1. Depreciation,
Provision
&
Reserves

2. Depreciation, Provision and Reserves

3. 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.”

4. 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.

5. 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.

6. 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.

7. 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

8. 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.

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

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

11. 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.

12. 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.

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

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

15. 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.)

16. 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 for 4 yrs. At a cost of Rs It was decided to provide for replacement of Lease by setting up Depn. Fund. It was expected that investment will fetch 10%. Sinking fund table show that Rs invested each yr. will provide rs.1 at the end of 4 yrs. A 10% p.a. Interest. Was receivable on On the investment was sold at a profit of rs Prepare lease account , depreciation s fund account depn. Fund investment account assuming that the investments are made as multiple of Rs.100 .

17. 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
By bal c/d
By Depn. Fund a/c

18. Depreciation Fund Method example
Depreciation Fund account
Dt.
Pt.
Amt. “
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 10%)
By bank (interest. on 10%)
By bank (interest. on 10%)
By depn. Fund Investment a/c
10770
107336
22620
35660
5000

19. Depreciation Fund Method example
Depreciation Fund Investment account
Dt.
Pt.
Amt.
1.4.10
1.4.11
1.4.12
To bank
To bal b/d
To bank ( =118506)
To depn. Fund a/c (profit)
107700
118500
226200
130400
356600
5000
361600
By bal c/d
By bank

20. 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 a lease of premises is purchased for 4 yrs. For Rs & 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 Assume that the renewal of the lease costs Rs on

21. 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
By bal c/d
By depn. Reserve a/c

22. Insurance Policy Method example
Depreciation Reserve account
Dt.
Pt.
Amt.
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

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

24. 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 on It was expected it would yield tons of minerals in all. The actual output was tons, tons and tons. Write up Mine a/c

25. 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 “
By depn.
By bal c/d
100000
400000

26. 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 was rs against which the depn. Prov. Stood at rs on that date; the firm provided depn. At 10% of the diminishing value. On two machines costing rs & rs both purchased on had to be discarded because of damage & had to be replaced by two new machines costing rs & rs One of the discarded machines was sold for rs against the other it was expected that rs.7500 would be realisable.

27. Asset Disposal account ( example)
Machinery account
Dt.
Pt.
Amt.
1.4.11
To bal b/d
To bank
625000
87500
712500
By Mach. Disposal a/c
By bal c/d
27000
685500
Provision for Depreciation account
Dt.
Pt.
Amt.
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

28. Asset Disposal a/c example
Machinery Disposal a/c
Dt.
Pt.
Amt.
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

29. Provisions and Reserves

30. 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 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.

31. 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

32. 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.

33. 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.