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DEPRECIATION ACCOUNTING
CONCEPT: Depreciation is the process of spreading the cost of fixed Asset over the
different accounting periods which derive the benefit from their use.

Eg.Of Assets – M/C,Furniture,Buildings,Leases,etc. Land is a fixed Asset but not

subject to depreciation because it has infinite lifetime.

 Meaning and Definition of Depreciation :

Depreciation is a permanent decline in the value of an Asset.The gradual
decrease, both in the value and usefulness of an Asset due to its nature and usage
is termed as Depreciation.

“Depreciation is the measure of the exhaustion of the effective life of an Asset from
any cause over a given period”.

ICAI “Depreciation is the measure of wearing out, consumption or other loss of

value of a depreciable Asset arising from use, efflusion of time or obsolescence
through technology and market changes”.

 IMPORTANT TERMS :
1) Depreciable Assets – The Assets whose lifetime can be estimated and used during
two or more accounting periods in production or service activities of an
organisation.

2) Useful Life – It is the time during which the Asset is helpful in the normal business
activities of a firm.It can be less than the total lifetime of the Asset.

3) Depreciable Amount – is the cost of acquisition and installation of an Asset after

reducing any realisable value at the end of useful life.

4) Realisable Value – This is the amount realisable at the end of the Asset’s of an
Asset as in the case of leased Assets.

5) Efflusion of Time – is the passage of time irrespective of actual use of an Asset as

in the case of leased Assets.

6) Obsoloscence – refers to an Asset becoming out of date due to improved models

or methods.

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CAUSES OF DEPRECIATION

1) Use – Wear and Tear is an important cause of depreciation in the case of a

tangible fixed Asset.It is due to use of the Asset.

2) Lapse of Time – Asset such as lease, copyright, patent etc. Cost is written off
over the legal life and the aamount charged against revenue every year is
known as Depreciation.

3) Obsoloscence – Loss of usefulness by improved production methods ios known

as obsoloscence.

4) Accidents – An Asset may reduce in value because of an accident.accidental

loss may be permanent but it is not continuing and gradual.

5) Disuse – A M/C remaining continously idle becomes less and less useful with
the passage of time.

6) Inadequacy – refers to the termination of the use of an Asset because of growth

and changes in the size of the firm.

7) Depletion – An Asset may get exhausted through working as in the case of

mines, quarnes, oil fields and forest etc.

OBJECTIVES AND NECESSITY FOR PROVIDING DEPRECIATION

1) Ascertainment of True Profits– Depreciation is an invisible expense.So it must

be changed to the P&L A/C.

2) Presentation of True Financial Position – Assets will be shown at true value.

3) Replacement – Dep. Amount is available for replacement of the Asset when its
life is over.

4) No Distortion of Divisible profits – If dep. is not charged to profits, trading results

are vitiated and divisible profits are distorted.

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BASIC FACTORS AFFECTING THE AMOUNT OF DEPRECIATION

1) Original Cost of the Asset.

2) Estimated Scrap or Residual Value.
3) Estimated Effective or commercial or Legal life whichever is shorter.

METHODS OF RECORDING DEPRECIATION

1) When a provision for Depreciation A/C is not maintained :

Under this method, the amount of depreciation is debited to the depreciation

A/C and credited to the Asset account.Dep A/C is closed by the transfer to P&L
A/C and is shown as a deduction from the value of the Asset on the Assets side
of the B/S.
a) For Providing Depreciation :
Depreciation A/C - - - - - - - - - - Dr
To Asset A/C

b) For transferring depreciation to the P & L A/C

P & L A/C - - - - - - - - - -Dr
To Depreciation A/C

 In case the Asset is sold, the sale proceeds are credited to the Asset A/C. Any
profit or loss on sale of the Asset is transferred to the P & L A/C.The entris will
be-
c) When the Asset is sold
Bank A/C - - - - - - - - - - -Dr
To Asset A/C

d) For the depreciation (on the sold Asset) of the current period
Depreciation A/C - - - - - - - - - - -Dr
To Asset A/C

e) For Loss on sale of Asset

P & L A/C - - - - - - - - - - - -Dr
To Asset A/C
Reverse entry will be passed when there is a profit on sale of an Asset.

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2) When a provision for Depreciation A/C is maintained :

Under this method, the amount of Depreciation to be provided in a particular
year is credited to provision for Depreciation account and debited to P & L
A/C .The Asset account appears in the books at original cost. In this case,
provision for Depreciation appears on the liabilities side of the B/S and the Asset
appears at the cost on the Assets side.Any amount realised on the sale of the
Asset is transferred to the Asset A/C.The balance,if any, in the Asset A/C is
transferred to the P & L A/C.

a) For providing Depreciation

Dep A/C - - - - - - - - - - - -Dr
To provision for Dep A/C

b) For transferring Dep to P & L A/C

P & L A/C - - - - - - - - - - - -Dr
To Dep A/C

c) When Asset is sold

i) For transferring Accumulated Dep

Provision for Dep A/C - - - - - - - - - -Dr
To Asset A/C

ii) For sale proceeds of the Asset

Bank A/C - - - - - - - - - -Dr
To Asset A/C

iii) For profit on sale

Asset A/C - - - - - - - - - Dr
To P & L A/C

iv) For loss on sale

P & L A/C - - - - - - - - - Dr
To Asset A/C

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METHODS OF PROVIDING DEPRECIATION

a) Straight Line Method

b) Diminishing Balance Method or WDV or RBM
c) Annuity Method
d) Depreciation Fund Method (or Sinking Fund Method)
e) Insurance Policy Method
f) M/C Hour Rate Method
g) Units of Output or Production Method or Depletion Method
h) Revaluation Method
i) Sum-of-the-Years Method
j) Group Depreciation Method

a) SLM – It allocates an equal amount of depreciation in each of the accounting

periods of the service life of the asset.
Annual Depreciation = (original cost – estimated salvage value)/(estimated
useful life in years)

b) Diminishing Balance Method or WDV OR RBM – Dep. is calculated on the

reducing balance (asset cost minus depreciation) and not on the original cost.In
the next accounting period, the fixed percentage is applied to the WDV and not
on the original cost.
The rate of depreciation in the diminishing balance method is:

r = 1- (S/C)1/n * 100

where, r = rate of depreciation,

n = no of years of asset’s life,
s = salvage value,
C = cost of asset.

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Points Of Distinction SLM
1) Change in amount of The same amount of
Depreciation depreciation is charged
every year throughtout
the life of the asset.
2) Balance in Asset A/C The balance in the asset
A/C will be reduced to
zero.
3) Recognition by IT Not Recognized
Authorities
4) Profits During the earlier years of
the life of the asset,
profits under this method
are more.
5) Overall Charge The total charge against
profit and loss A/C in
respect of Dep and
repairs goes on
increasing from year to
year, because the amount
of Dep and repairs is
relatively less during the
earlier years of the life of
the asset than later years
because repairs go on
increasing with use of
asset.
CHANGE IN METHOD OF DEPRECIATION
 From SLM to WDV or vice – versa.
It can be prospective (from current year) or retrospective.
1) Prospective Change – It does not introduce any complication in
accounting.All that is necessary is to merely shift to the new method, from
the date on which the change becomes effective
11th A/C’S- Depreciation
WDV Method
Depreciation is
calculated at fixed rate
on the book value of an
asset every year.Dep
goes on decreasing.
The balance in the asset
A/C will not be reduced
to zero.
Recognized
Profits aare less during
earlier years than the
later years.
The total charge against
P & L A/C in respect of
depreciation and repairs
remains almost uniform
year after year because
as the Dep goes on
decreasing, repairs go
on increasing thus
keeping the total charge
almost uniform.
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2) Retrospective Change – From the date of purchase. In such a case, it is

necessary to find out the book value of the asset as on the date on which
the Dep method is changed.Further, dep should be calculated both by
existing method as well as by the changed method and the difference is
adjusted in the current year’s asset account on the date specified for the
change, giving a corresponding debit or credit to P & L A/C.
If dep. provided in the original method is more than that in the new method
proposed, the book value on the date of change will be “less than what it
should be” as per the new method.Then the asset A/C is debited and P & L
A/C is credited with difference in depreciation.
Similarly, if depreciation provided in the method is less than the dep. under
the new method, the BV of the asset A/C shows excess balance.So, the
asset is credited with the difference in depreciation and P & L A/C is debited.

c) ANNUITY METHOD - Interest at a fixed rate is calculated on the capital

investment involved in the purchase of the asset , on the assumption that, if
the same amount of capital was employed in some other investment, it
would have earned a certain rate of interest.The owner not only losess the
original cost of the asset in the shape of depreciation, but also loses the
interest thereon.Under the annuity method, the cost of the asset as also the
interest thereon are written down annually by equal installments until the BV
of the asset in question is either reduced to zero or its residual value at the
end of its usefulness to the business.The amount of dep. includes some
portion of the asset ansd some portion of the expected amount of interest
also.

 Method of Calculating of Interest and Depreciation –

In first year, interest is calculated on the BV of the asset and during the next
year, it is calculated on the balance of the asset which is on the 1 st date of
the year and so on.
Dep for all years = “Asset value * Annuity factor “

Journal Entries:
1) Purchase Asset :
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Asset A/C - - - - - - - - Dr
To Bank A/C

2) For charging given ROI on the opening balance of asset each year :
Asset A/C - - - - - - - - -Dr
To interest A/C

3) For charging dep. on Asset:

Dep A/C - - - - - - - -Dr
To Asset A/C

d) DEPRECIATION FUND OR SINKING FUND METHOD –

Dep is calculated with reference to sinking fund tables.It is debited to dep.
A/C and credited to sinking fund A/C.At the end of the year, dep. is changed
to P & L A/C .This amount is invested in outside securities in order to earn
compound interest on the investment.This process continues in all the
years of the life of the asset.In the last year, the investments are sold and
whatever amount that is realised from the sale of securities is utilised for the
replacement of the asset.

Journal Entries:
1) When the Asset is bought:
Asset A/C - - - - - - - -Dr
To Bank A/C

2) For Dep at the end of 1st year:

Dep A/C - - - - - - - -Dr
To Sinking Fund A/C

3) For transfer of Depreciation:

P & L A/C - - - - - - - - Dr
To Dep A/C

4) For investment of annual Installment

Sinking Fund Investment A/C - - - - - - - - Dr
To Bank A/C

2nd & SUBSEQUENT YEARS –

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1) For Dep Charges:

Dep A/C - - - - - - - - -Dr
To Sinking Fund A/C

2) For Interest on Investments received:

Bank A/C - - - - - - - Dr
To Interest on Sinking Fund Investment A/C

3) For transferring Interest to sinking Fund:

Interest on Sinking Fund Investments A/C - - - - - - - - Dr
To Sinking Fund A/C

4) For transferring Depreciation:

P & L A/C - - - - - - - - -Dr
To Dep A/C

5) For Investments of Annual Installments along with Interest

Sinking Fund Investments A/C - - - - - - - - -Dr
To Bank A/C
LAST YEAR –

1) For Dep Charges:

Dep A/C - - - - - - - - -Dr
To Sinking Fund A/C

2) For Interest on Investments received:

Bank A/C - - - - - - - Dr
To Interest on Sinking Fund Investment A/C

3) For transferring Interest to sinking Fund:

Interest on Sinking Fund Investments A/C - - - - - - - - Dr
To Sinking Fund A/C

4) For transferring Depreciation:

P & L A/C - - - - - - - - -Dr
To Dep A/C

5) For Investments of Annual Installments along with Interest

Sinking Fund Investments A/C - - - - - - - - -Dr
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To Bank A/C

6) For Transfer of Profit on Sale of Investments :

Sinking Fund Investments A/C - - - - - - - - -Dr
To Sinking Fund A/C

7) For Transfer of Loss on Sale of Investments:

Sinking Fund A/C - - - - - - - - Dr
To Sinking Fund Investments A/C

8) For Transfer of Balance of Sinking Fund A/C To Asset A/C:

Sinking Fund A/C - - - - - - - - -Dr
To Asset A/C

PROVISION AND RESERVES

A Provision is an amount set aside to meet a future expense or loss whose

occurrence or exact amount is uncertain.According to Part III of schedule VI to
the Companies Act, 1956, a provision means “any amount written off or retained
by way of providing for depreciation, renewal or diminution in value of assets or
retained by way of providing for any known liability of which the amount cannot
be determined with substantial accuracy”.
Thus a provision may be made either
a) Provision in the value of an asset or
b) For a known liability the amount of which cannot be ascertained accurately.

A Provision is a ‘charge’ against profits and can be created by debiting the P & L
A/C.

Features of Provision:
a) It continues an amount set aside out of income or profits.It is a retention of
profit, made temporarily for a specific purpose.
b) The purpose for which a provision is created, is to meet.
1) An anticipated loss which has occurred but the amount is not ascertained
or
2) A known depletion or diminution in the value of an asset or
3) A liability which hass been known to have arisen.

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c) The exact amount of the anticipated loss or the depletion in the value of the
asset or the liability is not ascertained or ascertainable, at the time of
accounting.
d) It is a charge to P & L A/C.

IMPORTANCE OF PROVISION:
1) A provision is an amount set aside out of current earnings considered
necessary to provide for all losses that are expected to arise out of
transactions entered into and during the accounting period.
2) A provision is made to retain future operating performance undisturbed by
losses arising out of transactions of prior periods.
3) A provision is following the Prudence Concept of Accounting.
4) Creation of Provisions is an attempt to maintain the capital of business intact.

RESERVES
These are the amounts sets aside out of profits.
‘Any sum which is appropriated out of profit and loss appropriation account
and is not meant to cover up liaability, contigency, commitment or reduction
in the value of an asset is a reserve’.Reserves are undisturbed, accumulated
profits.They are provided for meeting prospective losses or liabilities, to
increase the working capital of the business and to strengthen its financial
position.
They belong to the proprietors over and above the capital contributed by
them.The amount to be transferred to a reserve is debited to P & L
appropriate A/C.Eg of Reserves are General Reserve, Capital
Reserve,Dividend Equalisation Reserve, Share Premium, Debenture
Redemption fund, investment Reserve, etc.

IMPORTANCE OF RESERVES:
1) Expansion
2) Better Financial Position
3) Redemption of Liabilities
4) Meeting Unforseen Contigencies
5) Making Dividends Uniform from year to year, and
6) Meeting Legal requirements such as Investment Reserve required by IT law.

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BASIS RESERVES PROVISION

1) Nature Appropriation out of Charge against profits.

profits.

2) Place in Income Debited To P & L Debited To P & L A/C.

Statement Appropriate A/C.

3) Purpose Is created to strengthen Is made to meet a

the financial position of specific liability or
the concern and to contigency.
meet unforeseen
liabilities and losses.

4) Investment Can be invested outside Cannot be invested

the business. else where.

5) Usage Can be used for Cannot be applied for

purposes other than other purposes.
those for which it has
been created.

6) Creation Can be created only Can be made even

when there are profits. when the business has
incurred loss.

7) Place in B/S Liabilities side of B/S Deducted from the item

for which it is created.

8) Divisible Profit Reduces divisible Reduces the net profit

profits and can be and is not invested in
invested in outside outside securities.
securities.

9) Legal Profit It is a matter of financial It is made of legal

prudence, i.e. it is
created to save the
concern from
prospective losses and
11th A/C’S- Depreciation
necessity or financial
prudence.
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liabilities.

10) Tax Benefit Creation of reserves Provisions are usually

does not provide tax ‘tax saving’.
benefit.

11) Distribution and It can be distributed as It cannot be distributed

Transfer dividend, if it remains as dividend or
unutilised for some transferred to any
period.Some amount of general reserve.
reserves can be
transferred to
provisions, if needed.

TYPES OF RESERVES

A) REVENUE AND CAPITAL RESERVES

a) REVENUE RESERVES – are created out of revenue profits which are available
for distributed as dividend.Any reserve can be termed as REVENUE RESERVE if
i) It is created out revenue surplus, and
ii) It is available for distribution as dividend to the shareholders.

Types of Revenue Reserves –

1) P & L A/C
2) General reserve
3) Debenture Redemption Reserve
4) Dividend Equalisation Reserve
5) Investment Fluctuation Reserve

b) CAPITAL RESERVE – are created out of capital profits which are not earned in
the normal course of business.They are not used for payment of dividend, though
some of them are available for dividend with certain restrictions.

Eg of Capital Reserves are:

1) Profit prior to incorporation
2) Premium on Issue of shares or Debentures
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3) Profit on Forfieture of Shares

4) Profit on Redemption of Debentures
5) Capital Redemption Reserve
6) Profit on Sale of fixed Assets over the original cost, and
7) Profit on Revaluation on Fixed Assets and Liabilities.

BASIS REVENUE RESERVE CAPITAL RESERVE

1) Source It is created out of business Created out of capital profits.

profits.

2) Dividend Used for distribution of dividends Can be used for distribution

without any precondition. of dividends only if the Co.
satisfies certain conditions
prescribed by the Co. Act.

3) Purpose Strengthening the financial For meeting capital losses to

position and meeting the be used for purposes
unforeseen contingencies or specified by the Co. Act
some specific reserve.

B) GENERAL AND SPECIFIC RESERVE

a) GENERAL RESERVE – is the amount set aside out of profits for no specific
purpose.It is available for any future contingency or expansion of
business.Such reserve strengthens the financial position of the business.It is
like a cushion to face the ‘ups and downs’ in the profitability of businesss
firms.

b) SPECIFIC RESERVE – are reserves created for specific future contingencies

or expected repayment of liabilities.They are also created by debited the P &L
App. A/C.They are usually used for the purpose for which they are created
though the management can divert any portion of them if necessary.
Eg: Dividend Equalisation Reserve
Debenture Redemption Reseve

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Investment Fluctuation Reserve

 SECRET RESERVE or HIDDEN RESERVE or INTERNAL RESERVE – A

reserve whose existence is not disclosed on the face of a B/S (though it really
exists) is called a ‘Secret Reserve’.When secret reserve exists, the financial
position of the business is better than what is disclosed by the B/S.Banks,
Insurance Co’s and Finance Reserves hoises usually maintain secret reserves.

 Methods of Creating Secret Reserves

1) By Charging Excessive Depreciation.
2) By undervaluing stock-in-trade and goodwill.
3) By creating excessive provision for bad debts and other contingencies.
4) By charging capital expenditure to the P & L A/C.
5) By supressing sales.
6) By sharing a contingent liability as a real liability.
7) By grouping free reserves as creditors.
8) Grouping free reserves with creditors.
9) Inflating Purchases.

 MERITS OF SECRET RESERVES –

1) Dividends can be maintained with the use of secret reserves even when profits
are fluctuating.
2) Working capital position and general financial strength improves through
secret reserves without the knowledge of the shareholders or the general
public.
3) In lines of business where profit margin is high, secret reserves can hide the
extent of margin to discourage competitors.
4) Heavy losses of an exceptional nature can be met without disclosing the fact in
the published statements and without disturbing the normal business profit.

 DISADVANTAGES OF SECRET RESERVES –

1) Secret reserves diminish the profits available for dividends which may deny
the shareholder their legitimate due.
2) ‘Insider Trading’ may be encouraged due to lower value of the Co’s share in
stock markets because of non disclosure of real financial strength of the
company.
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3) Losses arising from bad and inefficient management are not disclosed to the
shareholders.
4) The prime object of the B/S i.e. showing true and fair view of the financial
position of a business is defeated through secret reserves.
5) Sometimes the directors make use of such reserve for their personal benefits.

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