The use of a provision for depreciation account is an improvement over the accounting treatment of depreciation discussed on “accounting treatment of depreciation” page. This account is used to accumulate depreciation that is provided against a fixed asset. If a provision for depreciation account is used, the accounting entries are made as follows:
- One provision for depreciation account is opened for every fixed asset account. Thus if there is a motor vehicle account, there will be opened a “provision for depreciation on motor vehicle account”. Similarly, in respect of plant and machinery, there will be a “plant and machinery account” and also one “provision for depreciation on plant and machinery account”.
- At the end of each financial year, we debit the depreciation expense account and credit the provision for depreciation (on relevant fixed asset account) with the amount of depreciation calculated for the year.
Dr. the depreciation expense account
Cr. the provision for depreciation on the relevant fixed asset
- The balance in depreciation expense account is transferred to the profit and loss account at the end of the year.
- The balance of the provision for depreciation account is carried forward to the next year. Note that the provision on depreciation account is not a nominal account, it is a part of the asset account. Also note that it will always show a credit balance and that its balance will increase each year. At any given time, the balance on provision for depreciation account represents the total accumulated depreciation that has been provided against the particular asset.
- No entry is made in the fixed asset account in so far as the depreciation is concerned. This account will continue to show a debit equal to the cost of the fixed asset concerned. The only entries that will be made in the fixed asset account will be in respect of fresh purchases or sale of the asset concerned.
- IF it is desired to find out the book value of the fixed asset, it is ascertained as follows:
Book value = Cost (per fixed asset account) – Accumulated depreciation (per provision for depreciation account)
- It is important that while one depreciation account is sufficient to accommodate the depreciation expense on all fixed assets for the year, a separate provision for depreciation account must be maintained for each fixed asset account.
- If a fixed asset is being written down using the revaluation approach of calculating depreciation, it is usually not necessary or of any significant advantage to maintain separate provision for depreciation account for it. For such assets, the treatment shown on the revaluation method is sufficient i.e., depreciation may be directly credited to the fixed asset account.
PQR company bought a machine for $20,000 on January 1, 2005. The company uses fixed installment method of depreciation and estimates that the machine will have a useful life of 6 years and leave a scrap value of $ $2,000. Show the relevant ledger accounts for the year 2016, 2017 and 2018.
Step 1: Computation of depreciation per year
Depreciation per year = (Cost – Scrap value)/Useful life of the asset
= ($20,000 – $2,000)/6
The depreciation charge for each of the six years of the machine’s useful life will be $3,000.
Step 2: Preparation of ledger accounts
Advantages of maintaining a separate provision for depreciation account
Keeping a separate provision for depreciation account for each fixed asset offers the following advantages:
- As no entry is made in the fixed asset account, it continues to show the historical cost of the asset. Historical cost of a fixed asset is needed for a number of reasons, e.g. computation of depreciation using fixed installment method (also known as straight line method), payment of rates and taxes, etc. If depreciation were credited direct to the fixed asset account, it may be difficult to ascertain the historical cost of that asset after a few years.
- A separate provision for depreciation account also ensures that total accumulated depreciation on each fixed asset is always known. This helps ascertain the book value of the fixed asset. In addition, it also provides an idea about the age of the fixed assets held. Hence if the total cost of the fixed assets is, say $4,000 and total provision for depreciation stand at, say, $3,200, it can be seen that the fixed assets are nearing their useful life. Knowing just the book value of $800 ($4,000 – $3,200) cannot provide this assessment.
- When fixed assets are revalued (for whatever reason), it is always helpful to know both the original cost and accumulated depreciation of each fixed asset. Maintaining separate provision for depreciation accounts make this possible.