Depreciation, Provisions and Reserves - 1 NCERT Solutions | Accountancy Class 11 - Commerce PDF Download

Short Question Answer

Q1: What is ‘Depreciation’?
Ans: Depreciation is the decrease in the value of fixed assets caused by wear and tear over time. These fixed assets could be anything from furniture to machinery to a building. It is important to note that such fixed assets do not include land, as the value of land increases over time.

Q2: State briefly the need for providing depreciation.
Ans: The following are the requirements for providing depreciation: 

• The value of fixed assets depreciates over time as a result of wear and tear, reducing the asset's capacity. As a result, depreciation must be recorded in order to reflect such an effect on the books of account. 
• Depreciation depicts the true financial position of the business because it eliminates the possibility of assets being overvalued. 
• Depreciation meets the need and requirements of tax regulations and other compliances. ∙ Depreciation allows the business to meet the revenue matching principles, which require that the expenses incurred by the business be incurred in the same period that the income is recognized.

Q3: What are the causes of depreciation?
Ans: The following are the causes of depreciation: 

• Some current assets have a finite life after which they become perishable. Inventory is an example of such an asset. 
• Because fixed assets wear and tear over time, it is necessary to record the reduction in the cost of such fixed assets. 
• As new technological innovations emerge, fixed assets such as equipment and machinery become obsolete. This must be properly recorded in the books of account, and depreciation accomplishes this. 
• The use of some assets depletes over time, and this depletion of assets is recorded using accounting depreciation. Gas and oil reservoirs are examples of such assets.

Q4: Explain basic factors affecting the amount of depreciation.
Ans: The following are the primary factors that influence the amount of depreciation:

• Depreciable cost: This is the cost that remains after deducting both the residual cost and the various costs of the asset. The total depreciation should be equal to the total depreciation charged over the useful life of the asset. 
• Net residual value: This is the value of the asset's sales after its useful life has ended. It is calculated by deducting all expenses incurred during the disposal of the asset. 
• Various Costs of the Asset: Aside from the basic purchase cost of the asset, an asset will incur various costs. These expenses can take the form of transportation, commission fees, insurance premiums, and so on. These are the expenses incurred in order to restore the asset to working order. 
• Estimation of useful life: The useful life of any asset is defined as its actual commercial life. As a result, the concept of the asset's physical life is excluded because it considers the fact that the asset will continue to sustain even after its useful life has ended, which may not be of commercial productivity for the business.

Q5: Distinguish between straight line method and written down value method of calculating depreciation.
Ans: The following are the differences between the straight line and written down value methods: 

• The straight-line method calculates depreciation based on the original cost, whereas the written down value method calculates depreciation based on the net cost. 
• In the straight line method, the amount of annual depreciation is fixed, whereas in the written down value method, depreciation decreases the asset's value each successive year. 
• The straight line method charges on the depreciation of the total charge of the asset, which includes the depreciation charge and other repair expenses. However, the charge of depreciation decreases year after year in written down value, so the total charge remains constant. 
• The income tax authority recognizes the written down value method of depreciation but does not recognize the straight line method. Straight-line depreciation is appropriate for assets that require fewer repairs and thus become less scrap and obsolete over time. Land and buildings are two examples of such assets. The written down value method, on the other hand, is used in cases where there is a significant amount of repair expense or the market is affected by technological change.

Q6: “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.
Ans: When the assets have long-term utility and the repair and maintenance costs are expected to rise in the later years of the asset's life, the written down value method is more useful than the straight line method of depreciation. As a result, this method of depreciation does not impose a burden on the profit or loss accounts. This occurs because the rate of depreciation in this method of depreciation decreases year after year.

Q7: What are the effects of depreciation on profit and loss account and balance sheet?
Ans: Depreciation has a direct impact on the profit and loss account because it is recorded as an expense. When the amount of depreciation is greater, the net company of income is less than in the case where the rate of depreciation was lower. The effect of depreciation on the balance sheet reduces the net amount of assets, which has a further impact on the business's net income on the balance sheet.

Q8: Distinguish between ‘provision’ and ‘reserve’.
Ans: The distinction between provision and reserve is as follows: 

• Provision refers to the charge against profit for determining net profit, whereas reserve refers to the appropriation of profit to determine the business's strengthened financial position. 
• Provision determines the likely expenses that the business will incur in a given accounting period, whereas reserves are used to strengthen the business's financial position. 
• Provision is shown on the asset side of the balance sheet, whereas reserves are shown as the current liability on the liabilities side of the balance sheet. 
• Provisions reduce taxable profit because they are deducted from pre-tax profits. The reserves, on the other hand, are calculated on the basis of profits after taxes, which does not show the effect on profits. 
• The creation of provisions in accordance with regulations is required to determine fair profits, whereas the creation of reserves, with the exception of specific reserves, is at the discretion of a company. 
• Provisions cannot be used to distribute dividends, whereas a company's general reserve can be used to do so.

Q9: Give four examples each of ‘provision’ and ‘reserves’.
Ans: It is required to make provisions, which are undertaken and determined based on the identifiable expenses that any business incurs in an expected manner during the accounting period. The reserves, on the other hand, are intended to strengthen the company's financial position. The four examples of each are: 

• Provision for bad and doubtful debts 
• Provision for repairs and maintenance 
• Provision for depreciation 
• Provision for taxes 
• General reserve 
• Capital reserve 
• Workmen compensation reserve 
• Dividend equalisation reserve

Q10: Distinguish between ‘revenue reserve’ and ‘capital reserve’.
Ans: The following are the distinctions between revenue reserves and capital reserves:

• Revenue reserves are created to strengthen the financial position of the business, whereas capital reserves are created to meet legal requirements. 
• Revenue reserves are generally used to meet contingencies and general needs such as dividend distributions, whereas capital reserves are used to meet legal requirements. 
• Revenue reserves are created on the basis of revenue profits that occur in a routine manner during the regular operation of the business. The capital reserve, on the other hand, is created from the business's capital and is used for purposes that do not occur in regular business operations.

Q11: Give four examples each of ‘revenue reserve’ and ‘capital reserves’.
Ans: Here are four examples of revenue reserves: 

• General reserve 
• Dividend equalization reserve 
• Workers' compensation reserve 
• Debenture redemption reserve The four examples of capital reserves are as follows: 
• Premium on share or debenture issuance 
• Profit from the sale of fixed assets; 
• Profit from the revaluation of fixed assets and liabilities; and 
• Profit from the redemption of debentures.

Q12: Distinguish between ‘general reserve’ and ‘specific reserve’.
Ans: The 'general reserve' is established to strengthen the company's financial position, and it can thus be used for any purpose the management sees fit. On the other hand, the creation of a "specific reserve" is done to address a specific need of the organization. Thus, when specific reserves are used for the purpose for which they were created, they outlive their usefulness.

Q13: Explain the concept of ‘secret reserve’.
Ans: The secret reserve is established to deal with the reduction of the business's tax liability and to combine it with the profits made by the business in years when it is incurring losses in order to increase net profits. The secret reserve is not shown on the company's Balance Sheet, and it is created on the basis of highly charged depreciation on assets, showing contingent liabilities as actual liabilities, and making an excessive provision for doubtful debts. Thus, the establishment of a secret reserve is permissible if it is within reasonable limits.

Long Question Answers

Q1: Explain the concept of depreciation. What is the need for charging depreciation and what are the causes of depreciation?
Ans: Depreciation is defined as the reduction in the value of a business's asset over time. Fixed assets that must be depreciated include machinery, furniture, buildings, offices, and so on. (It is important to note that land is not a depreciable asset, and its value increases over time.) The following are the requirements for providing depreciation: 

• Every fixed asset loses value over time due to wear and tear, reducing the working capacity of these assets. As a result, the depreciation is carried out in order to reflect this decrease in the books of accounts. 
• The depreciation thus depicts the company's true financial position because it does not overestimate the prices of assets in the books of account. Companies are required to meet the obligations imposed by the tax authorities, which necessitates the recording of depreciation in the books of accounts. According to the revenue matching principles, expenses incurred by the business must be accounted for in the same accounting period in which they occurred in order for the business to gain revenue.

The following are the causes of depreciation: 

• The value of fixed assets decreases over time as fixed assets such as equipment and machinery become obsolete due to the introduction of new technology and equipment. As a result, such asset obsolescence must be recorded in the books of account through accounting depreciation. 
• Some fixed assets have a very short life span and die after their life is over. This occurs with current assets such as inventory, and it is critical for the business to record this depreciation in the price of the business's assets.
• Every fixed asset is bound to suffer from wear and tear over time, which reduces the value of the asset, and such depreciation is required to account for the reduction in the amount of the asset.
• As the use of some assets depletes, depreciation becomes the means by which the asset's decrease in value can be accounted for.

Q2: 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.
Ans: The Straight-line method is a technique for calculating the depreciation that occurs to the asset's original cost. The amount with which the depreciation must be done is fixed under this method, and thus the depreciation occurs every year with the specified fixed amount.
The written down value method, on the other hand, refers to a depreciation technique in which the depreciation to the value of the fixed asset occurs with the reduction decreasing year after year. It subtracts the amount of the original cost from the amount of depreciation, which is calculated based on the asset's usage until it is used.
The straight line method has the following advantages: 

• The straight line method is easier and simpler to calculate than the written down value method. 
• Assets can be depreciated until the asset's value is zero. 
• Because the same amount of depreciation is charged each year, comparing figures in the Statement of Profit or Loss becomes easier. 
• It is used for assets that have incurred low repair and maintenance costs as a result of continuous use of the asset over a period of time.

The Straight Line Method has the following limitations: 

• The burden of depreciation increases on the profit or loss account in the later years of the asset as the cost of repairs and maintenance rises and the assets age. 
• Even if the asset is in usable condition for the business, its value becomes zero.

Similarly, the Written Down Value Method has a number of advantages, which are as follows: 

• This method of depreciation is based on the logical assumption that the asset is used more in its early years and less in its later years. 
• As a result, it is appropriate for assets that have a higher cost of repair I the later years of the asset's life as the amount of depreciation decreases I the later years of the asset's life 
• The income tax authorities recognize this method. 
• The loss due to asset obsolescence decreases as more depreciation is charged in the early years of the asset.

The written down value method has the following limitations: 

• The written down value method of calculation can be complex and difficult.
• The asset cannot be completely written off while it is being used in the business because the asset's value does not become zero at any time.

Q3: Describe in detail two methods of recording depreciation. Also give the necessary journal entries.
Ans: Depreciation is recorded using one of two methods: 
(I) Charging depreciation directly to the asset account – In this method, depreciation is first charged from the asset's cost, then to the profit and loss account. The balance sheet thus shows the net value of the asset after depreciation is dedcted. The journal entries in this method are as follows: 

• Subtracting depreciation from the asset's cost
  
• To charge the depreciation to profit and loss account

(II) Making a provision for accumulated depreciation – The amount of depreciation to be charged in the accumulated under the separate account under this method of charging depreciation. Thus, in the balance sheet, the asset's value is shown in its original value, and the accumulated amount of depreciation is shown in the liabilities side of the balance sheet.
The journal entries in this method are as follows:

• Including depreciation in the depreciation provision

• To charge the depreciation to profit and loss account

Q4: Explain determinants of the amount of depreciation.
Ans:

• Depreciable cost : This is the cost that remains after deducting both the residual cost and the various costs of the asset. The total depreciation should be equal to the total depreciation charged over the useful life of the asset. 
• Net residual value: This is the value of the asset's sales after its useful life has ended. It is calculated by deducting all expenses incurred during the disposal of the asset. 
• Various Costs of the Asset: Aside from the basic purchase cost of the asset, an asset will incur various costs. These expenses can take the form of transportation, commission fees, insurance premiums, and so on. These are the expenses incurred in order to restore the asset to working order.
• Estimation of useful life: The useful life of any asset is defined as its actual commercial life. As a result, the concept of the asset's physical life is excluded because it considers the fact that the asset will continue to sustain even after its useful life has ended, which may not be of commercial productivity for the business.

Q5: Name and explain different types of reserves in details.
Ans: A business establishes a reserve in order to strengthen its financial position through retained earnings. There are several types of reserves: 

1. Revenue Reserve: The revenue reserve is a reserve created from profits generated by the business's normal routine operations. These can be used to meet either a general or a specific purpose. There are two kinds of reserves: general reserves and specific reserves.
   • General Reserve: These reserves are created without a specific purpose in mind, so they can be used for anything, including the goal of expansion and growth. For example, retained earnings, contingency reserves, and so on.
   • Specific Reserve: These are reserves that are created for a specific purpose.
     Examples of such reserves include: debenture redemption reserves, dividend equalization reserves, and so on.
2. Capital Reserve: It is created from capital profit, i.e., profit from activities other than normal business operations, such as the sale of fixed assets, and so on. It was created to compensate for the capital loss. It cannot be paid out as a dividend. The following is an example of capital reserves. 
   • Premium on share issuance 
   • Premium on debenture issuance
   • Profit on debenture redemption 
   • Profit on fixed asset sale 
   • Profit on reissue of forfeited shares 
   • Profit before incorporation 
3. Secret Reserves: Secret reserves are reserves created by overstating liabilities or understating assets. They are not reflected in the Balance Sheet. Because the liabilities are overstated, this reduces tax liabilities. Management creates it to avoid competition by lowering profit. The Companies Act of 1956 forbids the establishment of a secret reserve and requires full disclosure of all material facts and accounting policies when preparing final statements.

Q6: What are ‘provisions’. How are they created? Give accounting treatment in case of provision for doubtful Debts.
Ans: Provisions are created by businesses to allow them to incur expenses and losses that are known to the business and that they may incur in the future Provisions are charged on the business's revenue and are thus shown as a deduction from assets or as the business's current liability. Some examples of provisions are as follows: 

• Provision for bad and doubtful debts 
• Provision for depreciation 
• Provision for repairs and maintenance 

The accounting treatment of provision for doubtful debts is as follows: Doubtful debts are those for which the company is unsure of the recovery, so they make a provision to account for such losses. The following is the journal entry:

Numerical Question Answers

Q1: On April l, 2010, Bajrang Marbles purchased a Machine for Rs. 1,80,000 and spent Rs. 10,000 on its carnage and Rs. 10,000 on its installation. It is estimated that its working life is 10 years and after 10 years its scrap value will be Rs. 20,000.
(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 31 every year.
Ans:

(a) Books of Bajrang Marbles

Working notes: Calculation of annual depreciation

(b)

Q2: On July 01, 2010, Ashok Ltd. Purchased a Machine for Rs. 1,08,000 and spent Rs. 12,000 on its installation. At the time of purchase it was estimated that the effective commercial life of the machine will be 12 years and after 12 years its salvage value will be Rs. 12,000.
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: Books of Ashok Ltd.

Working Note: Calculation of annual depreciation

Q3: Reliance Ltd. Purchased a second hand machine for Rs. 56,000 on October 01, 2011 and spent Rs. 28,000 on its overhaul and installation before putting it to operation. It is expected that the machine can be sold for Rs. 6,000 at the end of its useful life of 15 years. Moreover, an estimated cost of Rs. 1,000 is expected to be incurred to recover the salvage value of Rs. 6,000. Prepare machine account and Provision for depreciation account for the first three years charging depreciation by fixed Instalment Method. Accounts are closed on March 31, every year.
Ans: Books of Reliance Ltd.

Working Note: Calculation of annual depreciation

Note: As per the solution, the balance of provision for depreciation account, as on March.31, 2015 is Rs 11,850; whereas, as per the book, it is Rs 18,200. However, if we ignore the scrap value and prepare provision for depreciation for 4 years, the answer would match to that of the book.

Q4: Berlia Ltd. Purchased a second hand machine for Rs 56,000 on July 01,2015 and spent Rs 24,000 on its repair and installation and Rs 5,000 for its carriage. On September 01, 2016, it purchased another machine for Rs 2,50,000 and spent Rs 10,000 on its installation.
(a) Depreciation is provided on machinery @10% p.a on original cost method annually on December 31. Prepare machinery account and depreciation account from the year 2015 to 2018. 
(b) Prepare machinery account and depreciation account from the year 2015 to 20018, if depreciation is provided on machinery @10% p.a. on written down value method annually on December 31.
Ans:
(a)Books of Berlia Ltd.

Working notes: Calculation of annual depreciation

(i) Depreciation (p.a.) on Machinery Purchased on July 01,2015

(ii) Depreciation (p.a.) on Machinery purchased on September 01, 2016.

(b)