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

Important Points to Note

• 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 a 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 equipment 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., useful life.

NCERT Solutions 

Short Answers

Q1: What is Depreciation?

Ans: 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, thus, due to their regular use, there occurs continuous wear and tear and consequently fall in their value. This fall in the value of fixed assets due to their regular use or expiry of time is termed depreciation.
Example: Machinery costing Rs 1,00,000 and its useful life is 10 years; so depreciation is calculated as:

Q2: State briefly the need for providing depreciation.
Ans: The need for providing depreciation is given below.

1. 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 their cost is charged in form of depreciation from the Profit and Loss Account.
2. To show the true and fair view of financial statements- If depreciation is not charged, assets are shown at a higher value than their actual value in the Balance Sheet; consequently, the Balance Sheet does not reflect true and fair view of financial statements.
3. 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, the cost of production is underestimated, which will lead to a low sale price and thus leads to low profit.
4. Distribution of dividend out of profit- If depreciation is not charged, which leads to overestimating of profit, and consequently, more profit is distributed as a dividend out of capital instead of the profit. This leads to the flight of scarce capital out of the business.
5. To provide funds for the 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 the replacement of fixed assets after their useful life.
6. Consideration of tax- If depreciation is charged, then Profit and Loss Account will disclose lesser profit as to when the depreciation is not charged. This depicts reduced profit and thus the business will be liable for lesser tax amount.

Q3: What are the causes of depreciation?

Ans :

1. Constant use - Due to the constant use of the fixed assets, there exists normal wear and tear that leads to falling in the value of fixed assets.
2. 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 the deterioration of the fixed assets.
3. 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.
4. 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. For example, if a land is acquired for Rs 1,00,000 for 25 years on lease, then each year its value depreciates by  of its gross value. At the end of the 25th year, the value of the lease will be zero.
5. Accident - An asset may lose its value and damage may happen to it due to mishaps such as a fire accident, theft or a natural calamity. The loss due to accident is permanent in nature.
6. Permanent fall in value - Generally, we do not record fluctuations in the market price of the fixed assets in the books. However, if the fall in market price is permanent, it is accounted for, which leads to a fall in the value of fixed assets in the books.

Q4: Explain basic factors affecting the amount of depreciation.

Ans:

1. The total cost of the asset - The total cost of an asset is taken into consideration for ascertaining the amount of depreciation. The expenses incurred in acquiring, installing and constructing asset and bringing the asset to its usable condition are included in the total cost of asset.
2. Estimated useful life - Every asset has its useful life other than its physical life (in terms of number of years, units, etc.), used by a business. The useful life of an asset is considered to estimate the effective life of a fixed asset. For example, land has indefinite life; however, if a business acquires a piece of land on lease for 25 years, then the useful life of the piece of land is considered to be 25 years.
3. Estimated scrap value - It is estimated as the net realisable value or sale value of an asset at the end of its effective life. It is deducted from the total cost of an asset. For example, furniture is acquired at Rs 50,000 and its effective life is 10 years. After 10 years, the furniture will be sold at Rs 10,000. So, depreciation is charged as:

Q5: Distinguish between the straight-line method and the written-down value method of calculating depreciation.

Ans:

Q6:  In the case of a long-term asset, repair, and maintenance expenses are expected to rise in later years than in earlier years. Which method is suitable for charging depreciation if the management does not want to increase the burden on profits and loss account on account of depreciation and repair?

Ans: If the management does not want to exert undue burden on the profits due to high depreciation and repair costs in the latter years of the assets, then 'written down method' should be a preferred method to provide depreciation. This is because the cost of depreciation reduces; whereas, repair and maintenance expenses increase in the latter years. However, on the whole, it does not exert an increasing burden on profits.

Q7: What are the effects of depreciation on the profit and loss account and balance sheet?

Ans: The effects of depreciation on the Profit and Loss Account are given below.

1. Depreciation increases the debit side of the profit and loss account and hence reduces net profit.
2. Depreciation increases the total expenses, leading to an excess of debit over credit balance.

The effects of depreciation on Balance Sheet are given below.

1. It reduces the original cost or book value of the concerned asset.
2. It reduces the overall balance of asset column in the balance sheet.

Q8: Distinguish between provision and reserve.

Answer :

Q9: Give four examples of provision.

Ans: Four examples of provisions are given below:

1. Provision for bad and doubtful debts
2. Provision for discount on debtors
3. Provision for depreciation
4. Provision for taxation

Q10: Distinguish between revenue reserve and capital reserve.

Ans: 

Q11: Give four examples each of revenue reserve and capital reserves.

Ans: Four examples of revenue reserve are given below.
    1. General Reserve
    2. Retained Earnings
    3. Dividend Equalisation Reserve
    4. Debenture Redemption Reserve

Four examples of capital reserves are given below.
    1. Issues of shares at a premium
    2. Profit or issue of shares
    3. Sale of fixed assets
    4. Profit on redemption of debentures

Q12: Distinguish between the general reserve and the specific reserve.

Ans:
 

Q13: Explain the concept of a secret reserve.

Ans: Reserves that are created by overstating liabilities or understating assets are known as secret reserves. They are not shown on the balance sheet. These reduce tax liabilities, as the liabilities are overstated. It is created by management to avoid competition by reducing profit. The creation of a secret reserve is not allowed by Companies Act, 1956 that requires full disclosure of all material facts and accounting policies while preparing final statements.

Long Answers 

Q1: Discuss in detail the straight-line method and written-down value method of depreciation. Also, give situations where they are useful.

Ans: 

1. Straight Line method: It is a simple method of charging depreciation. Under this method, depreciation is charged on the original cost of an asset at a fixed rate of percentage. In this method, the amount of depreciation remains the same from year to year and the asset's value becomes zero at the end of its useful life. The amount of depreciation is calculated as under:

• Advantages of Straight Line Method
  1. It is simple to calculate.
  2. Asset can be completely written off, i.e., the asset can be depreciated until the net scrap value is zero.
• Limitations of Straight Line Method
  1. Burden of deprecation is more on profit and loss account in the later years, when repair and maintenance costs increase, as asset becomes older.
  2. Value of the asset becomes zero in the books even if the asset is still in usable condition in business.
• Uses of Straight Line Method
  1. This method is useful where repairs and maintenance expenses on assets are low.
  2. It is also useful when an asset is continuously used from one year to another.
  3. It is useful when the value of assets, such as patents, copyright, goodwill, etc., becomes zero.

2. Written Down Value Method: This method is applicable where depreciation is charged on the diminishing balance, i.e., the book value of the asset. In this method, the asset's value goes on diminishing year after year, and the amount of depreciation declines. The rate of depreciation is calculated as follows:

Where,
R represents the rate of depreciation
n represents the expected useful life of the asset
s represents the scrap value
c represents the cost of the asset

• Advantages of Written Down Value Method
  1. It is based on the logical assumption that asset is used more in the earlier years, so more cost is charged in form of depreciation.
  2. This method is accepted by the income tax authorities.
• Limitations of Written Down Value Method
  1. It is difficult to calculate and is a time-consuming process.
  2. The value of an asset cannot be zero. Thus the asset cannot be completely written off.
• Uses of  Written Down Value Method
  1. It is useful when assets have a long life.
  2. It is useful for those assets that require more repair and maintenance costs in the later years.
  3. It provides easy calculation to provide depreciation of additional assets purchased during a year. 

Q2: Describe in detail two methods of recording depreciation. Also, give the necessary journal entries.

Answer :
The two methods of recording depreciation are diagrammatically presented below.

1. Charging depreciation to Asset Account- Under this method, depreciation is directly credited to the asset account and no separate account is prepared for provision of depreciation. Under this method, the original cost of an asset and the total amount of depreciation cannot be determined from the Balance Sheet, as the Asset Account appears at its written down value.
Journal entries for depreciation are given below.

• When depreciation is charged to Assets Account
  Depreciation A/c      Dr.
                   To Assets A/c
  (Depreciation charged to Assets Account)
• Closing of Depreciation Account
  Profit and Loss A/c         Dr.
                   To Depreciation A/c
  (Depreciation transferred to Profit and Loss Account)

2. Creating Provision for Depreciation Account- Under this method, depreciation is not credited to the Assets Account; in fact, it is credited to the provision for Depreciation Account. At the year-end, asset is shown at the original cost in the Balance Sheet and total depreciation up to the date of Balance Sheet is shown as Provision for Depreciation Account.

Journal entries for depreciation are:

• Charging Depreciation
  Depreciation A/c            Dr.
                     To Provision for Depreciation A/c
  (Depreciation charges)
• Closing of Depreciation Account
  Profit and Loss A/c                     Dr.
                       To Depreciation A/c
  (Depreciation account is transferred to Profit and Loss Account)

• When the asset is sold, the accumulated depreciation on that asset is credited to the Asset Account by passing the following Journal entry:
  Provision for Depreciation A/c        Dr.
                          To Asset A/c
  (Accumulated depreciation transferred to Assets Account)

Q3: Name and explain different types of reserves in detail.

Ans: Reserves- Reserves are created for strengthening financial positions and future growth. It is created out of profit earned by the business.
The broad classification of the reserve is diagrammatically presented below.

1. Revenue Reserve- It is created out of revenue profit, i.e., revenue earned from normal activities of the business. It can be used for either general purposes or specific purposes. It is of two types:

• General Reserve- When the reserve is created without any specified purpose, then the
  reserve is called a general reserve. It is a free reserve and so can be used for any purpose. It can also be used for future growth and expansion. For example, reserve funds, retained earnings, contingencies reserves, etc.
• Specific Reserve- When a reserve is created for some specific purpose, then the reserve is called a specific reserve. Examples of the specific reserve are Debenture Redemption Reserve, Investment Fluctuation Reserve, Dividend Equalisation Reserve, and Workmen Compensation Fund.

2. Capital Reserve- It is created out of capital profit, i.e., gain from other than normal activities of business operations, such as the sale of fixed assets, etc. It is created to meet the capital loss. It cannot be distributed as a dividend. Examples of capital reserves are Premium on the issue of shares, Premium on the issue of debentures, Profit on redemption of debentures, Profit on sale of fixed assets, Profit on the reissue of forfeited shares, and Profit prior to incorporation.

3. Secret Reserves- Reserves that are created by overstating liabilities or understating assets are known as secret reserves. They are not shown on the Balance Sheet. These reduce tax liabilities, as the liabilities are overstated. It is created by management to avoid competition by reducing profit. The creation of a secret reserve is not allowed by the Companies Act, 1956, which requires full disclosure of all materials, facts, and accounting policies while preparing final statements.

Q4:  What are provisions? How are they created? Give accounting treatment in case of provision for doubtful Debts.

Ans: Provisions are the amount that is created against profit to meet the known liability; however, the amount of liability is uncertain. It is created for specific liability. The creation of a provision is compulsory even if there is no profit. The underlying principle behind the creation of provision is conservatism, viz., to prepare for future loss. The main rationale for making provisions is to provide a cushion for future business performance against the uncertain and unforeseen losses that may arise from past transactions. A few examples of provisions are given below.
1. Provision for bad and doubtful debts
2. Provision for depreciation
3. Provision for taxation
4. Provision for discount on debtors

• Provisions are made by debiting the Profit and Loss Account on an estimate basis. 
• The provisions of a certain percentage are created on the basis of past experiences.
• These unascertained liabilities in form of provisions are kept aside, which help future business activities, undisturbed from future losses.

Accounting treatment for provision for doubtful debts is:

Profit and Loss A/c
               To Provision for Doubtful Debts
(Provision for doubtful debt made)