Questions
5–8 questions in Class 12 Boards
Difficulty
Medium
Importance
High yield for Class 12 Boards and Accounting basics in PSU exams
Overview
Depreciation, Provisions, and Reserves form the bedrock of financial accounting, focusing on the systematic allocation of asset costs and the prudent management of business earnings. Mastery of this topic is essential for both Class 12 board scoring and competitive PSU finance exams as it directly impacts profit calculation and tax liability.
Methods of Depreciation: SLM vs WDV
Depreciation represents the permanent decrease in the value of a fixed asset due to usage, wear and tear, or passage of time. Straight Line Method (SLM) charges a constant amount annually, whereas Written Down Value (WDV) applies a fixed percentage to the diminishing book value.
- SLM Depreciation Amount = (Cost - Scrap Value) / Estimated Life
- WDV Depreciation Amount = Opening WDV of Asset * Rate of Depreciation
- SLM assumes equal utility over the asset's life
- WDV is tax-compliant and matches depreciation with higher repairs in later years
- Depreciation is a non-cash expense
Asset Disposal and Accounting Entries
When an asset is sold or discarded, its net book value must be cleared from the books by transferring it to an Asset Disposal Account. This process identifies the gain or loss incurred on disposal, which must be reflected in the Profit and Loss Statement.
- Step 1: Transfer Asset to Asset Disposal Account
- Step 2: Transfer accumulated depreciation to Asset Disposal Account
- Step 3: Record sale proceeds in Asset Disposal Account
- Gain or Loss = Sale Proceeds - Book Value at date of sale
Provisions vs Reserves
Provisions are charges against profits meant to meet known liabilities of uncertain amounts, like Bad Debts. Reserves are appropriations of profits to strengthen the financial position or meet unforeseen future contingencies.
- Provision is a Charge against Profit (mandatory)
- Reserve is an Appropriation of Profit (discretionary)
- Provision reduces net profit; Reserve retains profit within the business
- Provisions are created for specific liabilities; Reserves are for general strengthening
- Capital Reserves are created out of capital profits
Formula Sheet
SLM Annual Depreciation = (Cost - Residual Value) / Useful Life
Book Value = Original Cost - Accumulated Depreciation
Gain/Loss = Sale Price - Book Value
Exam Tip
Always verify if the depreciation rate is 'per annum' or fixed for the period; failing to pro-rate depreciation in the year of purchase or sale is the most common reason for calculation errors.
Common Mistakes
- Confusing the calculation of WDV when the depreciation rate is applied on the original cost instead of the opening balance.
- Forgetting to calculate depreciation for the exact number of months an asset was used during the purchase or sale year.
- Treating the creation of a provision as an appropriation of profit rather than a charge against profit.
More Revision Notes
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