A machine bought for 1,80,000 and used for five years is not a cost of the year it was bought. It is a cost of all five years, paid up front. Charging the whole 1,80,000 to the first year would make that year look disastrous and the next four look better than they were — exactly what the matching concept of Unit 1 forbids.
Depreciation is the systematic spreading of that cost over the years that get the use. It is a real expense, debited to the profit and loss account, even though no cash moves when it is charged.
Four things cause it: wear and tear from use, the passage of time for leases and patents, obsolescence when something better arrives, and depletion for mines and quarries that are physically used up.
Either charge the asset directly:
Depreciation A/c Dr. — To Machinery A/c
or accumulate it separately, which keeps the original cost visible in the books:
Depreciation A/c Dr. — To Provision for Depreciation A/c
Either way Depreciation A/c is closed to the profit and loss account at year end. The second method is preferred in practice, because a balance sheet showing cost less accumulated depreciation tells a reader how old the assets are; a single net figure does not.
Cost 1,80,000, expected scrap value 20,000, useful life 5 years.
\[ \text{Annual depreciation} = \frac{\text{Cost} - \text{Scrap value}}{\text{Useful life}} = \frac{180000 - 20000}{5} = 32000 \]| Year | Opening book value (₹) | Depreciation (₹) | Accumulated (₹) | Closing book value (₹) |
|---|---|---|---|---|
| 1 | 1,80,000 | 32,000 | 32,000 | 1,48,000 |
| 2 | 1,48,000 | 32,000 | 64,000 | 1,16,000 |
| 3 | 1,16,000 | 32,000 | 96,000 | 84,000 |
| 4 | 84,000 | 32,000 | 1,28,000 | 52,000 |
| 5 | 52,000 | 32,000 | 1,60,000 | 20,000 |
The charge is 32,000 every year, and after five years the book value is exactly 20,000 — the scrap value, as intended. Accumulated depreciation of 1,60,000 equals \( 180000 - 20000 \), which is the check worth doing on any schedule: accumulated depreciation plus closing book value must equal cost.
Same asset, but charged at 20% of the written down value each year rather than of cost. The charge falls every year because the base falls.
\[ \text{Depreciation}_t = \text{Book value}_{t-1} \times \frac{20}{100} \]| Year | Opening book value (₹) | Depreciation (₹) | Accumulated (₹) | Closing book value (₹) |
|---|---|---|---|---|
| 1 | 1,80,000 | 36,000 | 36,000 | 1,44,000 |
| 2 | 1,44,000 | 28,800 | 64,800 | 1,15,200 |
| 3 | 1,15,200 | 23,040 | 87,840 | 92,160 |
| 4 | 92,160 | 18,432 | 1,06,272 | 73,728 |
Working the first two years: \( 180000 \times 0.20 = 36,000 \), leaving \( 180000 - 36000 = 1,44,000 \). Then \( 144000 \times 0.20 = 28,800 \), leaving 1,15,200. The charge falls from 36,000 to 18,432 and keeps falling.
The book value never reaches zero. Twenty per cent of something is always something, so the asset is written down towards zero without arriving — which is why this method is not used where a definite scrap value at a definite date matters.
| Straight line | Written down value | |
|---|---|---|
| Charge per year | Equal | High early, falling later |
| Base | Original cost | Falling book value |
| Reaches zero? | Yes, at the scrap value | Never quite |
| Suits | Assets used evenly — furniture, buildings, leases | Assets that lose value fast at first and need more repairs later — vehicles, machinery |
The argument for written down value is about the total charge, not depreciation alone. Repairs are small when an asset is new and large when it is old. Under written down value depreciation is large when repairs are small and small when repairs are large, so depreciation plus repairs stays roughly level across the asset’s life. Straight line gives a level depreciation charge but a rising total.
The distinction is examined constantly and is easy once stated properly.
| Provision | Reserve | |
|---|---|---|
| What it is for | A known liability or loss whose amount is uncertain | Strengthening the business out of profit already earned |
| Made | Whether or not there is a profit | Only if there is a profit |
| Where | Debited to the profit and loss account | Appropriated from the profit and loss appropriation account |
| Examples | Provision for doubtful debts, provision for depreciation | General reserve, reserve fund |
So a provision reduces profit and a reserve divides it up after it has been measured. A firm making a loss must still provide for doubtful debts; it cannot create a general reserve.
A secret reserve is one not disclosed — created by over-providing for depreciation or undervaluing stock. It makes the firm stronger than it looks and is therefore a breach of full disclosure. The exemption usually quoted for banking and insurance companies comes from the Companies Act of 1956; textbooks still repeat it, so check the law in force before relying on it.
Small firms often keep only a cash book and personal accounts — no nominal accounts at all, so no trading or profit and loss account can be drawn up. This is single entry, and it is incomplete rather than a different system.
Profit is still recoverable, because capital moves for only four reasons. List assets and liabilities at both ends and take the difference.
| Opening (₹) | Closing (₹) | |
|---|---|---|
| Cash | 12,000 | 15,500 |
| Stock | 34,000 | 41,000 |
| Debtors | 28,000 | 31,000 |
| Furniture | 40,000 | 40,000 |
| less Creditors | (23,000) | (19,500) |
| Capital | 91,000 | 1,08,000 |
Drawings during the year were 18,000 and fresh capital of 10,000 was brought in.
\[ \text{Profit} = \text{Closing capital} + \text{Drawings} - \text{Fresh capital} - \text{Opening capital} \] \[ = 108000 + 18000 - 10000 - 91000 = 25000 \]Why drawings are added back: money taken out reduced the closing capital but was not a business loss, so it must be restored before the comparison means anything. Why fresh capital is subtracted: it raised the closing capital without the business having earned it.
The answer, 25,000, is a profit figure and nothing more. Single entry cannot tell you the gross profit, the expense breakdown, or whether the profit came from trading at all — which is precisely the argument for keeping proper books.
A club exists to serve members, not to earn. Its statements are named differently for that reason, and the names carry the logic:
| Trading concern | Non-trading concern | Difference |
|---|---|---|
| Cash book | Receipts and payments account | A summary of the cash book. All cash, both capital and revenue, any period. |
| Profit and loss account | Income and expenditure account | Revenue items of this year only, on an accrual basis. Its balance is a surplus or deficit, not a profit. |
| Capital | Capital fund | Accumulated surpluses plus donations and legacies. |
The examinable step is converting the first into the second: start from receipts and payments, remove capital items (a new building, purchase of furniture), remove amounts belonging to other years (last year’s subscriptions received this year), and add amounts belonging to this year but not yet received or paid. Subscriptions are the classic trap, because a year’s receipts routinely contain arrears for last year and advances for next.