CBSE Class 11 Accountancy: Depreciation, Provisions and Reserves NCERT Solutions

Depreciation refers to the systematic reduction in the book value of a depreciable fixed asset over its useful life. This decrease in value occurs due to several reasons:

1. Wear and tear: Normal usage of an asset leads to physical deterioration and reduced efficiency.
2. Passage of time: Even if an asset is not used, its value diminishes with the mere passage of time due to factors like expiry of lease or the asset becoming outdated.
3. Obsolescence: Technological advancements, new inventions, or changes in market demand can make an existing asset outdated and less valuable.
4. Accident: Unexpected events like fire, floods, or other mishaps can permanently damage an asset, reducing its value.

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

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

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

Providing depreciation is essential in accounting for several key reasons:

1. To ascertain the correct profit or loss: Charging depreciation as an expense in the Profit and Loss Account ensures that all costs incurred in earning revenue are accounted for, leading to an accurate calculation of profit or loss.
2. To show a true and fair view of financial statements: Without charging depreciation, assets would be overstated on the Balance Sheet. Recording depreciation ensures that the financial statements accurately reflect the company's financial position and performance.
3. For ascertaining the accurate cost of production: Depreciation on assets used in production is a part of the cost of production. Charging it prevents the underestimation of production costs, which could otherwise lead to incorrect pricing strategies 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 the Income Tax Act, mandate the charging of depreciation for compliance and tax purposes.

The value of a fixed asset can decrease due to several factors, commonly referred to as the causes of depreciation:

• Use of asset: Continuous usage of an asset leads to normal wear and tear. This physical deterioration reduces its efficiency and value over time.
• Passage of time: Even if an asset is not actively used, its value can decrease simply due to the aging process. For instance, certain assets might become obsolete or less effective as time progresses, irrespective of their usage.
• Obsolescence: The introduction of new technologies, improved designs, or innovative methods can render existing assets outdated. This technological obsolescence significantly reduces the market value and utility of older assets.
• Accident: Assets can suffer damage from unforeseen events such as fires, floods, earthquakes, or other natural calamities. Such accidents can lead to a permanent loss in the asset's value or even its complete destruction.

The amount of depreciation charged each year is influenced by three primary factors:

1. Original cost of asset: This is the total cost incurred to acquire the asset and bring it to its working condition. It includes the purchase price, plus any expenses like freight, transportation, installation charges, and initial testing costs necessary to make the asset ready for its intended use. The formula is: $$\backslash text\{Total\; Cost\}\; =\; \backslash text\{Purchase\; Price\}\; +\; \backslash text\{Freight\; Expenses\}\; +\; \backslash text\{Installation\; Charges\}$$
2. Estimated useful life: This refers to the period (in years) or the volume of production (in units) over which the asset is expected to be used by the business. It's important to distinguish this from the asset's physical life. An asset might physically exist but become uneconomical to operate. For accounting purposes, the useful life is the relevant factor. For example, if an asset is expected to be useful for 15 years, that is its accounting useful life.
3. Estimated scrap value: This is the net amount expected to be realized from the sale or disposal of an asset at the end of its useful life. This estimated scrap value (also known as residual value or salvage value) is deducted from the original cost of the asset. The resulting amount (cost minus scrap value) is then written off as depreciation over the asset's useful life. 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: $$\backslash text\{Depreciation\; per\; annum\}\; =\; \backslash frac\{₹\; 1,30,000\; -\; ₹\; 10,000\}\{10\; \backslash text\{\; years\}\}\; =\; \backslash frac\{₹\; 1,20,000\}\{10\}\; =\; ₹\; 12,000$$