What is Provision for Depreciation Account?

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Grade Level:

Class 12

AI/ML, Physics, Biotechnology, FinTech, EVs, Space Technology, Climate Science, Blockchain, Medicine, Engineering, Law, Economics

Definition

What is it?

The Provision for Depreciation Account is a separate account maintained to accumulate the total depreciation charged on an asset over its useful life. Instead of reducing the asset's value directly, depreciation is transferred to this account, keeping the asset in the books at its original cost. This account helps show the total wear and tear an asset has experienced without changing its initial purchase price on the balance sheet.

Simple Example

Quick Example

Imagine your family buys a brand-new scooter for Rs. 80,000. Every year, its value decreases a little because of use. Instead of showing the scooter's value as Rs. 70,000 in the second year, and Rs. 60,000 in the third, you keep its value at Rs. 80,000. The amount it loses each year (like Rs. 10,000) is put into a 'Scooter Wear and Tear Fund' (which is like the Provision for Depreciation Account). This fund tells you how much the scooter has depreciated in total.

Worked Example

Step-by-Step

Let's say a company buys a machine for Rs. 1,00,000. Its useful life is 5 years, and its scrap value is Rs. 0. The company uses the Straight-Line Method to calculate depreciation and maintains a Provision for Depreciation Account.

Step 1: Calculate annual depreciation. Depreciation = (Cost - Scrap Value) / Useful Life = (Rs. 1,00,000 - Rs. 0) / 5 years = Rs. 20,000 per year.
---Step 2: At the end of Year 1, the depreciation of Rs. 20,000 is charged. The journal entry would be: Depreciation Account Dr. Rs. 20,000 | To Provision for Depreciation Account Cr. Rs. 20,000.
---Step 3: At the end of Year 2, another Rs. 20,000 depreciation is charged. The journal entry would be: Depreciation Account Dr. Rs. 20,000 | To Provision for Depreciation Account Cr. Rs. 20,000.
---Step 4: The balance in the Provision for Depreciation Account at the end of Year 2 would be Rs. 20,000 (Year 1) + Rs. 20,000 (Year 2) = Rs. 40,000.
---Step 5: On the Balance Sheet, the Machine will still be shown at its original cost of Rs. 1,00,000. Below it, the Provision for Depreciation Account will show a credit balance of Rs. 40,000, which is then deducted to get the Net Book Value (Rs. 60,000).

Answer: After 2 years, the Provision for Depreciation Account will have a balance of Rs. 40,000.

Why It Matters

Understanding this account is crucial for anyone managing money, whether in FinTech startups designing new payment systems or engineers calculating the lifespan of EV batteries. Financial analysts use this to assess a company's true asset value and profitability. Even space technology companies need this to track the value of their expensive equipment over time.

Common Mistakes

MISTAKE: Students confuse Provision for Depreciation with Depreciation Account itself. | CORRECTION: Depreciation Account is an expense account for the current year's wear and tear, while Provision for Depreciation Account is a liability account that accumulates total depreciation over multiple years.

MISTAKE: Students directly deduct depreciation from the asset account even when a Provision for Depreciation Account is maintained. | CORRECTION: If a Provision for Depreciation Account is maintained, the asset account always shows the original cost. Depreciation is credited to the Provision for Depreciation Account.

MISTAKE: Students think the Provision for Depreciation Account represents actual cash set aside. | CORRECTION: It's an accounting entry, not a physical fund of money. It simply shows the accumulated reduction in an asset's value due to usage and time.

Practice Questions

Try It Yourself

QUESTION: A company buys furniture for Rs. 50,000. It charges 10% depreciation using the Straight-Line Method and maintains a Provision for Depreciation Account. What will be the balance in the Provision for Depreciation Account after 1 year? | ANSWER: Rs. 5,000

QUESTION: A truck was purchased for Rs. 4,00,000 on April 1, 2021. Depreciation is charged at 15% per annum on the original cost. If the company closes its books on March 31 every year and maintains a Provision for Depreciation Account, what will be the balance in this account on March 31, 2023? | ANSWER: Rs. 1,20,000 (Rs. 60,000 for 2021-22 + Rs. 60,000 for 2022-23)

QUESTION: A machine costing Rs. 2,50,000 was bought on Jan 1, 2020. Depreciation is provided at 20% per annum on the diminishing balance method. If a Provision for Depreciation Account is maintained and the financial year ends on Dec 31, calculate the balance in the Provision for Depreciation Account on Dec 31, 2021. | ANSWER: Rs. 90,000 (Year 1: 20% of 2,50,000 = 50,000. Year 2: 20% of (2,50,000 - 50,000) = 40,000. Total = 50,000 + 40,000 = 90,000)

MCQ

Quick Quiz

If a Provision for Depreciation Account is maintained, how is the asset shown in the Balance Sheet?

At its written down value (cost minus total depreciation)

At its original cost

At its market value

At its scrap value

The Correct Answer Is:

When a Provision for Depreciation Account is maintained, the asset itself is always shown at its original cost in the Balance Sheet. The accumulated depreciation is shown separately in the Provision for Depreciation Account and then deducted to arrive at the net book value.

Real World Connection

In the Real World

Think about large Indian manufacturing companies that make cars or mobile phones. They use giant machines that cost crores of rupees. To accurately show their financial health, they use a Provision for Depreciation Account. This helps investors and banks understand the original value of their factories and how much wear and tear has occurred over time, without altering the initial investment figures on paper.

Key Vocabulary

Key Terms

Depreciation: The gradual decrease in the value of an asset due to wear and tear, passage of time, or obsolescence. | Asset: Something of value owned by a business, like machinery, buildings, or vehicles. | Original Cost: The initial price paid to acquire an asset, including installation expenses. | Book Value: The value of an asset as recorded in the company's accounting records.

What's Next

What to Learn Next

Next, you should learn about 'Asset Disposal Account' when a Provision for Depreciation Account is maintained. This will teach you how to record the sale or scrapping of an asset, taking into account the accumulated depreciation, which is a crucial step in understanding the complete lifecycle of an asset in accounting.