Depreciation, Provisions and Reserves

Creation of secret reserves within reasonable limits is justifiable on grounds of expediency, prudence and preventing competition from other firms. Test Your Understanding - V I State with reasons whether the following statements are True or False ; (i) Making excessive provision for doubtful debits builds up the secret reserve in the business. (ii) Capital reserves are normally created out of free or distributable profits. (iii) Dividend equalisation reserve is an example of general reserve.

(iv) General reserve can be used only for some specific purposes. (v) ‘Provision’ is a charge against profit. (vi) Reserves are created to meet future expenses or losses the amount of which is not certain. (vii) Creation of reserve reduces taxable profits of the business.

II Fill in the correct words : (i) Depreciation is decline in the value of ........... (ii) Installation, freight and transport expenses are a part of ........... (iii) Provision is a ........... against profit.

(iv) Reserve created for maintaining a stable rate of dividend is termed as........... Key Terms Introduced in the Chapter Depreciation, Depreciable cost, original cost, useful life; Depletion, Obsolescence, Amortisation; Salvage value/Residual value/Scrap value; Written down value/Reducing balance value/Diminishing value; Straight Line/Fixed Installment Method; Asset Disposal Account; Accumulated Depreciation/Provision for Depreciation Account, Reserve, Provision, Capital Reserve, Revenue Reserve, General Reserve, Specific Reserve, Secret Reserve, Provision for Doubtful Debts. Summary With Reference to Learning Objectives . Meaning of depreciation : Depreciation is decline in the value of a tangible fixed asset.

In accounting, depreciation is the process of allocating depreciable cost over useful life of a fixed asset. . Depreciation and similar terms : Depreciation term is used in the context of tangible fixed assts. Depletion (in the context of extractive industries), and amortisation (in the context of intangible assets) are other related terms.

Factors Affecting Depreciation : Wear and Tear due to use and/or passage of time Expiration of Legal Rights Obsolescence . Importance of depreciation : Depreciation must be charged to ascertain true and fair profit or loss. Depreciation is a non-cash operating expense. .

Methods of charging depreciation : Depreciation amount can be calculated using : Straight line method, or Written down value method . Factors affecting the amount of depreciation : Depreciation amount is determined by — Original cost Salvage value, and Useful life of the asset . Provisions and Reserves : A provision is a charge against profit. It is created for a known current liability the amount of which is uncertain.

Reserve on the other hand, is an appropriation of profit. It is created to strengthen the financial position of the business. . Types of Reserves : Reserves may be — General reserve and specific reserve; Revenue reserve and capital reserve.

. Secret Reserve : When total depreciation charged is higher than the total depreciable cost, Secret reserve’ is created. Secret reserve is not explicitly shown in the balance sheet. Questions for Practice Short Answers .

What is ‘Depreciation’? . State briefly the need for providing depreciation. .

What are the causes of depreciation? . Explain basic factors affecting the amount of depreciation. .

Distinguish between straight line method and written down value method of calculating depreciation. . “In case of a long term asset, repair and maintenance expenses are expected to rise in later years than in earlier year”. Which method is suitable for charging depreciation if the management does not want to increase burden on profits and loss account on account of depreciation and repair.

. What are the effects of depreciation on profit and loss account and balance sheet? . Distinguish between ‘provision’ and ‘reserve’ .

. Give four examples each of ‘provision’ and ‘reserves’. . Distinguish between ‘revenue reserve’ and ‘capital reserve’.

. Give four examples each of ‘revenue reserve’ and ‘capital reserves’. . Distinguish between ‘general reserve’ and ‘specific reserve’.

. Explain the concept of ‘secret reserve’. Long Answers . Explain the concept of depreciation.

What is the need for charging depreciation and what are the causes of depreciation? . Discuss in detail the straight line method and written down value method of depreciation. Distinguish between the two and also give situations where they are useful.

. Describe in detail two methods of recording depreciation. Also give the necessary journal entries. .

Explain determinants of the amount of depreciation. . Name and explain different types of reserves in details. .

What are ‘provisions’. How are they created? Give accounting treatment in case of provision for doubtful Debts. Numerical Problems .

On April , , Bajrang Marbles purchased a Machine for Rs. , , and spent Rs. , on its carriage and Rs. , on its installation.

It is estimated that its working life is years and after years its scrap value will be Rs. , . (a) Prepare Machine account and Depreciation account for the first four years by providing depreciation on straight line method. Accounts are closed on March 31st every year.

(b) Prepare Machine account, Depreciation account and Provision for depreciation account (or accumulated depreciation account) for the first four years by providing depreciation using straight line method accounts are closed on March every year. (Ans: [a] Balance of Machine account on April , Rs. , , . [b] Balance of Provision for depreciation account as on .

. Rs. , .) . On July , , Ashok Ltd.

Purchased a Machine for Rs. , , and spent Rs. , on its installation. At the time of purchase it was estimated that the effective commercial life of the machine will be years and after years its salvage value will be Rs.

, . Prepare machine account and depreciation Account in the books of Ashok Ltd. For first three years, if depreciation is written off according to straight line method. The account are closed on December 31st, every year.

(Ans: Balance of Machine account as on . . Rs. , ).

. Reliance Ltd. Purchased a second hand machine for Rs. , on October , and spent Rs.

, on its overhaul and installation before putting it to operation. It is expected that the machine can be sold for Rs. , at the end of its useful life of years. Moreover an estimated cost of Rs.

, is expected to be incurred to recover the salvage value of Rs. , . Prepare machine account and Provision for depreciation account for the first three years charging depreciation by fixed installment Method. Accounts are closed on December , every year.

(Ans: Balance of provision for depreciation account as on . . Rs. , ).

. Berlia Ltd. Purchased a second hand machine for Rs. , on July , and spent Rs.

, on its repair and installation and Rs. , for its carriage. On September , , it purchased another machine for Rs. , , and spent Rs.

, on its installation. (a) Depreciation is provided on machinery @ % p.a on original cost method annually on December . Prepare machinery account and depreciation account from the year to . (b) Prepare machinery account and depreciation account from the year to , if depreciation is provided on machinery @ % p.a.

on written down value method annually on December . (Ans: [a] Balance of Machine account as on . . Rs.

, , . [b] Balance of Machine account as on . . Rs.

, , ). . Ganga Ltd. purchased a machinery on January , for Rs.

, , and spent Rs. , on its installation. On September , it purchased another machine for Rs. , , .

On May , it purchased another machine for Rs. , , (including installation expenses). Depreciation was provided on machinery @ % p.a. on original cost method annually on December .

Prepare: (a) Machinery account and depreciation account for the years , , and . (b) If depreciation is accumulated in provision for Depreciation account then prepare machine account and provision for depreciation account for the years , , and . (Ans: [a] Balance of machine account as on . .

Rs. , , . [b] Balance of provision for dep. account as on .

Azad Ltd. purchased furniture on October , for Rs. , , . On March , it purchased another furniture for Rs.

, , . On July , it sold off the first furniture purchased in for Rs. , , . Depreciation is provided at % p.a.

on written down value method each year. Accounts are closed each year on March . Prepare furniture account, and accumulated depreciation account for the years ended on March , , March , and March , . Also give the above two accounts if furniture disposal account is opened.

(Ans. Loss on sale of furniture Rs. , , , Balance of provision for depreciation account as on . .

Rs. , .) . M/s Lokesh Fabrics purchased a Textile Machine on April , for Rs. , , .

On July , another machine costing Rs. , , was purchased . The machine purchased on April , was sold for Rs. , on October , .

The company charges depreciation @ % p.a. on straight line method. Prepare machinery account and machinery disposal account for the year ended March , . (Ans.

Loss on sale of Machine account Rs. , . Balance of machine account as on . .

Rs. , , ). . The following balances appear in the books of Crystal Ltd, on Jan , Machinery account on , , Provision for depreciation account , , On April , a machinery which was purchased on January , for Rs.

, , was sold for Rs. , . A new machine was purchased on July , for Rs. , , .

Depreciation is provided on machinery at % p.a. on Straight line method and books are closed on December every year. Prepare the machinery account and provision for depreciation account for the year ending December , . (Ans.

Profit on sale of Machine Rs. , . Balance of machine account as on . .

Rs. , , . Balance of Provision for depreciation account as on . .

Excel Computers has a debit balance of Rs. , (original cost Rs. , , ) in computers account on April , . On July , it purchased another computer costing Rs.

, , . One more computer was purchased on January , for Rs. , . On April , the computer which has purchased on July , became obselete and was sold for Rs.

, . A new version of the IBM computer was purchased on August , for Rs. , . Show Computers account in the books of Excel Computers for the years ended on March , , , , and .

The computer is depreciated @ p.a. on straight line method basis. (Ans: Loss on sale of computer Rs. , , .

Balance of computers account as on . . Rs. , ).

. Carriage Transport Company purchased trucks at the cost of Rs. , , each on April , . The company writes off depreciation @ % p.a.