Depreciation is the permanent, continuous, and gradual diminution (reduction) in the book value of a fixed asset due to usage, passage of time, or obsolescence.

• To ascertain the true profit or loss of the business.
• To show the true and fair view of the financial position in the Balance Sheet.
• To accumulate funds for the replacement of assets.
• To compute the correct cost of production.

• Wear and Tear: Due to constant use.
• Efflux of Time: Value decreases over time (e.g., patents, leasehold).
• Obsolescence: Due to new technology or market changes.
• Accidents: Sudden fall in value.

• Cost of Asset: Purchase price + Installation + Freight.
• Estimated Useful Life: How long the asset will be used effectively.
• Estimated Scrap Value: The residual value expected at the end of its life.

Written Down Value (WDV) Method is suitable.

Reason: In WDV, depreciation is higher in early years and lower in later years. Repairs are usually low in early years and high later. This balances the total charge (Depreciation + Repairs) to the P&L account over the asset’s life.

• Profit & Loss A/c: Depreciation is shown on the Debit side as an expense, reducing the Net Profit.
• Balance Sheet: It is deducted from the respective Asset on the Assets side, showing the asset at its net book value.

• Revenue Reserve: General Reserve, Workmen Compensation Fund, Investment Fluctuation Fund.
• Capital Reserve: Premium on Issue of Shares, Profit on Sale of Fixed Assets, Profit on Redemption of Debentures.

• General Reserve: Not created for a specific purpose. It is a “free reserve” usable for any future contingency or expansion.
• Specific Reserve: Created for a definite/specific purpose (e.g., Debenture Redemption Reserve). It can only be utilized for that specific purpose.

A Secret Reserve is a reserve the existence or amount of which is not disclosed in the Balance Sheet. It is created by showing assets at a lower value than actual or liabilities at a higher value.

Common methods: Charging excessive depreciation, under-valuing closing stock, or treating capital expenditure as revenue expenditure.

Depreciation is the permanent, continuous, and gradual shrinkage in the book value of a fixed asset. It represents the cost of the asset that has been “consumed” during a specific accounting period.

• Matching Principle: To match the cost of the asset against the revenue it helped generate during the year.
• True Financial Position: Assets should be shown at their correct value (Cost less Depreciation) in the Balance Sheet.
• Replacement Fund: Depreciation is a non-cash expense; charging it retains profits within the business, creating a fund to replace the asset when it expires.
• Legal Compliance: Companies Act mandates charging depreciation before declaring dividends.

• Physical Wear and Tear: Due to usage, friction, and erosion.
• Passage of Time: Some assets (like patents, leases) lose value simply because time passes, regardless of use.
• Obsolescence: Innovation creates new machinery that makes old machinery inefficient or outdated.
• Accidents: Fire, earthquake, or other calamities can permanently reduce asset value.

Straight Line Method (SLM): A fixed percentage of the original cost is written off every year. The amount of depreciation remains constant.

Written Down Value (WDV): A fixed percentage is charged on the reducing balance (book value) every year. The amount of depreciation decreases annually.

• SLM is useful for: Assets with low repair costs and fixed legal life (e.g., Leases, Patents).
• WDV is useful for: Assets requiring heavy repairs and liable to obsolescence (e.g., Machinery, Vehicles).

In this method, depreciation is directly deducted from the asset value. The asset appears in the Balance Sheet at Net Book Value.

Depreciation is credited to a separate “Provision for Depreciation A/c”. The Asset remains at Original Cost in the ledger. In the Balance Sheet, the Provision is deducted from the Cost.

• Total Cost of Asset: This includes the invoice price, freight, transit insurance, and installation charges. It is the base value.
• Estimated Useful Life: The commercial lifespan of the asset in terms of years or production units. A shorter life means higher depreciation per year.
• Estimated Scrap Value: The net realizable value expected at the end of the asset’s life.
  Formula (SLM): $Depreciation = \frac{\text{Cost} – \text{Scrap Value}}{\text{Useful Life}}$

• Revenue Reserve: Created out of day-to-day operating profits. Available for dividend distribution. (e.g., General Reserve).
• Capital Reserve: Created out of capital profits (e.g., profit on sale of assets). Generally not available for dividends, used to write off capital losses.

• General Reserve: Retained earnings kept for future contingencies. It strengthens the financial position and is not tied to a specific purpose.
• Specific Reserve: Created for a specific purpose (e.g., Workmen Compensation Fund, Debenture Redemption Reserve). It cannot be used for other purposes.

A reserve not disclosed in the Balance Sheet. It is created by deliberately understating assets or overstating liabilities to hide the actual high profits.

Provision: An amount set aside out of profits to meet a known liability, the amount of which cannot be determined with substantial accuracy.

Creation: They are created by debiting the Profit & Loss Account. They are a “charge against profit,” meaning they must be created even in case of a loss.