Depreciation, Provision & Reserves

Depreciation, Provision and Reserves

Concept of Depreciation Depreciation is a permanent, continuing and gradual shrinkage in the book value of a fixed asset. It is charged on fixed asset only. The Institute of Chartered Accountants of India defines depreciation as “a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, affluxion of time or obsolescence through technology and market changes.”

Causes of Depreciation Physical depreciation – It is caused mainly from wear and tear when the asset is in use and from erosion, rust, rot and decay from being exposed to wind, rain, sun and other elements of nature. Economic factors – These may be said to be those that cause the asset is in use even though it is in good physical condition. Time factors – There are certain assets with a fixed period of legal life such as lease, patents, and copyrights.

Cause of Depreciation Depletion – Some assets are of a wasting character perhaps due to extraction of raw materials from them. Accident – An asset may reduce in value because of meeting of an accident. Depreciation Accounting – It is a process of allocation, not of valuation.

Need for Depreciation Accounting To know true profits – Though it is not visible like other expenses and never paid to the outside party yet it is desirable to charge depn. On fixed assets as these are used for earning purposes. To show true financial position – If assets are shown in the balance sheet without any charge made for their use or depn., then their value value will be overstated and balance sheet wont reflect true financial position. To make provision for replacement of assets – if depreciation Isn't provided, the profits of the concern will be overstated and can be distributed to the shareholders as dividend.

Methods of Depreciation Fixed Installment or Straight line method – Under this method a fixed percentage of the original value of the asset is written off every yr. so as to reduce the asset A/c to nil or to its scrap value at the end of the estimated life of the asset. Depreciation = Cost price of asset – scrap value Estimated life of asset

Fixed Installment Method Merits : It is simple to understand and easy to apply. It can write down an asset to 0 at the end of its working life. Demerits: It becomes difficult to calculate the depn. On additions made during the yr. It does not provide funds for replacement of assets.

Fixed Installment Method example ABC ltd. Purchased on 1st Apr 09 a small plant for Rs.4500. On 1st Oct 09 additional plant was purchased costing Rs.22500. On 1st Oct 10, plant purchased on 1st Apr 09 having become obsolete, was sold for Rs.18000. On 1st Oct 11 fresh plant was purchased for Rs.54000 and the plant on 1st Oct 09 was sold for Rs.18900. Depreciation is provided at 10% every yr. on 31st Mar 12

Fixed Installment Method example Machinery account Dt. Pt. Amt. 1.4.09 1.10.09 1.4.10 To bank To bal b/d 45000 22500 -------------- 67500 61875 31.3.10 1.10.10 By depreciation (4500+1125) By bal c/d By bank By P/L (loss) 5625 18000 20250 2250 19125

Diminishing Balance method It is also called Reducing Installment or Written Down Value method – Under this method, depn. Is calculated at a certain % each yr. on the balance of the asset which is brought forward from previous yr. Merits - It doesn’t provide for replacement of asset on the expiry of its useful life. It is recognized by the income tax authorities in India.

Diminishing Balance Method Demerits – As compared to the straight line method, its difficult to determine the suitable rate of depn. This method doesn’t take into consideration the asset as an investment and interest isn’t taken into consideration.

Diminishing Balance method example Bajaj & co. close their accounts on 31.3 every yr. they purchased the machineries as follows : Purchased machineries costing rs.120000 on 1.7.09 On 1.1.10 some machines were purchased costing rs.120000 On 1.1.10 again purchased some machinery costing rs.20000 On 1.1.12 purchased a new machine for rs.60000 One machine costing rs.40000 which was purchased on 1.7.09 was sold for rs.12000 on 1.4.11 They charge depn. @ 33.33% on written down value method. Prepare machinery a/c in the books of Bajaj & co. for the 3 yrs. Ending 31.3.12

Diminishing Balance method example Machinery account Dt. Pt. Amt. 1.7.09 1.1.10 1.4.10 1.10.10 1.4.11 1.1.12 To cash To bal b/d 120000 -------------- 240000 160000 20000 180000 60000 31.3.10 “ 31.3.11 31.3.12 By depn. (33.33% of 240000) By bal c/d (33.33% of 180000) By cash By P/L 80000 12000 5778 54074 108148

Sum of Digits method This is a variant of the reducing installment method. Depreciation Is calculated in this as follows : Depreciation = No. of yrs. Of the remaining life of the asset including the current yr. Amt. to be X -------------------------------------- written off The total of all the digits representing the life of the asset (in yrs.)

Depreciation Fund Method The method implies that the amount written off as depreciation Should be kept aside and invested in readily saleable securities. The securities accumulate and when the life of the asset expires, the securities are sold and the sale proceeds a new asset is purchased. Example: A lease purchased on 1.4.08 for 4 yrs. At a cost of Rs.500000. It was decided to provide for replacement of Lease by setting up Depn. Fund. It was expected that investment will fetch interest. @ 10%. Sinking fund table show that Rs.0.215471 invested each yr. will provide rs.1 at the end of 4 yrs. A 10% p.a. Interest. Was receivable on 31.3. On 31.3.12 the investment was sold at a profit of rs.5000. Prepare lease account , depreciation s fund account depn. Fund investment account assuming that the investments are made as multiple of Rs.100 .

Depreciation Fund Method example Lease account Dt. Pt. Amt. 1.4.08 1.4.09 1.4.10 1.4.11 To bank To bal b/d 500000 -------------- 31.3.09 31.3.10 31.3.11 31.3.12 By bal c/d By Depn. Fund a/c

Depreciation Fund Method example Depreciation Fund account Dt. Pt. Amt. 31.3.09 31.3.10 31.3.11 31.3.12 “ To bal c/d To lease To P/L 107736 -------------- 226242 356598 500000 4994 504994 1.4.10 1.4.11 1.4.12 By depn. By bal b/d By bank (interest. on 107700 @ 10%) By bank (interest. on 226242 @ 10%) By bank (interest. on 356600 @ 10%) By depn. Fund Investment a/c 10770 107336 22620 --------------356598 35660 5000

Depreciation Fund Method example Depreciation Fund Investment account Dt. Pt. Amt. 31.3.09 1.4.10 31.3.10 1.4.11 31.3.12 1.4.12 To bank To bal b/d To bank (107736+10770=118506) To depn. Fund a/c (profit) 107700 -------------- 118500 226200 130400 356600 5000 361600 31.3.11 By bal c/d By bank

Insurance Policy Method This method is similar to the Depreciation Fund method but instead of making investment, arrangements are made with an insurance company which will receive premiums annually and pay at the end of fixed period the required amount . Example: On 1.1.08 a lease of premises is purchased for 4 yrs. For Rs.50000 & it is decided to make provision for the replacement of the lease by means of an insurance policy purchased for an annual premium of Rs.12000.Assume that the renewal of the lease costs Rs.50000 on 1.1.12

Insurance Policy Method example Lease account Dt. Pt. Amt. 1.1.08 1.1.09 1.1.10 1.1.11 To bank To bal b/d 50000 -------------- 31.12.08 31.12.09 31.12.10 31.12.11 By bal c/d By depn. Reserve a/c

Insurance Policy Method example Depreciation Reserve account Dt. Pt. Amt. 31.12.08 31.12.09 31.12.10 31.12.11 To bal c/d To lease a/c 12000 -------------- 24000 36000 50000 1.1.09 1.1.10 1.1.11 “ By P/L a/c By bal b/d By depn. Insurance policy a/c 2000

Insurance Policy Method example Insurance Policy account Dt. Pt. Amt. 1.1.08 1.1.09 1.1.10 1.1.11 “ 31.12.11 To bank To bal b/d To depn. Reserve a/c (profit) 12000 -------------- 24000 36000 2000 50000 31.12.08 31.12.09 31.12.10 By bal c/d

Depletion Method This method is mostly used in case of mines, quarries etc. from which a certain quantity of output is expected to be obtained. The rate of depn. Is worked out only so much per tonne. Example: A mine was acquired at a cost of rs.2000000 on 1.7.09. It was expected it would yield 200000 tons of minerals in all. The actual output was 09-10000 tons, 10-40000 tons and 11-32000 tons. Write up Mine a/c

Depletion Method example Cost of mine Rate of Depreciation . = ------------------------------------- Estimated quantity to be raised Mine account Dt. Pt. Amt. 1.7.09 1.1.10 1.1.11 1.1.12 To bank To bal b/d 2000000 -------------- --------------1900000 1900000 1500000 1180000 31.12.09 31.12.10 “ 31.12.11 By depn. By bal c/d 100000 400000 1100000

Asset Disposal account Sometimes a part of machinery is disposed off then it is better to open a Mach. Disposal a/c. The book value less depn. for the discarded portion should be debited to this a/c. Example: The cost of the machinery in use with the firm on 1.4.11 was rs.625000 against which the depn. Prov. Stood at rs.262500 on that date; the firm provided depn. At 10% of the diminishing value. On 31.12.11 two machines costing rs.15000 & rs.12000 both purchased on 1.10.08 had to be discarded because of damage & had to be replaced by two new machines costing rs.50000 & rs.37500. One of the discarded machines was sold for rs.20000 against the other it was expected that rs.7500 would be realisable.

Asset Disposal account ( example) Machinery account Dt. Pt. Amt. 1.4.11 31.12.11 To bal b/d To bank 625000 87500 -------------- 712500 31.3.12 By Mach. Disposal a/c By bal c/d 27000 685500 Provision for Depreciation account Dt. Pt. Amt. 31.12.11 31.3.12 To Machinery Disposal a/c To bal c/d 6224 292635 -------------- 298859 1.4.11 By bal b/d By depn. a/c 262500 36359

Asset Disposal a/c example Machinery Disposal a/c Dt. Pt. Amt. 31.12.11 31.3.12 To mach. a/c To P/L a/c 27000 8282 -------------- 35282 “ By prov. For depn. By depn (for 2 machines for 9 months) By bank By bal c/d 6224 1558 20000 7000

Provisions and Reserves

Provisions It means any amt. written off or retained by way of providing depn., renewals or diminution in the value of assets or retained by way of providing for any known liability the amt. of which may not be determined with substantial accuracy. Example: A firm desires to debit its P/L a/c with a uniform figure every yr. in respect of repairs & renewals. It expects that considering the life of the asset in question rs.10000 will be the avg. amt. to be spent per yr. Actual repairs are rs.1000in the 1st yr., rs.2300 in the 2nd yr. & rs.3700 in the 3rd yr. Show the Provisions for repairs & renewals a/c.

Provisions example Provision for Repairs & Renewals a/c Dt. Pt. Amt. Yr.1 Yr.2 Yr.3 To bank (repairs) To bal c/d 1000 9000 -------------- 10000 2300 16700 19000 3700 23000 26700 By P/L a/c By bal b/d

Reserves Any sum which is appropriated out of P/L Appropriation a/c & isn’t meant to cover up liability, contingency, commitment or reduction in the value of an asset is a reserve. Types of reserves : Capital reserve- Any reserve which is created out of capital profits as against trading or revenue profit & isn’t readily available for distribution as dividend among the shareholders. Revenue reserve-Any reserve which is available for distribution as dividend to the shareholders.

Reserves Secret reserve- It’s a reserve the existence & or the amt. of which cant be disclosed in the balance sheet. General reserve- These are those reserves which aren't created for a specific purpose & are available for any future contingency or expansion of business. Specific reserves- These are those reserves which aren’t created for a specific purpose & can be utilized for only that purpose. Investment reserves- These are created to have a ready money after a particular period either for a replacement of an asset or for the repayment of a liability.