CBSE Class 11 Financial Accounting Chapter 7: Depreciation, Provisions, and Reserves NCERT Solutions

Depreciation refers to the decrease in the book value of a depreciable fixed asset. This reduction in value occurs due to several factors, including:

1. Wear and tear: Normal usage of an asset over time causes it to wear out and lose its efficiency.
2. Passage of time: Even if an asset is not used, its value may decrease simply due to the passage of time, especially for assets like patents or leasehold rights.
3. Obsolescence: Technological advancements, new inventions, or changes in market demand can make an existing asset outdated and less valuable.
4. Accident: An asset might suffer damage due to unforeseen accidents, natural calamities, or theft, leading to a permanent fall in its value.

For example, if a machinery costs ₹ 1,00,000 and has an estimated useful life of 10 years with no scrap value, the annual depreciation would be calculated as:

$$Annual\; Depreciation\; =\; \backslash frac\{Cost\; of\; Asset\; -\; Estimated\; Scrap\; Value\}\{Expected\; or\; Estimated\; Life\; of\; Asset\}$$

$$Annual\; Depreciation\; =\; \backslash frac\{₹\; 1,00,000\; -\; ₹\; 0\}\{10\; \backslash text\{\; years\}\}\; =\; ₹\; 10,000\; \backslash text\{\; per\; annum\}$$

Providing for depreciation is essential in accounting for several key reasons:

1. To ascertain the correct profit or loss: Depreciation is an expense incurred for earning revenue. By charging it to the Profit and Loss Account, businesses can determine their true profitability for a period.
2. To show a true and fair view of financial statements: If depreciation is not accounted for, assets will be overstated on the Balance Sheet. Charging depreciation ensures that the financial statements accurately reflect the company's financial position.
3. For ascertaining the accurate cost of production: Depreciation on assets used in production is a part of the cost of goods produced. Omitting it would lead to an underestimation of production costs, potentially resulting in incorrect pricing and lower profits.
4. To provide funds for replacement of assets: Depreciation is a non-cash expense. The amount debited to the Profit and Loss Account is retained within the business. Over time, these accumulated funds can help in replacing the asset when it reaches the end of its useful life.
5. To meet legal requirements: Various statutes, such as the Companies Act and Income Tax Act, mandate the charging of depreciation for compliance and tax purposes.

The primary causes of depreciation, which lead to a fall in the book value of fixed assets, are:

1. Use of asset (Wear and Tear): Continuous use of an asset in operations leads to normal wear and tear, reducing its efficiency and value over time.
2. Passage of Time: Even if an asset is idle, its value can diminish with the mere passage of time. This is particularly relevant for assets like patents or copyrights which have a limited legal life, or for assets that become outdated due to market changes.
3. Obsolescence: The introduction of new technologies, improved designs, or more efficient machinery can render existing assets obsolete, causing a loss in their value even if they are still physically functional.
4. Accident: Assets can lose value or become completely unusable due to unforeseen events such as fire, floods, earthquakes, or accidents during operation. These are often permanent and significant reductions in value.

The amount of depreciation charged for an asset is influenced by three fundamental factors:

1. Original Cost of Asset: This includes the purchase price of the asset plus all expenses incurred to bring the asset to its working condition and location. These additional costs can include freight, transportation, installation charges, and initial testing expenses. The total cost forms the basis for calculating depreciation. The formula is: $$Total\; Cost\; =\; Purchase\; Price\; +\; Freight\; Expenses\; +\; Installation\; Charges$$
2. Estimated Useful Life: This refers to the period (in years or units of production) during which the asset is expected to be productively used by the business. It's not necessarily the physical life of the asset but the period it remains economically viable. For accounting purposes, the shorter of the physical life or economic life is considered. For example, if an asset is physically functional for 20 years but economically useful for only 15 years, its useful life for depreciation is considered 15 years.
3. Estimated Scrap Value (or Residual/Salvage Value): This is the estimated net amount that can be realized by selling the asset at the end of its useful life. This value is deducted from the original cost before calculating the total depreciation to be written off. For instance, if a furniture item costs ₹ 1,30,000, has a useful life of 10 years, and an estimated scrap value of ₹ 10,000, the annual depreciation would be calculated as: $$Depreciation\; per\; annum\; =\; \backslash frac\{₹\; 1,30,000\; -\; ₹\; 10,000\}\{10\; \backslash text\{\; years\}\}\; =\; \backslash frac\{₹\; 1,20,000\}\{10\}\; =\; ₹\; 12,000$$

The Straight-Line Method (SLM) and the Written Down Value (WDV) Method are two primary ways to calculate depreciation. Here's a distinction between them:

Straight-Line Method (SLM):

• Basis of Calculation: Depreciation is calculated on the original cost of the asset.
• Amount of Depreciation: A fixed amount of depreciation is charged each year throughout the useful life of the asset.
• Formula: $$Annual\; Depreciation\; =\; \backslash frac\{Original\; Cost\; -\; Scrap\; Value\}\{Useful\; Life\; (in\; years)\}$$
• Suitability: Suitable for assets whose utility and expected revenue generation remain constant over their life, or where repairs are minimal in the early years.
• Advantage: Simple to calculate and understand; results in a consistent charge to profit and loss.
• Disadvantage: Ignores the fact that repairs and maintenance costs tend to increase with age, and the earning capacity of the asset might decrease.

Written Down Value (WDV) Method (also known as Diminishing Balance Method):

• Basis of Calculation: Depreciation is calculated on the book value (original cost less accumulated depreciation) of the asset at the beginning of each year.
• Amount of Depreciation: The amount of depreciation charged decreases each year as the book value of the asset diminishes.
• Formula: $$Depreciation\; =\; Book\; Value\; at\; the\; beginning\; of\; the\; year\; \backslash times\; Rate\; of\; Depreciation$$
• Suitability: Suitable for assets whose efficiency decreases over time and for which repair costs are likely to increase with age. It aligns better with the principle of matching expenses with revenues.
• Advantage: Provides a more realistic charge to profits as it accounts for increasing repair costs and decreasing efficiency. Also, it results in a lower tax liability in the early years.
• Disadvantage: The calculation can be more complex, and the asset value may never be fully depreciated to its scrap value unless specifically accounted for.