Introduction

Imagine you buy a brand-new car. Over time, no matter how carefully you drive, its value drops due to wear and tear, newer models in the market, and general usage. This gradual reduction in value is what we call depreciation in accounting. Just like your car, businesses own fixed assets like machinery, buildings, and equipment that lose value over time. To ensure accurate financial reporting, businesses systematically account for this loss. Alongside depreciation, businesses also set aside funds as provisions and reserves to manage unforeseen expenses and financial stability.

This chapter is divided into two sections:

1. Depreciation – Understanding the reduction in the value of fixed assets.
2. Provisions and Reserves – Allocating funds for future obligations and business growth.

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Section 1: Depreciation

7.1 Meaning of Depreciation

Depreciation refers to the systematic allocation of an asset’s cost over its useful life. It accounts for the asset’s decreasing value due to wear and tear, obsolescence, or time.

7.1.1 Difference Between Depreciation, Amortization, and Depletion

• Depreciation – Applies to tangible fixed assets (e.g., machinery, buildings).
• Amortization – Applies to intangible assets (e.g., patents, trademarks).
• Depletion – Applies to natural resources (e.g., coal mines, oil fields).

7.2 Need for Depreciation

Why do businesses need to record depreciation?

1. True Profit Calculation – Without depreciation, profits would be overstated.
2. Asset Replacement Planning – Helps businesses save for future asset replacements.
3. Fair Valuation of Assets – Ensures assets reflect their true worth in financial statements.
4. Compliance with Accounting Standards – Proper depreciation is required by law and accounting principles.

7.3 Causes of Depreciation

1. Wear and Tear – Continuous use leads to physical deterioration.
2. Obsolescence – New technology or models make older assets less useful.
3. Passage of Time – Some assets lose value even without use (e.g., leased assets with fixed terms).
4. Depletion – Resources like mines diminish as they are used.

7.4 Methods of Calculating Depreciation

There are two primary methods of calculating depreciation:

7.4.1 Straight-Line Method (SLM)

• Formula: (Cost of Asset – Scrap Value) / Useful Life
• Depreciation remains constant every year.
• Best for assets with uniform usage (e.g., office buildings).

7.4.2 Written Down Value Method (WDV)

• Formula: Depreciation % × Book Value at Beginning of Year
• Higher depreciation in initial years, lower in later years.
• Suitable for assets like vehicles and machinery that lose more value in early years.

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Section 2: Provisions and Reserves

7.5 Meaning and Purpose of Provisions and Reserves

Businesses must prepare for uncertainties. This is done by creating provisions and reserves.

• Provision – An amount set aside to cover known liabilities or expenses (e.g., provision for doubtful debts).
• Reserve – A portion of profit retained for future needs or growth (e.g., general reserve for expansion).

7.6 Differences Between Provisions and Reserves

Feature	Provisions	Reserves
Nature	Created for specific expenses	Created from profit for general/business growth
Profit Impact	Reduces profit	Comes after profit calculation
Mandatory?	Yes, for foreseeable expenses	No, optional and strategic
Shown in?	Liability side of Balance Sheet	Liability or under Equity section

7.7 Types of Provisions

1. Provision for Depreciation – Covers asset value reduction.
2. Provision for Bad Debts – Protects against unpaid receivables.
3. Provision for Taxation – Ensures tax obligations are met.
4. Provision for Warranty – Covers potential warranty claims on products.

7.8 Types of Reserves

Reserves are broadly classified into:

7.8.1 Revenue Reserves

• General Reserve – Used for any future business need.
• Specific Reserve – Created for a specific purpose (e.g., Dividend Equalization Reserve).

7.8.2 Capital Reserves

• Created from capital profits (e.g., profit from selling fixed assets).
• Used for special purposes like business expansion.

7.9 Secret Reserve

A secret reserve is an undisclosed reserve created by undervaluing assets or overstating liabilities. While it strengthens financial stability, it can also mislead stakeholders.

7.10 Importance of Reserves

1. Financial Stability – Helps businesses withstand economic downturns.
2. Debt Repayment – Funds long-term liability settlements.
3. Business Growth – Enables expansion and innovation.
4. Dividend Equalization – Maintains steady dividend payouts.

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Conclusion

Depreciation, provisions, and reserves are essential for a company’s financial health. Depreciation helps in fair asset valuation, provisions safeguard against known risks, and reserves ensure long-term stability and growth. By understanding and implementing these concepts effectively, businesses can maintain accurate financial records and make informed decisions.