Chapter 7 Depreciation, Provisions and Reserves

Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.

Depreciation needs to be provided because an asset is bound to undergo wear and tear over a period of time. This reduces the working capacity and effectiveness of the asset. Hence, this should reflect the value of the asset, at which it is carried in the books of accounts.

1) For ascertaining the true profit or loss
2) For showing the true and fair view of the financial position
3) To ascertain the accurate cost of production
4) To provide funds for replacement of assets
5) To prevent the distribution of profits out of capital
6) For avoiding over payment of Income tax.

Causes of Depreciation:

1) By Constant Use
2) By Expiry of Time
3) By Expiry of Legal Rights
4) By Obsolescence
5) By Accident
6) By Depletion
7) By Permanent fall in Market Price

The factors affecting the amount of depreciation:

1) Total Cost of asset
2) Estimated useful life of asset
3) Estimated Scrap Value

Straight line method

1) Depreciation is calculated on the original cost of an asset.
2) Equal amount of depreciation is charged each year over the useful life of the asset.
3) Book value of the asset becomes zero at the end of its effective life.
4) It is suitable for assets such as patents, copyright, land and buildings which have lesser possibility of obsolescence and lesser repair charges.
5) As depreciation remains the same over the years but repair cost increases in the later years, there will be an unequal effect over the life of the asset.
6) It is not recognized under the income tax act.

Value method

1) Depreciation is calculated on the reducing balance, i.e., the book value of an asset.
2) Diminishing amount of depreciation is charged each year over the useful life of the asset.
3) Book value of the asset can never be zero.
4) It is suitable for assets which needs more repair in the later years such as plant and machinery, car.
5) As depreciation cost is high and repairs are less in the initial years but in the later years the repair costs increase and depreciation cost decreases, there will be equal effect over the life of the asset.
6) It is recognized under the income tax act.

Written Down Value Method is suitable because under this method depreciation charge declines in later years. Hence, total of depreciation and repair charges remain similar or equal year after year.

Depreciation is charged as expenditure in Profit and Loss account and the depreciation figure is deducted from the value of concerned assets in the assets side of the balance sheet.

In that case, it reduces the profit of the concern;

On the other hand, it reduces the assets side in the balance sheet.
Here, it is worth mentioning that Depreciation is a non - cash expenditure.

Four examples of ‘Provision’ are as follows:-

1) Provision for Depreciation of Assets
2) Provision for Taxation
3) Provision for Bad and Doubtful Debts
4) Provision for Discount on Debtors

Four examples of ‘Reserves’ are as follows:-

1) General Reserve
2) Capital Reserve
3) Reserve for Redemption of Debentures
4) Workmen Compensation Fund

Four examples of revenue reserve are given below:

1. General Reserve
2. Retained Earnings
3. Dividend Equalization Reserve
4. Debenture redemption Reserve

Four examples of capital reserve are given below:

1. Issues of shares at premium
2. Profit or issue of shares
3. Sale of fixed assets
4. Profit on redemption of debentures.

Secret reserve is the amount by which the assets of an organization are understated or its liabilities are overstated. An entity might establish a secret reserve for competitive reasons, to hide from other businesses that it is in a better financial position than appears in its financial statements.

Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.

Every business acquires fixed assets for its use in the business over a period of time. As the benefits of these assets can be availed over a long period of time (due to their regular use), there exists continuous wear and tear and consequently fall in their value. This fall in the value of fixed assets (due to regular use or expiry of time) is termed as depreciation. A machinery that costs Rs 1,00,000 and its useful life of 10 years, its depreciation will be calculated as:

• To ascertain true net profit or net loss: Correct profit or loss can be ascertained when all the expenses and losses incurred for earning revenues are charged to the profit and loss account. Assets are used for earning revenues and its cost is charged in the form of depreciation from profit and loss accounts.

• To show a true and fair view of financial statements: If depreciation is not charged, assets are shown at higher value than their actual value in the balance sheet; consequently, the balance sheet does not reflect the true view of financial statements.

• For ascertaining the accurate cost of production: Depreciation on plant and machinery and other assets, which are engaged in production, is included in the cost of production. If depreciation is not included, cost of production is underestimated, which will lead to low sale price and thus lead to low profit.

• Distribution of dividend out of profit: If depreciation is not charged, which leads to over estimating of profit & consequently more profit is distributed as dividend, out of capital instead of the profit. This leads to the flight of scarce capital out of the business.

• To provide funds for replacement of assets: Unlike other expenses, depreciation is not a cash expense. So, the amount of depreciation charged will be retained in the business and will be used for replacement of fixed assets after its useful life.

• Consideration of tax: If depreciation is charged, then the profit and loss account will disclose less profit as to when the depreciation is not charged. This depicts reduced profit and thus the business will be liable for lesser tax amount.

The causes for depreciation:

• Constant use: Due to constant use of the fixed assets there exists normal wear and tear that leads to fall in the value of fixed assets.

• Expiry of time: With the passage of time, whether assets are used or not, its effective life decreases. The natural forces like rain, weather, etc. lead to deterioration of the fixed assets.

• Obsolescence: Due to the fast technological innovations and inventions today’s assets may be outdated by tomorrow’s sophisticated assets. This leads to the obsolescence of fixed assets.

• Expiry of legal rights: If an asset is acquired for a specific period of time, then, whether the asset is put to use or not, its value becomes zero at the end of its useful life.

• Accident: An asset may lose its value and damage may happen to it due to mishaps such as a fire accidents, theft or a natural calamity. The loss due to accidents is permanent in nature.

Straight Line Method : In a straight line method of depreciation a fixed and an equal amount is charged as depreciation in every accounting period during the lifetime of an asset. The amount annually charged as depreciation is such that it reduces the original cost of the asset to its scrap value, at the end of its useful life. In this case, depreciation amount is also calculated by dividing depreciable cost by the estimated life of the assets. It is also a Fixed installment method because the amount of depreciation remains constant from year to year over the useful life of the asset.

Written Down Value Method : In written down value method, the depreciation is calculated at a fixed percentage of written down value of the asset. The method assumes that the benefit acquired to business by utilization of assets keeps on decreasing as the asset gets old. As the value of assets goes on decreasing from year to year, the amount of depreciation charged to different accounting years decreases with the passage of time.

Distinguish between Straight Line Method and Written Down Value Method:

Suitability of Straight Line Method & Written Down Value Method:

• Suitability of Straight Line Method : This method depreciation is suitable for assets in which the repair charges are less and the possibility of obsolescence is less and expiration of cost depends upon the time period involved.
• Suitability of Written Down Value Method : This method of depreciation is suitable for assets which are affected by technological changes; require more repairs with passage of time.

The two methods of recording depreciation are:-

a) Direct method : In this the depreciation gets charged by debiting depreciation account and crediting the asset account

• The journal entries under this method are- Depreciation account to asset account, profit and loss account to Depreciation account.

b) Indirect method : In this the amount of depreciation is debited to depreciation account and credited to provision for depreciation account.

• The journal entries under this method are- Bank account to asset account, Asset account to profit and loss account.

Factors that determining the Amount of Depreciation are as follows:-

1) Original cost of the asset: It implies the cost incurred on its acquisition, installation, commissioning and for additions or improvements thereof which are of capital nature. The cost of asset include the purchase price, less any trade discount plus all the costs essential to bring the asset to a usable condition

2) Estimated life: It implies the period over which an asset is expected to be used. Useful life refers to the window of time that a company plans to use an asset. Useful life can be expressed in years, months, working hours, or units produced. Therefore, the useful life of an asset is generally to be taken in terms of asset’s expected use. This estimated useful life of an asset determines the rate or the amount of depreciation.

3) Residual value: It implies the value expected to be realized on its sale on the expiry of its useful life. This is otherwise known as scrap value or turn-in value. It is the amount of money the company expects to recover, less disposal costs, on the date the asset is scrapped, sold, or traded in. Depreciation should be determined after deducting the estimated scrap value from the cost of the asset.

Types of Reserves are as follows:-

1) Revenue Reserves:- These reserves come into existence out of profits which have been earned in the course of day-to-day business operations. Therefore, the revenue reserves represent undistributed profits and as such are available for the distribution of dividends.

Revenue reserves may be of the following two types:-

(A) General Reserve:- Usually, the businessmen do not withdraw the entire profits from the business but retain a part of it in the business to meet unforeseen future uncertainties.
(B) Specific Reserve:- Such a reserve is created for a specific purpose and can be utilised only for that purpose.

2) Capital Reserves:- In addition to the normal profits, capital profits are also earned in the business from many sources. The reserves created out of such capital profits are known as Capital Reserves. Such reserves generally, are not available for distribution as cash dividend among the shareholders of a Company. Profits received from the following sources are termed as Capital profits:-

(A) Profits on the sale of fixed assets.
(B) Profits on the revaluation of fixed assets and liabilities.
(C) Premiums received on issues of Shares or Debentures.
(D) Profit on redemption of Debentures.
(E) Profit from the reissue of forfeited shares.
(F) Profit prior to the incorporation of a Company.
(G) Profit on the purchase of a running business.

According to the Companies Act the term ‘Provision’ refers to any of the following amounts :-

(a) The amount written off or retained by way of providing for depreciation renewals or diminution in value of assets; or
(b) The amount retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy.

E.g. A trader who sells on credit basis knows that some of the debtors of the current period would default and would not pay or would pay only partially. It is necessary to take into account such an expected loss while calculating true and fair profit/loss according to the principle of Prudence or Conservatism.

Therefore, the trader creates a provision for doubtful debts to take care of expected loss at the time of realization from debtors. In a similar way, provision for repairs and renewals may also be created to provide for expected repair and renewal of the fixed assets.

Examples of provisions are:-

(i) Provision for depreciation
(ii) Provision for bad and doubtful debts
(iii) Provision for taxation
(iv) Provision for discount on debtors
(v) Provision for repairs and renewals

Accounting Treatment for Doubtful Debts : First of all the amount of expected bad debts is ascertained which is posted in the debit side of P&L Account as new provision for doubtful debts is greater than new one, it will be shown in the credit side of P&L account and if the new provision is greater than the old one, the balance amount will be shown in the debit side of the P&L account. After that the amount of new provision will be deducted from the debtors figure in the assets side of the balance sheet.

1. True
2. False
3. False
4. True
5. True
6. False
7. True
8. False
9. False
10. False

Depreciation for 1 year (2014-15) = 7500 (Charged for 9 months)

Depreciation for 2 year (2015-16) = 1,00,000 – 7500 = 92,500
= ₹ 92500 × 10/100 = ₹ 9250

Depreciation for 3 year (2016-17) = ₹ 92500 – ₹ 9250 = 83050
= ₹ 83050 × 10/100 = ₹ 8305

(i) True
(ii) False
(iii) False
(iv) False
(v) True
(vi) False
(vii) False

(i) Asset
(ii) Acquisition Cost
(iii) Charge
(iv) Dividend Equalisation Fund