Depreciation, Provisions and Reserves
Depreciation means a fall in the value of an asset because of its usage or with the efflux of time, or due to its obsolescence or accident. Features of Depreciation are that, it reduces the book value of the asset and not its market value, reduction in the book value of an asset is permanent, gradual and has a continuing nature, etc. Depreciation is shown as expense and asset is shown with reduced value in the Balance Sheet. Factors affecting amount of depreciation are cost of an asset, scrap value, useful life, legal provisions, etc. Depletion is used in place of depreciation in case of natural resources like mines, oil wells etc. Amortisation means writing off the value of intangible assets. Obsolescence refers to decline in value due to improved technique. Objectives for providing depreciation are to ascertain the correct profit and loss; to show true and fair view of the financial position; and to provide funds for replacement of assets. Methods of providing depreciation include Straight Line Method and Diminishing Balance Method. Under straight line method a percentage of original cost of the asset is written off every year. It is based on the assumption of equal usage of the asset over its entire useful life. This method is also called Equal Installment Method or Original Cost Method. Under Diminishing Balance Method, depreciation is charged at fixed rate on the reducing balance every year.
Asset account may be prepared with or without opening Provision for depreciation account. Asset may be sold or discarded before or on the expiry of estimated useful life of the asset. In this case profit or loss on sale of asset is required to be computed. For this purpose sometimes assets disposal account is also opened. Reserve is the amount set aside out of the profits. It is an appropriation of profit and not a charge against profit. Provision is an amount provided for a known liability the amount of which cannot be determined with accuracy. Provision and reserves are different from each other.