Depreciation, Provisions and Reserves

Depreciation means reduction in the value of a fixed asset because of use, time, wear and tear, or becoming old.

If a business buys a laptop today, after one year the laptop will not have the same value.

It becomes older and less valuable.

This fall in value is called depreciation.

Simple line: Depreciation means the value of an asset goes down over time.

Example: Riya buys a laptop for her shop for Rs.40,000. After using it for one year, its value may reduce. This reduction is depreciation.

Fixed assets are used for many years.

Assets lose value every year.

The loss in value is part of business expense.

Profit will be overstated if depreciation is ignored.

Balance Sheet will show wrong asset value if depreciation is ignored.

Simple example: if machinery is used to earn income, some part of its cost should be treated as expense every year.

Memory line: Depreciation helps show correct profit and correct asset value.

Riya runs a small mobile accessories shop.

She buys a computer for billing for Rs.50,000.

She uses it every day to make bills, check stock, record sales, and print invoices.

After one year, the computer is older and less valuable.

Should Riya show the computer at Rs.50,000 forever?

No. Its value has reduced.

The reduction in value is called depreciation.

If depreciation is Rs.5,000, Profit and Loss Account shows Depreciation Expense Rs.5,000 and Balance Sheet shows Computer value reduced by Rs.5,000.

Use: a delivery bike used every day loses value.

Passage of time: furniture becomes old even if used carefully.

Wear and tear: machines wear out after regular use.

Obsolescence: an old computer becomes outdated when new technology comes.

Accident or damage: a machine may lose value after damage.

Simple line: assets reduce in value because they are used, become old, or become less useful.

Depreciation has two effects.

Profit & Loss Account: depreciation is shown as an expense.

Balance Sheet: depreciation is deducted from the asset.

Example: Machinery Rs.50,000 and depreciation Rs.5,000.

Profit & Loss Account shows Depreciation Rs.5,000.

Balance Sheet shows Machinery Rs.50,000 less Depreciation Rs.5,000, so value is Rs.45,000.

Simple line: Depreciation reduces profit and reduces asset value.

Journal entry: Depreciation A/c Dr. Rs.5,000 / To Machinery A/c Rs.5,000.

Under Straight Line Method, the same amount of depreciation is charged every year.

Example: Computer cost Rs.50,000 and depreciation every year is Rs.5,000.

Year 1 depreciation is Rs.5,000.

Year 2 depreciation is Rs.5,000.

Year 3 depreciation is Rs.5,000.

Simple line: same depreciation every year.

Very simple formula: Depreciation = Cost of asset x Rate / 100.

Example: Machine Rs.40,000 and depreciation rate 10%. Depreciation is Rs.40,000 x 10% = Rs.4,000 every year.

Under Written Down Value Method, depreciation is calculated on the reduced value of the asset every year.

Example: Machine cost Rs.40,000 and rate is 10%.

Year 1 depreciation is 10% of Rs.40,000 = Rs.4,000.

Value after Year 1 depreciation is Rs.36,000.

Year 2 depreciation is 10% of Rs.36,000 = Rs.3,600.

Value after Year 2 depreciation is Rs.32,400.

Simple line: depreciation becomes smaller because it is calculated on reduced value.

A provision is an amount kept aside for a known or expected loss or liability, but the exact amount may not be fully certain.

Sometimes the business knows that a loss or expense may happen, but the exact amount is uncertain.

So it creates a provision.

Example: Riya sold goods on credit to many customers. Some customers may not pay.

So she creates Provision for Doubtful Debts.

Simple line: Provision is made for expected loss or liability.

Debtors are customers who owe money to the business.

But not all debtors may pay.

So the business creates a provision for doubtful debts.

Example: Debtors Rs.20,000 and Provision for Doubtful Debts Rs.1,000.

Balance Sheet shows Debtors Rs.20,000 less Provision Rs.1,000, so Net Debtors are Rs.19,000.

Profit & Loss Account may show provision as an expense if it is created or increased.

Simple line: Provision for doubtful debts reduces debtors.

A reserve is an amount kept aside from profit for future use.

If a business earns profit, it may not use all the profit immediately.

It may keep some profit aside for future needs.

This is called reserve.

Example: Riya's shop earns profit Rs.50,000. She keeps Rs.10,000 aside for future expansion. This is a reserve.

Simple line: Reserve is profit kept aside for future.