06/10/2015DEPRECIATION,PROVISIONS AND RESERVES1

1 CONCEPT OF DEPRECIATION 2 CAUSES OF DEPRECIATION 3 NEED OF DEPRECIATION 4 BASIC FACTORS 5 METHODS OF DEPRECIATION 6 PROVISION AND RESERVES 06/10/2015DEPRECIATION,PROVISIONS AND RESERVES3

DEFINITION Depreciation is the permanent decrease in the value of an asset due to use and /or the lapse of the time. CLMA, LONDON 06/10/ DEPRECIATION,PROVISIONS AND RESERVES

CAUSES OF DEPRECIATION Physical depreciation Economic factors Time factors Depletion Accident

06/10/2015DEPRECIATION,PROVISIONS AND RESERVES6 NEED FOR CHARGING DEPRECIATION To calculation the profit. True and fair view in balance sheet. Replacement of asset. Saving in income tax. Accurate ascertainment of cost.

BASIC FACTORS AFFECTING DEPRECIATION Cost of asset. Estimated working life. Salvage/Residual/Scrap value. Legal provisions Additions to assets

METHODS OF DEPRECIATION CHANGE MACHINE HOUR RATE DEPLETION REVALUATION INSURANCE POLICY DEPRECIATION FUND ANNUITY

STRAIGHT LINE METHOD Under this method,a fixed asset in written off annually so that,by the time asset is worn out,its proportion cost of the value in the book is reduced to zero. FORMULA FIXED ASSET- ESTIMATED SCRAP VALUE ESTIMATED LIFE OF ASSET 06/10/2015DEPRECIATION,PROVISIONS AND RESERVES9

MERITS AND DEMERITS 06/10/2015DEPRECIATION,PROVISIONS AND RESERVES10 MERITS- 1. Simple. 2. Asset is fully written off. 3. Knowledge of total depreciation charged. 4. Suitable for fixed life assets. DEMERITS- 1. Interest on capital. 2. Reairs and maintenance 3. Income tax

QUESTION:- A trader bought machinery on 1 st jan, 2001 for Rs whose useful life has been estimated 5 years. After the expiry of useful life, the scrap will realise Rs ANNUAL DEPRECIATION =5000 5

MACHINERY ACCOUNT DATEPARTICULARSAMTDATEPARTICULA RS AMT 2001 Jan 1 To bank a\c Dec 31 By depreciation a\c Dec 31By bal c\d Jan 1 To bal b\d Dec 31 By depreciation a\c Dec 31By bal c\d85000

Jan 1 To bal b\d Dec 31 By depreciation a\c Dec 31By bal c\d Jan 1 To bal b\d Dec 31 By depreciation a\c By bal c\d Jan 1 To bal b\d Dec 31 By depreciation a\c Dec 31By bal c\d

DIMINISHING BALANCE METHOD Depreciation is calculated at a certain percentage each year on the balance of the asset which is brought forward from the previous year. The amount of depreciation charged in each period is not fixed but it goes on decreasing gradually as the beginning balance of the asset in each year will reduce.

MERITS & DEMERITS MERITS 1. Fresh calculation of depreciation are not necessary as and when additions are made. 2. this method is recognized by the income tax authorities in India. DEMERITS 1.Its difficult to determine the suitable rate of depreciation. 2. the original cost of the asset is altogether lost sight of in subsequent years and the asset can never be reduced to zero.

QUESTION:- A company bought machinery for Rs , including a shaft Rs The machinery is subject to dep at 10% by reducing instalment method. In the beginning of the fifth year, the shaft became obsolete and instalment method. In the beginning of the fifth year, the shaft become obsolete and was sold for Rs Write up the machinery account for five years.

MACHINERY ACCOUNT DAT E PARTICULARSAMTDATEPARTICULARSAMT 1 ST YrTo bank a\c ST Yr.By depreciation a\c By bal c\d ND Yr To bal b\d ND Yr By depreciation ON By bal c\d324000

RD Yr.To bal b\d rd Yr.By Rs By bal c\d TH Yr.To bal b\d TH Yr.By Rs By bal c\d th Yr.To bal b\d TH Yr.By bank a\c8000 By profit & loss [Loss on sale of shaft] By Rs

By bal c\d

SUM OF THE DIGITS METHOD This is a variant of the reducing instalment or diminishing balance method.

QUESTION:-Suppose machinery was purchased for Rs on 1 st jan,2003 and depreciation was charged following the sum of the digits method assuming its useful life to be 3 years. Depreciation for three years will be calculated as under : DEPRECIATION FOR THE FIRST YEAR = 3 Rs =Rs SECOND YEAR = 2 Rs.60000=Rs THIRD YEAR = 1 Rs =Rs

ANNUITY METHOD Under this,amount spent on purchase of an asset is regarded as an investment which is assumed to earn interest at a certain rate. The amount to be written off as depreciation is calculated from annuity table, an extract of which is given below : Years3%3 1% 2 4%4 1% 2 5%

QUESTION:- A firm purchases a 5 yr lease for Rs.40,000 on 1 st jan. It decides to write off depreciation on annuity method,presuming the rate of interest to be 5% per annum. The annuity tables show that a sum of Rs. 9,239 should be written off every year. Show the lease account for five yr.calculation are to be made to the nearest – rupee.

DATEPARTICULARSAMTDATEPARTICULARSAMT 1 st yr Jan 1 To cash st yr Dec 31 By depreciation a\c 9239 Dec 31To interest2000Dec 31By bal c\d nd yr Jan 1 To bal b\d nd yr Dec 31 By depreciation a\c 9239 Dec 31To interest1638Dec 31By bal c\d LEASE ACCOUNT

3 rd yr Jan 1 To bal b\d rd yr Dec 31 By depreciation a\c9239 Dec 31 To interest1258Dec 31By bal c\d th yr Jan 1 To bal b\d th yr Dec 31 By depreciation a\c9239 Dec 31 To interest859Dec 31By bal c\d th yr Jan 1 To bal b\d87995 th yr Dec 31 By depreciation a\c9239 Dec 31 To interest

DEPRECIATION FUND METHOD This method is 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 asset expires, the securities are sold and with the sale proceeds a new asset is purchased. The rate of interest which is easily calculated from sinking fund tables, an extract of given below :

years3%3 1% 2 4%4 1% 2 5% SINKING FUND TABLE

QUESTION:- A company purchased a 3 years lease on January 1,2007 for Rs It is decided to provide for the replacement of lease at the end of 3 years by setting up a depreciation fund.It is expected that the investments will fetch interest at 5%. Sinking fund table show that to provide the requisite sum at 5% at the end of 3 years an investment of Rs 7932 is required every year. Investment are made to the nearest rupee. On 31 st Dec,2009 the investments were sold for Rs on 1 st January,2010, the same lease was renewed for a further period of 3 years by payment of Rs

DEPRECIATION FUND ACCOUNT 2007 Jan 1 To bal c\d Dec 31 By depreciation a\c Dec 31 To bal c\d Jan 1 By bal b\d7932 Dec 31 By bank397 Dec 31 By depreciation a\c Dec 31 To depreciation Fund investment a\c Jan 1 By bal b\d16261

Dec 31 To lease a\c25000Dec 31By bank [interest]813 Dec 31By depreciation a\c7932 Dec 31By profit & loss a\c

DEPRECIATION FUND INVESTMENT ACCOUNT 2007 Dec 31 To bank Dec 31 By bal c\d jan 1 To bal b\d Dec 31 By bal c\d16261 Dec 31To bank jan 1 To bal b\d Dec 31 By bank15250 Dec 31By depreciation fund a\c [loss transferred]

INSURANCE POLICY METHOD This method is similar to the depreciation fund method but instead of making investment, arrangement are made with an insurance company which will receive premiums annually and pay at the end of the fixed period the required amount. Premiums have to be paid at the beginning of each year.

QUESTION:-On 1 st jan. 2006,a lease of premises is purchased for four years for Rs and 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 show the necessary ledger account for four years assuming that the renewal of the lease costs Rs on

LEASE ACCOUNT 2006 Jan 1 To bank a\c dec31 By bal c\d jan 1 To bal b\d dec31 By bal c\d jan 1 To bal b\d dec31 By bal c\d jan 1 To bal b\d dec31 By bal c\d50000

DEPRECIATION RESERVE ACCOUNT 2006 Dec 31 To bal c\d Dec 31 By profit and loss a\c Dec 31 To bal c\d Jan 1 By bal b\d12000 Dec 31By profit and loss a\c Dec 31 To bal c\d Jan 1 By bal b\d24000 Dec 31By profit and loss a\c 12000

Dec 31 To lease a\c jan 1 By bal b\d36000 Dec 31By profit and loss a\c Dec 31By depreciation insurance policy a\c [profit on the realisation of policy]

REVALUATION METHOD Under this, the asset is revalued at the end of the accounting year and this value is compared with the value of the asset at the beginning of the year. The difference is treated as depreciation.this method is used in case of bottles, corks, crates or etc

QUSETION:- A company manufactures loose tools for its own use.At the end of each year, depreciation is charged on revaluation method. From the following particulars show the loose tools account : Year ended loose tools manufactured Rs.5000 [revalued on :Rs.4100]

Year ended loose tools manufactured :Rs [revalued on :Rs5700] Year ended loose tools manufactured :Rs.1000 [revalued on :Rs.6000] Year ended loose tools manufactured :Rs.1500 [revalued on : Rs.5100]

LOOSE TOOLS ACCOUNT 2006TO COST OF PRODUCTION A\C BY DEP A\C [Bal.fig.] 900 BY BAL C\D TO BAL B\D BY DEP A\C [Bal.fig.] 1100 TO COST OF PRODUCTION A\C 2700BY BAL C\D5700

To bal b\d By depreciation a\c700 To cost of production a\c 1000By bal c\d

DEPLETION METHOD This method is mostly used in case of mine, quarries; etc. from which certain quantity of output is expected to be obtained. The value of mine depends only upon quantity of minerals that can be obtained.when the whole quantity is taken,the mine loses its value.the rate of depreciation is worked out only so much per tonne. It is simply dividing the cost of the mine by the total quantity of the minerals expected to be available.

QUESTION:-A mine was acquired at a cost of Rs.20,00,000 on 1 st July It was expected it would yield 2,00,000 tons of minerals in all. The actual output was ,000 tons, ,000 tons and ,000 tons. Write up the mine account for the above years using depletion method of charging depreciation. Rate of depreciation =Rs.10 per ton

MINE ACCOUNT 2007 July 1 To bank a\c Dec 31 By depreciation a\c Dec3 1 By bal c\d Jan 1 To bal b\d Dec3 1 By depreciation a\c Dec3 1 By bal c\d

Jan 1 To bal b\d Dec 31 By depreciation a\c Dec 31By bal c\d Jan 1 To bal b\d

MACHINE HOUR RATE METHOD This method is useful in case of machines.The life of machine is fixed in terms of hours. Hourly rate of depreciation is worked out by dividing the cost of the machine by the total number of hours for which the machine is expected to be used.depreciation to be written off in a year will be ascertained by multiplying the hourly rate of depreciation by the number of hours that the machine actually runs in the year.

QUESTION:- A machine was acquired on 1 st April,2008 at a cost of Rs 90,000, the cost of installation being Rs It is expected that its total life will be 20,000 hours. During 2008 it worked for 5,000 hours and during 2009 for 8,000 hours. Write up the machinery account for 2008 & Machine hour rate= Rs 5 per hour

MACHINERY ACCOUNT 2007 Ap 1 To bank a\c [cost and installation charges] Dec 31By depreciation a\c Dec31By bal c\d Jan 1 To bal b\d Dec31 By depreciation a\c Dec31By bal c\d Jan 1 To bal b\d35000

CHANGE OF METHOD Sometimes the method is changed either from straight line method to diminishing balance method or from diminishing balance method to straight line method with effect from the current year or with retrospective effect.if the change is from current year then there will be no problem but simply to change the method of depreciation.

QUESTION:- Plant and machinery account of a company had a debit balance of Rs. 1,47,390 on 1 st jan,2009.The company was incorporated in 2006 and has been following the practice of charging full year, depreciation every year on diminishing balance In 2009 it was, however decided to change the method from reducing system to straight line with retrospection effect from 2006 and to give effect of the change while preparing the final accounts for the year ended 31 st dec,2009, the rate of depreciation remaining same as before. In 2009, new machineries were purchased at a cost of Rs.50,000. All the other machineries were acquired in Show Plant and machinery account from 2006 to 2009.

PLANT AND MACHINERY ACCOUNT 2006 Jan 1 TO BANK A\C Dec31 BY DEP A\C [15% on Rs ] Dec31BY BALC\D Jan 1 TO BAL B\D Dec31 BY DEP A\C [15% on Rs Dec31BY BAL C\D173400

Jan 1 To bal b\d Dec 31 By depreciation a\c [15% on Rs Dec 31 By bal c\d Jan 1 To bal b\d Dec 31 By profit and loss a\c [additional dep] Jan 1To bank a\c [Additions] 50000Dec3 1 By depreciation a\c [15%on ] 43500

Dec 31By bal c\d

PROVISIONS AND RESERVES MEANING OF PROVISIONS The term “provision” means any amount written off or retained by way of providing depreciation,renewals or diminution in the value of assets or retained by way of providing for any know liability the amount of which may not be determined with substantial accuracy

Question:- A firm desires to debit its profit and loss account with a uniform figure every year in respect of repairs and renewals. It expects that considering the life of the asset in question Rs.10,000 will be the average amount to spent per year. Actual repairs are Rs.1,000 in the first year, Rs.2,300 in the second year and Rs.3,700 in the third year. Show the provision for repairs and renewals account.

FOR REPAIRS AND RENEWALS ACCOUNT YEAR 1 To bank [Repairs]1000YEAR 1 By profit and loss a\c To bal c\d To bank [Repairs]23002By bal b\d9000 To bal c\d16700By profit and loss a\c

3To bank [Repairs]37003By bal b\d16700 To bal c\d23000By profit and loss a\c

MEANING OF RESERVE Any sum which is appropriated out of profit and loss appropriation account and is not meant to cover up liability,contingency,commitment,or reduction in the value of an asset is a reserve.

QUESTION:- Show the distinction between sinking fund to repay a liability and sinking fund to replace a wasting asset by the operation of ledger account at the end of five years in the following cases: 1. sinking fund to replace leasehold property valued Rs at the end of five years. 2. sinking fund to repay Rs debentures at the end of five years.

To old lease a\c [transfer] By bal b\d Sinking fund [to replace an asset at the end of five years] OLD LEASE ACCOUNT To bal b\d900000By sinking fund a\c [transfer] To bank a\c NEW LEASE ACCOUNT 2. Sinking fund [to repay a liability at the end of five years] To reserve fund [transfer] By bal b\d DEBENTURES ACCOUNT To bank a\c900000By bal b\d900000