Depreciation, Provisions and Reserves

The full picture

Every business owns fixed assets — machinery, furniture, vehicles, buildings. These are bought once but used for many years. Here is the problem: if a bakery in Thrissur pays ₹4,00,000 for an oven and treats the full amount as an expense in Year 1, the profit that year looks terrible. In Year 2, when the oven still bakes bread every day, the accounts show zero cost at all. Neither year is telling the truth. Accountants solve this with the Matching Concept — costs must be matched to the revenue they help earn.

Depreciation is the systematic allocation of an asset's cost over its useful life. 'Systematic' means planned, not guesswork. 'Allocation' means spreading — not paying again. The bakery oven cost ₹4,00,000, has a 10-year life, and a scrap value of ₹20,000 at the end. The depreciable amount is ₹4,00,000 − ₹20,000 = ₹3,80,000. Spread over 10 years under the Straight Line Method (SLM), that is ₹38,000 per year — the same every year. The oven appears on the Balance Sheet at its original cost minus all depreciation charged so far. That reduced figure is called the Net Book Value (NBV) — how much of the asset's value remains on the books.

The second method is the Written Down Value Method (WDV). Instead of a fixed rupee amount each year, you apply a fixed percentage to whatever book value remains at the start of that year. Say the WDV rate is 20%. Year 1 depreciation on a ₹1,00,000 machine is ₹20,000. Year 2, the book value is ₹80,000, so depreciation is ₹16,000. Year 3, it is ₹12,800 — and so on, shrinking every year. WDV front-loads the expense. This suits assets like computers or smartphones that lose value fast early on. In India, the Income Tax Act uses WDV for calculating tax deductions on most assets.

Recording depreciation is straightforward. You debit Depreciation Account (an expense, so it reduces profit) and credit the asset account or a separate Accumulated Depreciation Account. The balance in Accumulated Depreciation grows each year and is shown on the Balance Sheet as a deduction from the gross asset cost. This is how you always know both the original cost and total depreciation — useful information for insurance or replacement planning.

Now for provisions. Imagine your school's cooperative store gives credit to students, with repayment due at year-end. Experience shows about 5% of debtors do not pay. The store cannot wait until those debtors actually default to reduce profit — the loss is probable right now. So the accountant creates a Provision for Bad and Doubtful Debts. This is debited to Profit and Loss Account (reducing profit) and credited to the Provision account (a liability). A provision is created for a known or likely future expense or loss, even when the exact amount is uncertain.

Reserves are different. A reserve is created after profit is calculated, as a decision about what to do with that profit. The owner might decide: 'Instead of withdrawing all the profit, let us keep ₹50,000 aside for future expansion.' That ₹50,000 moves from profit to a General Reserve — but it was already part of the year's profit. Creating a reserve does not change the profit figure. Reserves belong to the owners and appear under Capital/Owner's Equity in the Balance Sheet. The key exam test: provisions are created before profit is finalised and reduce it; reserves are created from profit after it is calculated and do not reduce it.

An Indian example

Anvar runs a small auto-repair garage in Kozhikode. In April 2024 he buys a hydraulic car lift for ₹3,60,000. The lift has a 9-year useful life and no scrap value, so under SLM he depreciates it at ₹40,000 per year. At the end of March 2025, his Depreciation Account shows ₹40,000 — debited to the Profit and Loss Account, reducing his taxable profit by that amount. The lift appears on the Balance Sheet at ₹3,60,000 minus ₹40,000, that is ₹3,20,000 NBV. Anvar also notices that about ₹8,000 of his customers' credit balances are doubtful, so he creates a Provision for Bad Debts of ₹8,000 — again reducing profit. Separately, because business was good this year, he transfers ₹25,000 to a General Reserve to fund a planned second lift next year. That transfer does not reduce profit; it simply sets aside part of what was already earned. Three entries, three different purposes — but all three keep Anvar's accounts honest.

Common misconceptions to watch for

• Wrong belief: 'Depreciation is a cash payment made every year.' Correction: Depreciation is a non-cash accounting entry. The only cash outflow happened when the asset was purchased. Depreciation simply apportions that one-time cost across many accounting periods — no cheque is written, no bank balance falls when you record it.
• Wrong belief: 'SLM and WDV always give the same total depreciation over the asset's life.' Correction: The total depreciation over the full useful life is the same (cost minus scrap value) under both methods. What differs is timing — SLM spreads equal amounts each year, while WDV charges more in early years and less in later years. This affects profit differently year by year, even though the lifetime total is identical.
• Wrong belief: 'Provisions and reserves are both just savings — you can use the terms interchangeably in answers.' Correction: They are fundamentally different. A provision is for a specific probable liability (like bad debts) and reduces profit in the year it is created. A reserve is an appropriation of profit that has already been earned — it does not reduce profit. Mixing them up in exam answers loses marks because the Balance Sheet treatment and profit impact are completely different.