Difference Between Depreciation and Provision for Depreciation

Key Difference – Depreciation vs Provision for Depreciation
 

Businesses use a number of tangible assets in order to carry out operations. For production-related companies, certain tangible assets are the main source of income generation. These assets are subjected to reduction in value as they are been used. Depreciation and provision for depreciation relate to the accounting method of incorporating such asset value reductions. The key difference between depreciation and provision for depreciation is, while depreciation is the method of allocating the cost of assets to compensate for their usage, provision for depreciation refers to the charge of depreciation for a specific accounting period.

CONTENTS
1. Overview and Key Difference
2. What is Depreciation
3. What is a Provision for Depreciation
4. Side by Side Comparison – Depreciation vs Provision for Depreciation

What is Depreciation?

Depreciation is an accounting method used in order to allocate the cost of tangible assets over their economic life (the time period that the asset is expected to assist in generating income for the business). The Economic life of assets can be reduced using the following ways.

• Wear and tear, degradation, or damage
• Obsolescence
• Changes in production capacity which reduce the output assets can deliver

Buildings, fixtures and fittings, machinery and office equipment, are common examples of assets depreciated to reflect the reduction in market value. Depreciation is a non-cash expense since there is no cash movement involved. Depreciation is charged in accordance with the Matching concept, which states that expenses relating to revenue generated should be recognised for the same accounting period. Therefore depreciation is charged to expense a portion of an asset that relates to the revenue generated by that asset.

The guidelines that can be used are specified with related accounting treatment in IAS 16/IAS 38- Acceptable methods for depreciation and amortisation.

Depreciation Calculation

There are different methods that can be used by a company to depreciate its assets. This method will change depending on the requirements of the company. Such methods include,

Straight-line Depreciation Method

This is the most convenient and simplest method of depreciation and is calculated as, (Purchase cost –Salvage value/ Economic useful life). Salvage value or the residual value is the amount to which the asset can be sold at the end of the economic useful life.

E.g. XYZ Ltd purchases a machine for $ 50,000 with an estimated salvage value of $10,000. The economic life of the machine is 10 years. This makes the annual depreciation amount as $ 4,000. ($50,000-$10,000/10)

The accounting entry for the above is,

Depreciation A/C                                        Dr $ 4,000

Accumulated depreciation A/C                       Cr $ 4,000

Reducing Balance Method

This method charges a higher depreciation amount at the earlier years of an asset and gradually reduce the charge as the asset wears off. This can be calculated as (Net book value-Salvage value)*Depreciation rate.

Units of Production Depreciation Method

This method charges depreciation at a fixed rate per unit of production. Here, the purchase cost (less salvage value) of the asset will be divided by the estimated total units of production instead of the economic useful life.

What is Provision for Depreciation?

Provision for depreciation is the portion of depreciation for the accounting period. Depreciation is charged at the end of the accounting period, and this results in lowering of the asset value. However, this reduction is not accounted for by crediting the asset account, as the asset will be continued to show in its original value. Instead, these depreciation amounts are credited to an account named ‘Accumulated depreciation account’ which records the collective provisions for depreciation.

At the time of the sale of the asset, the accumulated depreciation is debited, and the asset account is credited. Continuing with the same example,

E.g. At the time the machine is fully depreciated the accounting entry would be,

Accumulated depreciation A/C            Dr $40,000

Machine A/C                                                         Cr $40,000

Assuming is the machine sold for $20,000 (salvage value of $ 10,000 at the time of purchasing the asset is only an estimate; the actual value that the asset can be disposed for at the end of the economic life may be different to the salvage value )the accounting entry will be,

Cash A/C                                                   Dr $ 20,000

Accumulated depreciation A/C            Dr $ 40,000

Gain on disposal                                            Cr $ 10,000

Machine A/C                                                  Cr $ 50,000

What is the difference between Depreciation and Provision for Depreciation?

Reference

“Vienna – Vintage Franz Zajizek Astronomical Clock machinery” By © Jorge Royan (CC BY-SA 3.0) via Commons Wikimedia

“Depreciation” ( CC BY-SA 3.0) via Picserver.Org