Chapter 7 — Depreciation, Provisions and Reserves

Chapter 7 covers two broad topics presented in two sections: the first section explains depreciation on fixed assets — its meaning, causes, factors affecting it, methods of calculating it (straight line and written down value), and recording in accounts; the second section covers provisions and reserves, their differences, types, and the concept of secret reserve.

According to AS-6 issued by The Institute of Chartered Accountants of India, depreciation is 'a measure of the wearing out, consumption or other loss of value of 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.

The chapter identifies four causes: wear and tear due to use or passage of time, which reduces an asset's technical capacity; expiration of legal rights such as patents, copyrights, and leases that lose value when the agreement ends; obsolescence arising from technological changes, improvements in production methods, or changes in market demand; and abnormal factors such as accidents due to fire, earthquake, or floods.

Depreciation is a decline in the book value of fixed assets; it includes loss of value due to effluxion of time, usage, or obsolescence; it is a continuing process; it is an expired cost deducted before calculating taxable profits; and it is a non-cash expense — it does not involve any cash outflow but represents the writing-off of capital expenditure already incurred.

Under the straight line method, depreciation equals (Cost of asset minus Estimated net residual value) divided by Estimated useful life of the asset. The same fixed amount is charged every year. For example, if original cost is Rs 2,50,000, residual value is Rs 50,000, and useful life is 10 years, annual depreciation is Rs 20,000, giving a rate of 8% on acquisition cost.

Under the written down value method, a fixed percentage is applied to the book value (original cost less accumulated depreciation) at the beginning of each year, so the depreciation amount declines year after year. The rate is calculated using the formula R = [1 minus the nth root of (Scrap value divided by Cost)] multiplied by 100, where n is the expected useful life.

Under the straight line method, depreciation is calculated on original cost and remains constant every year; it is not recognised by Income Tax Law and suits assets with low repair charges and low obsolescence risk. Under the written down value method, depreciation is calculated on the declining book value, so it is highest in the first year and falls subsequently; it is recognised by the Income Tax Act and is suitable for assets affected by technological changes and requiring increasing repair expenses over time.

Depreciation relates to the declining book value of tangible fixed assets due to use or time. Depletion refers to the reduction in the quantity of natural resources such as mines or quarries that decreases with extraction. Amortisation refers to writing-off the cost of intangible assets such as patents, copyrights, trade marks, and goodwill whose utility is for a specified period; the procedure is the same as for depreciation of fixed assets.

Three parameters determine the amount of depreciation: (1) the original cost of the asset, which includes invoice price, freight, transportation, installation cost, and registration cost; (2) estimated net residual value, which is the expected sale value at the end of useful life less disposal expenses; and (3) estimated useful life, which is the period over which the asset is expected to be used commercially by the enterprise.

A provision is a charge against profit created for a known liability or expense of the current period whose amount is not certain; it must be created even if there are no profits, and it reduces taxable profits. A reserve is an appropriation of profit — not a charge — created to strengthen the financial position of the business; it can only be created when there are profits, and it does not reduce taxable profits.

Reserves are classified as general reserves (no specific purpose, freely usable by management) and specific reserves (for a defined purpose such as dividend equalisation reserve, workmen compensation fund, investment fluctuation fund, and debenture redemption reserve). They are also classified as revenue reserves (created from revenue profits arising from normal operations, available for dividend distribution) and capital reserves (created from capital profits not arising from normal operations, not available as dividend; used to write off capital losses or issue bonus shares).

A secret reserve is a reserve that does not appear in the balance sheet and is not known to outside stakeholders. It can be created by charging higher depreciation than required, undervaluing inventories or stock, charging capital expenditure to profit and loss account, making excessive provision for doubtful debts, or showing contingent liabilities as actual liabilities. It helps reduce disclosed profits and may be merged with profits during lean periods.

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