Class 11 Accountancy Notes Chapter 7 (Depreciation; Provisions and Reserves) – Financial Accounting-I Book

Detailed Notes with MCQs of a very important chapter for your exams: Chapter 7 - Depreciation, Provisions, and Reserves. Understanding these concepts is crucial not just for your Class 11 syllabus but also forms a base for many competitive government exams involving accounting.

We know that businesses acquire assets like machinery, buildings, and vehicles to generate revenue over several years. However, the value of these assets doesn't remain constant. It decreases over time due to usage and other factors. Similarly, businesses need to anticipate future liabilities or losses and set aside funds. This chapter deals with accounting for the decrease in asset value (Depreciation) and setting aside funds for specific purposes (Provisions and Reserves).

Detailed Notes: Chapter 7 - Depreciation, Provisions and Reserves

1. Depreciation

• Meaning: Depreciation is the gradual, continuous, and permanent decrease in the book value of a fixed tangible asset due to use, wear and tear, passage of time, obsolescence, or depletion. It is an expense charged against the profits of an accounting period. It represents the allocation of the cost of an asset over its estimated useful life.

• Key Characteristics:

  • It is a decline in the book value of fixed assets (excluding land).
  • The decline is permanent, gradual, and continuous.
  • It is a process of allocation of cost, not valuation.
  • It is a non-cash expense (doesn't involve immediate cash outflow).
  • It is charged against profit.

• Causes of Depreciation:

  • Wear and Tear: Due to actual use of the asset in operations.
  • Effluxion of Time: Decrease in value due to passage of time, even if not used (e.g., leasehold property).
  • Obsolescence: Becoming out-of-date due to technological advancements, improved production methods, change in market demand, or legal restrictions.
  • Depletion: Reduction in the value of natural resources (like mines, quarries) due to extraction.
  • Accidents: Damage or destruction due to unforeseen events like fire, flood, earthquake.

• Need/Objectives of Providing Depreciation:

  • To Ascertain True Profit or Loss: Matching principle requires that the cost of using an asset (depreciation) should be charged against the revenue earned during the period.
  • To Show True and Fair Financial Position: Assets should be shown at their realistic value in the Balance Sheet. Overstating assets would not reflect a true financial position.
  • To Accumulate Funds for Asset Replacement: Depreciation charge helps retain funds in the business (by reducing distributable profits) which can be used for replacing the asset at the end of its useful life.
  • To Ascertain Accurate Cost of Production: Depreciation on factory assets is an item of production overhead.
  • To Comply with Legal Requirements: Companies Act and Income Tax Act require charging depreciation.

• Factors Affecting the Amount of Depreciation:

  • Cost of Asset: Original cost including purchase price, freight, installation charges, etc. (all expenses incurred to bring the asset to usable condition).
  • Estimated Useful Life: The period for which the asset is expected to be used by the enterprise.
  • Estimated Scrap Value (Residual Value): The estimated sale value of the asset at the end of its useful life.
  • Depreciable Amount: Cost of Asset - Estimated Scrap Value. This is the amount allocated over the useful life.

• Methods of Calculating Depreciation (Focus on NCERT Syllabus):

  • (a) Straight Line Method (SLM) / Fixed Instalment Method / Original Cost Method:

    • Concept: A fixed and equal amount of depreciation is charged every year throughout the useful life of the asset.
    • Formula:
      • Annual Depreciation = (Cost of Asset - Estimated Scrap Value) / Estimated Useful Life (in years)
      • Rate of Depreciation (%) = (Annual Depreciation / Cost of Asset) * 100
    • Advantages: Simple to understand and apply, asset value becomes zero (or scrap value) at the end of useful life.
    • Disadvantages: Ignores the intensity of use, repair costs increase in later years but depreciation remains constant (leading to uneven charge against profit over the years), ignores the interest factor.
    • Suitability: Useful for assets where usage is uniform and obsolescence is low (e.g., Furniture, Buildings, Leases).

  • (b) Written Down Value (WDV) Method / Reducing Balance Method / Diminishing Balance Method:

    • Concept: Depreciation is charged at a fixed percentage on the book value (Cost - Accumulated Depreciation) of the asset each year. The amount of depreciation decreases year after year.
    • Formula:
      • Depreciation for the year = Book Value at the beginning of the year * Rate of Depreciation (%)
      • (Note: Rate is applied on the reduced balance, not the original cost).
      • The rate is often calculated using a formula (not usually required for basic problems): R = [1 - n√(s/c)] * 100, where n=life, s=scrap value, c=cost. Usually, the rate is given.
    • Advantages: More realistic as depreciation is higher in earlier years when the asset is more efficient and repair costs are low, recognized by income tax authorities, balances charge against profit (higher depreciation + lower repairs in early years; lower depreciation + higher repairs in later years).
    • Disadvantages: Asset value never becomes zero, calculation can be slightly more complex than SLM.
    • Suitability: Suitable for assets prone to obsolescence and requiring higher repairs in later years (e.g., Plant & Machinery, Vehicles).

• Accounting Treatment:

  • Charging Depreciation:

    • Method 1: Charging Depreciation to Asset Account

      • For charging depreciation:
        Depreciation A/c Dr.
        To Asset A/c
      • For transferring depreciation to P&L A/c:
        Profit & Loss A/c Dr.
        To Depreciation A/c
      • In this method, the Asset account appears in the Balance Sheet at its written down value (Cost - Depreciation charged till date).

    • Method 2: Creating Provision for Depreciation Account (or Accumulated Depreciation Account)

      • For charging depreciation:
        Depreciation A/c Dr.
        To Provision for Depreciation A/c (or Accumulated Depreciation A/c)
      • For transferring depreciation to P&L A/c:
        Profit & Loss A/c Dr.
        To Depreciation A/c
      • In this method, the Asset account continues to appear at its original cost in the Balance Sheet. The Provision for Depreciation A/c is shown either as a deduction from the Asset on the Assets side or on the Liabilities side.

  • Sale of Asset:

    • Calculate depreciation on the asset up to the date of sale.
    • Calculate the book value of the asset on the date of sale.
    • Compare the book value with the sale proceeds to determine Profit or Loss on Sale.
      • If Sale Proceeds > Book Value = Profit on Sale
      • If Sale Proceeds < Book Value = Loss on Sale
    • Journal Entries (assuming Provision for Depreciation A/c is maintained):
      1. For depreciation up to date of sale:
         Depreciation A/c Dr.
         To Provision for Depreciation A/c
      2. For transfer of accumulated depreciation of the sold asset:
         Provision for Depreciation A/c Dr.
         To Asset A/c
      3. For recording sale proceeds:
         Bank A/c Dr.
         To Asset A/c
      4. For Profit on Sale (if any):
         Asset A/c Dr.
         To Profit & Loss A/c (or Profit on Sale of Asset A/c)
      5. For Loss on Sale (if any):
         Profit & Loss A/c (or Loss on Sale of Asset A/c) Dr.
         To Asset A/c
    • (If Provision for Depreciation A/c is not maintained, entries are simpler: Depreciation is credited directly to Asset A/c, and profit/loss is calculated based on the WDV in the Asset A/c itself).

2. Provisions

• Meaning: A provision is an amount set aside out of profits to provide for a known liability or loss, the amount of which cannot be determined with substantial accuracy, or for a diminution in the value of an asset.
• Key Characteristics:
  • It is a charge against profit (debited to P&L Account before calculating net profit).
  • Created for a known liability or expected loss.
  • The exact amount of liability/loss is uncertain.
  • Created to meet specific anticipated losses or liabilities (e.g., bad debts, depreciation, taxation).
  • Not available for distribution as dividend.
• Purpose/Importance:
  • To ascertain the true profit for the period (by accounting for expected losses/liabilities).
  • To present a true and fair view of the financial position (by showing anticipated liabilities).
  • To provide for diminution in asset value (Provision for Depreciation) or expected losses (Provision for Doubtful Debts).
• Examples:
  • Provision for Depreciation
  • Provision for Doubtful Debts
  • Provision for Taxation
  • Provision for Repairs and Renewals
  • Provision for Discount on Debtors

3. Reserves

• Meaning: A reserve is an amount set aside out of profits and other surpluses, which are not meant to meet any known liability, contingency, or diminution in the value of an asset. Reserves strengthen the financial position of the business.

• Key Characteristics:

  • It is an appropriation of profit (set aside after calculating net profit).
  • Not created for any known liability or specific expected loss.
  • Created to strengthen the financial position, fund future growth, or meet unforeseen contingencies.
  • Generally available for distribution as dividend (unless it's a specific reserve with restrictions or a capital reserve).

• Types of Reserves:

  • (a) Revenue Reserves: Created out of revenue profits (profits earned from normal business operations). Available for dividend distribution (subject to specific restrictions).

    • General Reserve: Created without any specific purpose, strengthens the overall financial position, increases working capital, can be used for any purpose in the future (e.g., expansion, dividend equalisation, meeting contingencies).
    • Specific Reserve: Created for a specific purpose and can generally be utilized only for that purpose.
      • Dividend Equalisation Reserve: To maintain a stable rate of dividend.
      • Debenture Redemption Reserve (DRR): Legally required to be created out of profits for redemption of debentures.
      • Investment Fluctuation Reserve: To meet fluctuations in the value of investments.
      • Workmen Compensation Reserve: To meet claims of workers due to accidents.

  • (b) Capital Reserves: Created out of capital profits (profits not earned in the ordinary course of business). Not available for distribution as dividend.

    • Sources: Profit on sale of fixed assets, Profit on revaluation of assets/liabilities, Premium on issue of shares or debentures, Profit on redemption of debentures, Profit on forfeiture of shares, Profit prior to incorporation.
    • Usage: Generally used for writing off capital losses (e.g., discount on issue of shares/debentures) or issuing bonus shares (subject to legal provisions).

  • (c) Secret Reserves (Not explicitly detailed in NCERT but good to know): A reserve whose existence and/or amount is not disclosed in the Balance Sheet. Created by practices like excessive depreciation, undervaluing assets, creating excessive provisions, charging capital expenditure to P&L A/c. Such reserves are generally discouraged as they distort the true and fair view.

4. Distinction between Provision and Reserve

5. Distinction between Revenue Reserve and Capital Reserve

Multiple Choice Questions (MCQs)

1. Depreciation arises because of:
   a) Fall in the market value of an asset
   b) Physical wear and tear
   c) Obsolescence
   d) All of the above

2. Which of the following is a characteristic of Depreciation?
   a) It is an appropriation of profit
   b) It involves cash outflow
   c) It is a process of allocation of cost over the useful life of an asset
   d) It increases the book value of an asset

3. A machine was purchased for ₹1,00,000 with installation charges of ₹10,000. Its estimated scrap value is ₹5,000 and useful life is 5 years. What is the annual depreciation under the Straight Line Method (SLM)?
   a) ₹20,000
   b) ₹22,000
   c) ₹21,000
   d) ₹19,000

4. Under the Written Down Value (WDV) method, depreciation is calculated on:
   a) Original Cost of the asset
   b) Book Value of the asset at the beginning of the year
   c) Market Value of the asset
   d) Scrap Value of the asset

5. Which method of depreciation leads to a higher depreciation charge in the earlier years and lower in the later years?
   a) Straight Line Method
   b) Written Down Value Method
   c) Annuity Method
   d) Sinking Fund Method

6. Provision is a:
   a) Charge against profit for a known liability whose amount is uncertain
   b) Appropriation of profit to strengthen financial position
   c) Reserve created out of capital profits
   d) Reserve meant for dividend distribution

7. Which of the following is an example of a Provision?
   a) General Reserve
   b) Dividend Equalisation Reserve
   c) Provision for Doubtful Debts
   d) Capital Redemption Reserve

8. Reserves are created out of:
   a) Revenue Profits only
   b) Capital Profits only
   c) Both Revenue and Capital Profits
   d) Secret Profits only

9. Which of the following is a Capital Reserve?
   a) General Reserve
   b) Workmen Compensation Fund
   c) Premium received on issue of shares
   d) Provision for Taxation

10. The main purpose of creating Reserves is:
    a) To meet known liabilities
    b) To comply with legal requirements only
    c) To strengthen the financial position of the business
    d) To reduce the tax liability

Answers to MCQs:

1. d) All of the above
2. c) It is a process of allocation of cost over the useful life of an asset
3. c) ₹21,000 (Cost = 1,00,000 + 10,000 = 1,10,000. Dep = (1,10,000 - 5,000) / 5 = 1,05,000 / 5 = 21,000)
4. b) Book Value of the asset at the beginning of the year
5. b) Written Down Value Method
6. a) Charge against profit for a known liability whose amount is uncertain
7. c) Provision for Doubtful Debts
8. c) Both Revenue and Capital Profits
9. c) Premium received on issue of shares
10. c) To strengthen the financial position of the business

Make sure you revise these concepts thoroughly, especially the differences between provisions and reserves, and the calculation methods for depreciation. These are frequently tested areas. Good luck with your preparation!