DEPRECIATION, PROVISIONS AND RESERVES
After studying this lesson you will be able to:
Depreciation Concept: Fixed assets are held on a long term basis and used to generate periodic revenue. That portion of assets, which is believed to have been consumed or expired to earn the revenue, needs to be charged as cost. Such an appropriate proportion of the cost of fixed assets is called Depreciation.
Business enterprises require fixed assets for their business operations such as furniture and fixtures, office equipments, plant and machinery, motor vehicles, land and building etc. In the process of converting Raw material into finished products, the fixed assets depreciate in value over a period of time, i.e. its useful life.
In other words, the process of allocation of the cost of a fixed asset over its useful life is known as depreciation.
According to accounting standard- 6 (Revised) issued by the ICA "Depreciation is a measure of wearing out, consumption or other loss of value of a depreciable asset arising from use, effusion of time or obsolescence through technology and market changes. Depreciation is allocated so as to charge a fair proportion of the depreciable in each accounting period during the expected useful life of the asset. Depreciation includes amortization of assets whose useful life is predetermined.
Some Important Terms
1. Obsolescence- When a fixed tangible assets become useless or unwanted due to new invention.
2. Amortization- The term amortization is used for writing off intangible assets such as goodwill, copyright, patents, etc.
3. Depletion- The term depletion is used in relation to decreasing the value of wasting assets or natural resources such as mines, oil wells, timber trees & fishing etc. due to the continue removal or extraction of things.
Need or objectives of providing Depreciation
1. Ascertaining true profit or loss:
(i) The true profit of an enterprise can be ascertained when all cost; incurred for the purpose of earning revenues have been debited to the profit and loss account.
(ii) Fall in the value of assets used in business operations is a part of the cost and should be shown in the profit and loss account of concerned accounting period.
(iii) Keeping this in view, depreciation must be debited to profit & loss account, since loss in value of fixed assets is also an expenses like other expenses.
2. Presentation of True and Fair value of assets: If depreciation is not provided, the value of assets shown in Balance sheet will not present the true and fair value of assets because assets are shown at the cost price but actual value is less than cost price of the assets.
3. To ascertain the accurate cost of the Production: Depreciation is an item of expense, the correct cost of production cannot be calculated unless it is also taken into consideration. Hence, depreciation must be provided to ascertain the correct cost of production.
4. Computation of correct income tax:
(i) Income tax of an enterprise is determined after charging all the costs of production.
(ii) If depreciation is not charged, the profits will be higher and the income tax will also be higher.
(iii) If depreciation is charged, Tax liability is reduced.
5. Provision of funds and replacement of assets: Depreciation is a non-cash expense. So that amount of depreciation charged to profit and loss accounts is retained in business every year. These funds are available for replacement of the assets when its useful life is over.
Methods of providing depreciation
1. Straight line method
(i) This method is also known as 'original cost method'
(ii) Under this method, depreciation is charged at fixed percentage on the original cost of the asset, throughout its estimated life.
(iii) Under this method, the amount of depreciation is uniform from year to year. That is why this method is also known as 'Fixed Installment Method' or 'Equal installment method'.
(iv) The annual amount of depreciation can be easily calculated by the following formula :
Annual Depreciation =
For example: A firm purchases a machine for Rs. 2,25,000 on April 1,2013. The expected life of this machine is 5 years. After 5 years the scrap of this machine would be realized Rs. 25.000. Under straight line method, the amount of depreciation can be calculated as under:
Annual Depreciable =
Hence Rs. 40,000 will be charged every year as depreciation on this machine.
2. Diminishing balance method : Under this method, depreciation is charged as a fixed percentage on the book value of the asset every year. In first year the depreciation will be charged at the end of the year, on the total cost the asset.
Example: A machine is purchase for Rs.2,00,000 on April 1.2009. It is decided to charge depreciation on this machine @ 10% p.a. The amounts of depreciation for first four years by using both the methods (Straight line method and Diminishing balance method) are shown as under:
Hence, in Straight Line method, amount of depreciation is same but in Diminishing Balance Method amount of depreciation goes on decreasing every year. Depreciation can be recorded by crediting it to the Assets account.
Illustration 1: On January 1, 2013, a firm bought a machine for Rs.90,000 and spend Rs.6,000 on its installation and Rs.4,000 on its carriage. It is decided to charge depreciation @ 10% on straight line method. Books are closed on December 31st each year. Show Machinery Account for the year 2013 to 2015.
Illustration 2 : On the basis of information given in Illustration 1, Prepare machinery Account for the year 2013 to 2015 if depreciation is charged @ 10% on diminishing balance method.
Illustration 3 : On April 1, 2013 Kannu bought Machinery costing Rs.80,000. On July 1, 2015 Machinery was sold for Rs.40,000. Prepare Machinery Account from April, 1 2013 till July 1. 2015 assuming depreciation was charged @10% per annum on March 31, every year on the basis of Original cost method.
Illustration 4 : On the basis of information given in Illustration 3, prepare Machinery Account assuming depreciation was charged @ 15% per annum on reducing installment method.
There is another treatment for charging Depreciation. In this treatment, Provision for Depreciation Account is opened and depreciation is charged in this account instead of Asset Account.
In this treatment the balance of Asset Account remains same throughout its useful life. Provision for Depreciation is shown in the liabilities side of Balance Sheet.
Illustration 5: Vinod limited purchased a machine for Rs.2,50,000 including installation cost on January 1, 2012. On October 1, 2014, machine was sold for Rs.1,50,000. Depreciation was provided @ 10% p.a. on Fixed Installment method and accounts are closed on December 31, each year.
Show the Machinery Account and Provision for Depreciation Account for the year. 2012 to 2014.
Provision for Depreciation Account
Important Point : Total Depredation charged on Machinery from Jan 1, 2011 to Oct. 1,2013: Rs.25,000+Rs.25.000 + Rs.18,750 = Rs.68,750.
Illustration 6: On the basis of information given in Illustration 5, show the Machinery Account and Provision for Depreciation is provided @ 20 % p.a. on Written Down Value Method.
Provision for Depreciation Account
Important Point : Total Depreciation charged on Machinery from Jan. 1,2012 to Oct. 1,2014: Rs.50,000+Rs. 40,000 +Rs. 24,000 =Rs.1,14,000
Illustration 7: A Company purchased a machine for Rs. 40,000 on April 1, 2014. On October 1, 2015 it was sold for Rs. 13,000. The company charges depreciation @ 10% p.a. on straight line method.
Show Machinery Account, Provision for Depreciation Account and Machinery Disposal account if books are closed on March 31 each year.
Provision for Depreciation Account
Machinery Disposal Account
Important Point: Total Depreciation charged on Machine: Rs. 4,000 +Rs.2,000 = Rs.6,000
Illustration 8: On Oct. 1, 2012, Arora Auto Limited Purchased Furniture for Rs.1,00,000 and spent Rs.4,000 towards its installation. On July 1, 2013, the Furniture was disposed off Rs.59,820 and on the same day furniture costing Rs.1,60,000 were purchased.
Show the Furniture Account, Provision for Depreciation Account and Furniture Disposal Account for the year 2012, 2013 and 2014 if the rate of Depreciation is 15% per annum by Diminishing Balance method and accounts are closed or 31st march of every year.
Provision for Depreciation Account
Furniture Disposal Account
Important Point: Total Depreciation charged on Machinery sold : Rs. 7,800 + Rs. 3,608 = Rs. 11,408.
Illustration9: Afirm purchased on 1 st January, 2012 certain Machinery for Rs.5,82,000 and spent Rs.18,000 on its erection. On 1st July, 2012, additional machinery costing Rs.2,00,000 was purchased. On 1st July, 2014, the machinery purchased on 1st January, 2012 was auctioned for Rs.2,86,000 and a fresh machinery for Rs.4,00,000 was purchased on same date. Depreciation was provided annually on 31st December at the rate of 10% on written down
Working Notes: Cost of 1st Machine = Rs. 5,82,000 + Rs. 18,000 = Rs. 6,00,000 Profit/Loss on sale of 1st Loss on Sale of 1 st Machine = Book Value on- Sale Value (Rs. 4,86,000-Rs. 24,300) Rs. 4,61,700 - Rs. 2,86,000 Loss on Sale of Machine = Rs. 1,75,700
Illustration 10: The following balances appear in the books of Sankalp on 01-01-2015 Machinery A/c Rs. 8,00,000 Provision for Depreciation a/c Rs. 3,18,000 On 01-01-2015 they decided to sell a machine for Rs. 34,500. This machine was purchased for Rs. 1.20,000 on 01 -01 -2011.
Show the machinery A/c, Provision for Depreciation A/c for the year ended Dec 31,2015 assuming that depreciation was charged at 10% p.a. on Written Down value method.
Provision for Depreciation Account
Depreciation charged on Sold Machinery
Illustration 11 (Problem Based on Missing Figures) On 1st July 2012 Tata Private Ltd. purchased a machinery for Rs.60,000. On 1st Oct. 2013 another machinery was purchased for Rs.3,60000. On 1st July 2014, the machine purchased on July 2012 was sold for Rs.3,36,000 and on the same date a fresh machinery was purchased for Rs.4,00,00. Depreciation was provided @10% p.a. on the written down value method. Books are closed on 31 st march every year.
You are required to prepare machinery account and provision for Depreciation for three years ending 31 st March 2015.
PROVISION OR DEPRECIATION ACCOUNT
73,500 2) 1,18,500
Asset Disposal Account
Asset Disposal A/C is opened when an asset (partially or fully) is sold or disposed off. All entries related to sold asset are recorded in the asset disposal A/C. Methods of recording the entries in Asset Disposal A/C will depend on a fact whether a provision for depreciation a/c is maintained or not.
Format of Assets Disposal Account
When provision for Depreciation Account is maintained
When provision for Depreciation Account is not maintained
Illustration No. 12: (Problem based on missing figures) Fill up the missing figures in the plant Account given below. You are informed that the plant purchased on 1st Oct 2012 was sold on 1 st April, 2014 for Rs.95,000 . The depreciation is provided at the rate of 10% p.a on diminishing balance by the company.
1) On 1 st April, 2013 Ashok & Brothers bought a second hand machine for Rs. 6,00,000 and spent Rs.100000 for its repair and installation. On Oct 1,2015 the machine was sold for Rs.5,00,000. Prepare Machine Account after charging depreciation @ 10% p.a. by Written down value Method, assuming that the books are called on 31st March every year.
2) Vijay Ltd. purchased a plant on 1 st April 2012 for Rs.2,50,000. On 1 st 2013, it purchased a new plant for Rs.1,50,000. The part of the machine which was purchased on 1st April 2012 costing Rs.50,000 was sold for Rs.18000 on 30th September 2015. Prepare the plant A/C for four years. Depreciation is charged @ 10% p.a. on 31st March every year on the Diminishing Balance Method.
Loss on sale of plant 16627, Balance 31 March, 2015 Rs.2,46,645
Q.No.3: On 1st April 2012 a firm purchased a machinery for Rs. 8,00,000. On 1st Oct in the same accounting year, an additional machinery costing Rs.4,00,000 was purchased. On 1st 2013, the machinery purchased on 1st April 2012 was sold off for Rs.3,60,000. On October 2014, a new machinery was purchased for Rs.10,00,000 while the machinery purchased on 1st October 2012 was sold for Rs.3,40,000 on the same date. The firm provides depreciation on its machinery @ 10% p.a. on original cost 31st March every year.
Prepare Machinery Account (ii) Provision for Depreciation Account (iii) Machinery Disposal Account
Ans:- Balance of Machinery Account Rs.9,50,000 Loss on Sale of 1st Machinery Rs.3,20,000 Profit on sale of second Machinery Rs.20,000.
Q.No.4: You are given the following balances as on 1st April 2010 Plant Account =Rs.10,00,000 Provision for Depreciation on Account = Rs.2,32,000 Depreciation is charged on plant at 10% p.a by the Diminishing Balance Method. A piece of plant purchased on 1st April 2008 for Rs.2,00,000 was sold on 1st October 2010 for Rs.1,20,000.
Prepare the Plant Account and provision for the Depreciation Account for the year ended 31st March 2011 and also prepare the plant Disposal Account.
Loss on sale Plant Rs. 233,900 Balance of provision for Depreciation on A/C on April, 2011 Rs.2,54,000
Q.No.5: Fill up the missing information in the machinery account, provision for Depreciation Account and Disposal Account. You are informed that on 30th June 2008 it sold off the first machine purchased in 2006 for Rs. 5,24000 Accumlated Depreciation Account in maintained changing depreciation @ 10% on straight line method.
PROVISION FOR DEPRECIATION ACCOUNT
MACHINERY DISPOSAL ACCOUNT
Ans:- 1) By Balance b/d Rs.8,95,000 2) Rs.8,95,000
5) Machinery Disposal A/C Rs. 6,55,000 6) Rs.2,40,000
7) By Depreciation A/C Rs.34750 8) To Balance c/d Rs.34750 9) By Balance b/d Rs.34750 10) By Depreciation A/C (1)Rs.89500 11) To Balance c/d Rs. 1,14,250 12) By Balance c/d Rs.1,24,250 13) By Depreciation A/C (1)Rs.16375 14) By Depreciation A/C (4) Rs.24000 15) To Machinery Disposal A/C Rs.1,14,250 16) To Balance c/d Rs. 50,000 17)Rs. 1,14,625
19) Rs. 16375
20) To Machinery A/C Rs.6,55,000
Notes: Provision is a charge against profits, it means provision has to be made irrespective of business enterprise is earning enough profits or Incurring losses.
Examples of provisions : Provisions for Depreciation on assets, Provision for Repairs and Renewals of assets. Provision for Taxation. Provision for Discount on Debtors , Provision for Bad and Doubtful Debts.
DIFFERENCE BETWEEN PROVISIONS AND RESERV
Revenue Reserves are those reserves which are created by setting aside a part of the net profit of business. Since reserves represent undistributed profit of the company so they are available for declaration of dividend and distribution among shareholders.
Revenue reserves are of two types namely. (1) General Reserves (2) Specific Reserves.
(1) General Reserves : Those reserves which are created out of profit to meet out the unforseen contigencies is called general reserves. They are termed as 'Free Reserves' or 'Contingency Reserves'. Creation of general reserve is optional. It is an appropriation of profit so it is made only if adequate profit is earned by the company. They are shown on liability side of the balance sheet under the head,"Reserve and surplus".
(2) Specific Reserves:- These reserves are created for specific purpose and can be utilised for that purpose only.
Examples:-Divindend Equalization Reserves, Debentures Redemption Reserve, workman Compensation fund, Investment Reserves etc.
Reserve fund: If reserves are invested in outside securities, it is known as Reserve fund.
Capital Reserves: The reserves created out of capital profits are known as capital Reserve. Such reserves, generally are not available for distribution as cash dividend among the share holders of a company.
Examples:-i) Profit on sale of fixed assets.
ii) Profit on revaluation of assets and liabilities.
iii) Securities premium earned on issue of share or debentures.
iv) Profit on the purchase of running business.
v) Profit earned on forfeiture of shares.
vi) Profit on redemption of debentures.
vii) Profit prior to the incorporation of a company
Capital profits can be used to write off capital losses and to issue fully paid up bonus shares among the equity share holders. However, company can declare dividend out of capital profits on the fulfilment of the following conditions.
i) Articles of Associations of a company permits the declaration of dividend out of such profile.
ii) Capital profits realised in cash.
iii) Profile remains after revaluation of assets and liabilities.