
✗ Depreciation creates a fund for replacing the asset at the end of its life.
→ Depreciation is a non-cash expense; it does not involve any cash outflow or setting aside of funds. It is merely an allocation of cost.
✓ Depreciation is a non-cash expense that allocates the cost of an asset over its useful life; it does not create a fund for replacement.
Compare & Contrast
Basis of charging depreciation
Straight Line Method
Written Down Value Method
SLM charges depreciation on original cost; WDV charges depreciation on the net book value (original cost less depreciation till date) at the beginning of the year.
Annual depreciation charge pattern
Straight Line Method
Written Down Value Method
Under SLM, the annual depreciation amount remains fixed/constant every year; under WDV, the annual depreciation amount is highest in the first year and declines year after year.
Purpose
Provision
Reserve
A provision is created for a known liability or expense where the amount is uncertain (e.g., provision for doubtful debts), while a reserve is created out of profits for strengthening the financial position or for a specific future purpose (e.g., general reserve).
Exam Focus
Marks pattern: 2 MCQs (1 mark each), 1 Short Answer (3 marks), 1 Long Answer (5-6 marks) — typically involving numerical problem on depreciation calculation and journal entries.
Most asked: Calculation of depreciation under Straight Line Method and Written Down Value Method · Journal entries for recording depreciation (both methods of recording) · Disposal of asset and calculation of profit/loss on sale · Difference between Straight Line Method and Written Down Value Method · Meaning and causes of depreciation
Don't skip: Numerical problem on calculating depreciation using both SLM and WDV for multiple years, including purchase mid-year and disposal.; Journal entries for disposal of asset with profit or loss.
One-Line Revision (read aloud before the exam)
  1. Depreciation is the allocation of the depreciable amount of a fixed asset over its useful life.
  2. Depreciation is a non-cash expense and does not involve any cash outflow.
  3. The three factors affecting depreciation are cost, estimated useful life, and estimated net residual value.
  4. Under Straight Line Method, depreciation = (Cost - Scrap Value) / Useful Life.
  5. Under Written Down Value Method, depreciation is charged on the book value at the beginning of the year.
  6. Depreciation is charged to comply with the matching principle.
  7. Wear and tear, obsolescence, expiration of legal rights, and abnormal factors are causes of depreciation.
  8. Depletion is used for natural resources like mines; amortisation is used for intangible assets like patents.
  9. When recording depreciation, the asset account can be directly credited, or a Provision for Depreciation account can be used.
  10. On disposal of an asset, any profit or loss is transferred to the Profit and Loss Account.
  11. A provision is a charge against profit for a known liability; a reserve is an appropriation of profit.
  12. The rate of depreciation under WDV can be calculated using the formula: r = [1 - (s/c)^(1/n)] × 100.
  13. Depreciation must be charged to ascertain true profit or loss and to show a true and fair financial position.
  14. Straight Line Method is suitable for assets with low repair charges and low obsolescence; WDV is suitable for assets affected by technological changes.

MCQs — 10 Questions with Answers

Q1. Which of the following is NOT a characteristic of a depreciable asset according to AS-6?

  • A. Expected to be used during more than one accounting period
  • B. Held for sale in the ordinary course of business ✓
  • C. Has a limited useful life
  • D. Held for use in production or supply of goods and services

Answer: B — AS-6 explicitly states depreciable assets are held for business operations (production/supply/rental/admin), NOT for resale in ordinary business course.

Q2. A machine is purchased for ₹50,000 on 1 April 2023 with an estimated useful life of 5 years and salvage value of ₹5,000. Using the straight-line method, what is the annual depreciation?

  • A. ₹10,000
  • B. ₹9,000 ✓
  • C. ₹45,000
  • D. ₹15,000

Answer: B — SLM depreciation = (Cost − Salvage Value) ÷ Useful Life = (₹50,000 − ₹5,000) ÷ 5 = ₹45,000 ÷ 5 = ₹9,000.

Q3. The journal entry to record depreciation of ₹8,000 on machinery using the accumulated depreciation method is:

  • A. Dr. Machinery ₹8,000; Cr. Bank ₹8,000
  • B. Dr. Depreciation Expense ₹8,000; Cr. Accumulated Depreciation – Machinery ₹8,000 ✓
  • C. Dr. Accumulated Depreciation ₹8,000; Cr. Machinery ₹8,000
  • D. Dr. Bank ₹8,000; Cr. Depreciation Expense ₹8,000

Answer: B — Depreciation is an expense (debit) matched against revenue in P&L; accumulated depreciation (credit) accumulates the expired cost without reducing the asset's original cost directly.

Q4. Equipment has a book value of ₹10,000. If depreciation using written-down value method at 20% p.a. is charged, what is the depreciation for the next year?

  • A. ₹2,000 ✓
  • B. ₹1,600
  • C. ₹2,500
  • D. ₹800

Answer: A — WDV method: Depreciation = Book Value × Rate = ₹10,000 × 20% = ₹2,000; remaining book value becomes ₹8,000 for next year's calculation.

Q5. Which statement correctly describes the relationship between matching principle and depreciation?

  • A. Depreciation is charged only when cash is paid for the asset
  • B. Depreciation ensures capital expenditure cost is spread across all periods that benefit from the asset ✓
  • C. Matching principle requires all depreciation to be charged in the year asset is purchased
  • D. Depreciation has no connection to the matching principle

Answer: B — The matching principle requires revenue of a period to be matched with related expenses of that period; depreciation allocates asset cost fairly across its benefit-generating periods.

Q6. Book value of an asset is ₹20,000 and accumulated depreciation is ₹30,000. What is the original cost of the asset?

  • A. ₹10,000
  • B. ₹50,000 ✓
  • C. ₹20,000
  • D. ₹30,000

Answer: B — Original Cost = Book Value + Accumulated Depreciation = ₹20,000 + ₹30,000 = ₹50,000.

Q7. Both straight-line and written-down value methods must be applied consistently to ensure comparability. Which of the following statements is correct? Assertion (A): Change in depreciation method is never allowed once selected. Reason (R): Consistency in accounting methods ensures meaningful comparison across periods.

  • A. Both A and R are true; R is the correct reason for A
  • B. Both A and R are true; R is not the correct reason for A
  • C. A is false; R is true ✓
  • D. Both A and R are false

Answer: C — While consistency is important (R is true), AS-6 allows change in depreciation method under specific circumstances; therefore A is false.

Q8. A building is purchased for ₹5,00,000 with useful life of 25 years and no salvage value. After 10 years, what is the book value using the straight-line method?

  • A. ₹2,00,000
  • B. ₹3,00,000 ✓
  • C. ₹2,50,000
  • D. ₹3,50,000

Answer: B — Annual depreciation = ₹5,00,000 ÷ 25 = ₹20,000; Accumulated depreciation after 10 years = ₹20,000 × 10 = ₹2,00,000; Book Value = ₹5,00,000 − ₹2,00,000 = ₹3,00,000.

Q9. Which of the following statements about provisions and reserves is correct? Statement 1: A provision is a likely future liability charged against profit. Statement 2: A reserve is retained profit appropriated for specific future needs.

  • A. Statement 1 is correct; Statement 2 is incorrect
  • B. Statement 2 is correct; Statement 1 is incorrect
  • C. Both statements are correct ✓
  • D. Both statements are incorrect

Answer: C — Under conservatism principle, provisions (e.g. bad debts) are charged to P&L as likely future liabilities; reserves are amounts retained from profit for future growth—both definitions are accurate.

Q10. Why is depreciation considered an 'expired cost' rather than a current cash expense?

  • A. Because the cash was already paid in a prior period when the asset was purchased; depreciation only represents allocation of that historical cost to current period ✓
  • B. Because depreciation reduces the market value of the asset in the current period
  • C. Because depreciation is not an actual expense recognized under accounting standards
  • D. Because the asset will be sold for cash in the future

Answer: A — Depreciation is an 'expired cost' because the capital expenditure cash outflow occurred in a past period; in the current period, only a portion of that historical cost is matched as expense against revenue earned.

Flashcards

Define depreciation in accounting terms.

Depreciation is the permanent, gradual reduction in book value of a fixed asset due to its use, passage of time, or obsolescence, allocated fairly over its useful life.

What are the three factors that determine depreciation amount?

Cost of asset, useful life of asset, and net realisable value (salvage value) are the three factors affecting depreciation calculation.

State the matching principle and its link to depreciation.

The matching principle requires revenue of a period to be matched against expenses of the same period; depreciation ensures capital cost is spread across periods that benefit from the asset.

What is the difference between straight-line method and written-down value method?

Straight-line charges equal depreciation yearly: (Cost − Salvage) ÷ Life; written-down value charges a fixed percentage on the remaining book value, resulting in decreasing annual depreciation.

Give the standard journal entry to record depreciation.

Debit Depreciation Expense/Profit & Loss Account; Credit Accumulated Depreciation (or the Asset Account itself depending on method).

Define a depreciable asset according to AS-6.

A depreciable asset is used over more than one accounting period, has limited useful life, and is held for business operations—not for resale in ordinary course.

Why is depreciation charged despite no cash outflow in the current period?

Depreciation represents an expired cost of a capital expenditure already paid in a past period; it is charged to match the revenue generated by using that asset.

Distinguish between a provision and a reserve.

A provision is a likely future liability charged against profit in the current period under conservatism principle; a reserve is retained profit appropriated for future needs without being a liability.

What does 'obsolescence' mean in the context of depreciation?

Obsolescence is the loss of value due to technological changes, market changes, or arrival of new models that make an asset outdated or less useful.

How is book value of a fixed asset shown in the balance sheet?

Book value is displayed as: Cost of Asset minus Accumulated Depreciation, representing the unexpired portion of the asset's original cost.

Important Board Questions

Define depreciation and explain why it is charged despite being an expired cost and not a cash outflow in the current accounting period. [2 marks]

State that depreciation is permanent shrinkage in book value of fixed assets; explain that capital expenditure cash was paid in prior period, and current period expense allocation matches revenue earned from using that asset.

A company purchased machinery for ₹1,00,000 on 1 January 2023. The estimated useful life is 10 years and salvage value is ₹10,000. Calculate annual depreciation using the straight-line method and prepare the journal entry for the year ended 31 December 2023. Also show how the asset will appear in the Balance Sheet as on 31 December 2023. [5 marks]

Use formula: (Cost − Salvage Value) ÷ Useful Life = (₹1,00,000 − ₹10,000) ÷ 10. Journal entry debits Depreciation Expense and credits Accumulated Depreciation. Balance Sheet shows Machinery at cost less accumulated depreciation to arrive at book value.

Explain the difference between the straight-line method and written-down value method of depreciation. A company has three assets: a building used steadily for 50 years, a vehicle expected to depreciate faster in early years, and computer equipment subject to rapid technological obsolescence. Recommend and justify the appropriate depreciation method for each asset, citing how AS-6 guides method selection. [6 marks]

SLM charges equal depreciation yearly based on (Cost − Salvage) ÷ Life; WDV charges fixed percentage on remaining book value annually, resulting in decreasing charges. Building: SLM (even benefit use); Vehicle & Computer: WDV (faster early depreciation reflects actual pattern). Justify selection based on asset type, nature of use, and circumstances as per AS-6; consistency principle also applies.

Assertion-Reason Questions for Depreciation, Provisions and Reserves

Q1. Assertion (A):

Depreciation is charged in the Statement of Profit and Loss as an expense.

Reason (R):

Because depreciation represents the expired cost of a fixed asset that must be matched against the revenue of the same period as per the matching principle.

Answer: A — Both A and R are true, and R is the correct explanation of A — Both the assertion and reason are true, and the reason correctly explains why depreciation is charged as an expense. The matching principle requires that expenses be matched with revenues of the same period, which is why the cost of a long-lived asset is spread across its useful life.

Q2. Assertion (A):

The Written Down Value Method results in lower depreciation charges in later years compared to the Straight Line Method.

Reason (R):

Because the WDV method applies a fixed percentage to the written down value which decreases each year.

Answer: A — Both A and R are true, and R is the correct explanation of A — Both assertion and reason are true and logically connected. WDV applies the rate to a declining balance, resulting in decreasing depreciation amounts. SLM provides equal charges each year. Early years show higher depreciation under WDV but later years show lower depreciation compared to SLM's constant amount.

Q3. Assertion (A):

Depreciation is based on the cost of the asset rather than its market value.

Reason (R):

Because accounting principles require that all assets be valued at their current market prices as reported in financial statements.

Answer: C — A is true but R is false — The assertion is true—depreciation is indeed calculated on historical cost, not market value. However, the reason is false. Accounting principles do NOT require current market valuation for fixed assets in typical financial statements; they follow the historical cost principle. The reason contradicts the basis of depreciation calculation.

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Case-Based Questions (CBQ) for Depreciation, Provisions and Reserves

Case Study:

On 1st April 2023, Meera Enterprises purchased furniture for ₹2,00,000. The company charges depreciation at 10% per annum on the Straight Line Method. On 1st October 2024, the furniture was sold for ₹1,60,000. The company closes its books on 31st March each year.

Q1. What is the total depreciation charged on the furniture before its sale?

  • A. ₹20,000
  • B. ₹30,000 ✓
  • C. ₹40,000
  • D. ₹10,000

Answer: B

Q2. What is the book value of the furniture on the date of sale (1st October 2024)?

  • A. ₹1,80,000
  • B. ₹1,70,000 ✓
  • C. ₹1,60,000
  • D. ₹1,75,000

Answer: B

Q3. What is the profit or loss on sale of the furniture?

  • A. Loss of ₹10,000 ✓
  • B. Profit of ₹10,000
  • C. Loss of ₹20,000
  • D. Profit of ₹20,000

Answer: A

Q4. Which journal entry correctly records the sale of furniture (ignoring GST)?

  • A. Bank A/c Dr ₹1,60,000; Loss on Sale A/c Dr ₹10,000; To Furniture A/c ₹1,70,000 ✓
  • B. Bank A/c Dr ₹1,60,000; To Furniture A/c ₹1,60,000
  • C. Furniture A/c Dr ₹1,60,000; To Bank A/c ₹1,60,000
  • D. Bank A/c Dr ₹1,60,000; Profit on Sale A/c Cr ₹10,000; To Furniture A/c ₹1,70,000

Answer: A

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