Key Notes: Depreciation, Provisions and Reserves | Accountancy Class 11 - Commerce PDF Download

Introduction

• The matching principle states that revenue generated in a specific time frame should be compared with the expenses incurred during the same time frame.
• This principle is essential for accurately determining the profit or loss for that period.
• Costs benefiting multiple accounting periods should not be entirely listed as expenses in the year they occur; instead, they should be distributed across the periods they benefit.
• Depreciation on fixed assets is a key example of this principle in action.
• The principle of conservatism suggests making provisions for uncertain costs instead of ignoring them, allowing for a more realistic representation of profits.
• A portion of the profits may be retained as reserves to support future growth or address specific needs.

Depreciation

• Depreciation refers to the decline in the value of fixed assets due to usage, time passage, or obsolescence.
• Fixed assets, also called depreciable assets, are used in business for more than one accounting year, and their value decreases over time.
• For example, if a business buys a machine for ₹1,00,000, its value declines due to usage or the introduction of newer models.
• Depreciation is an accounting term representing the portion of a fixed asset's cost that has expired due to usage and/or the passage of time.
• It is deducted from the revenue of a specific accounting period, impacting the profit calculated.
• If a machine costing ₹1,00,000 is purchased on April 1, 2017, with an estimated useful life of 10 years, only ₹10,000 (one-tenth of ₹1,00,000) is charged against the revenue for 2017-18.
• This amount reflects the expired cost of the machine's value due to usage or time and is recorded as depreciation on the Income Statement.

Definition of Depreciation

• Depreciation is the gradual and permanent decrease in the book value of fixed assets over time.
• It is based on the cost of assets used in a business, not their market value.
• According to the Institute of Cost and Management Accounting, London, depreciation results from usage and/or the passage of time.
• Accounting Standard-6 defines depreciation as a measure of the wearing out, consumption, or loss of value of a depreciable asset.
• Depreciation is allocated to charge a fair proportion of the depreciable amount in each accounting period during the asset's expected useful life.
• It also includes the amortization of assets with a predetermined useful life.

Features of Depreciation

• Decline in Book Value: Depreciation represents the decrease in the book value of fixed assets over time.
• Causes of Value Loss: Loss of value can occur due to time, usage, or obsolescence. For instance, an older machine's value declines when a newer model is released.
• Continuing Process: Depreciation is a continuous process that occurs over time.
• Expired Cost: It is considered an expired cost deducted before calculating taxable profits. For example, if the profit before depreciation is ₹50,000 and the depreciation is ₹10,000, the profit before tax is ₹40,000.
• Non-Cash Expense: Depreciation does not involve cash outflow; it is the process of writing off capital expenditure already incurred.

Depletion

• Refers to the reduction in the quantity of natural resources such as minerals or fossil fuels due to extraction.
• Example: Purchasing a coal mine for ₹10,00,000, which decreases in value as coal is extracted.
• Depletion focuses on the exhaustion of economic resources.

Amortisation

• Involves writing off the cost of intangible assets like patents, copyrights, trademarks, franchises, and goodwill over a specified period.
• Similar to depreciation but applies to intangible assets.
• Example: A patent bought for ₹10,00,000 with an estimated useful life of 10 years results in an annual amortisation of ₹1,00,000.

Causes of Depreciation

Wear and Tear

• Occurs due to usage in business operations, leading to deterioration and loss of value.
• Physical deterioration can also happen over time, regardless of use.

Expiration of Legal Rights

• Assets may lose value when legal agreements expire, such as patents and copyrights.

Obsolescence

• Occurs when an asset becomes outdated due to better alternatives becoming available.
• Can result from technological advancements, changes in market demand, or legal regulations.

Abnormal Factors

• Includes unexpected events like accidents or natural disasters that reduce an asset's usefulness.
• Example: A car damaged in an accident may not retain its market value, even if repaired.

Need for Depreciation

Matching Costs and Revenue

• Fixed assets generate revenue but lose value over time; depreciation is needed to reflect this loss in financial statements.

Consideration of Tax

• Depreciation can be deducted for tax purposes, although the calculation method may differ from accounting practices.

True and Fair Financial Position

• Accurate accounting of depreciation prevents overvaluation of assets on the balance sheet.

Compliance with Law

• Certain laws require businesses to account for depreciation, ensuring legal compliance.

Factors Affecting the Amount of Depreciation

Cost of Asset

• Includes invoice price and all costs necessary to make the asset operational, such as transportation, installation, and commissions.
• Example: A photocopy machine costing ₹50,000 with ₹5,000 in transportation costs has a total cost of ₹55,000 for depreciation purposes.

Estimated Net Residual Value

• Also known as scrap value, it is the estimated value of an asset at the end of its useful life, after deducting disposal expenses.
• Example: A machine bought for ₹50,000 with an expected sale value of ₹6,000 and disposal costs of ₹1,000 has a net residual value of ₹5,000.

Depreciable Cost

• Calculated by subtracting the net residual value from the cost of the asset.
• Example: A machine costing ₹50,000 with a net residual value of ₹5,000 has a depreciable cost of ₹45,000.

Estimated Useful Life

• Refers to the expected economic lifespan of an asset, which may differ from its physical durability.
• Example: A production machine may still be functional after five years but may not be economically viable, defining its useful life as five years.
• Factors influencing useful life include legal limits, usage levels, and advancements in technology.

Methods of Calculating Depreciation Amount

• The calculation of depreciation is determined by the depreciable amount and the method of allocation.
• In India, the two main methods mandated by law are:
  1. Straight Line Method
  2. Written Down Value Method
• Other methods include:
  1. Annuity Method
  2. Depreciation Fund Method
  3. Insurance Policy Method
  4. Sum of Years Digit Method
  5. Double Declining Method
• Selection Criteria for the method include:
  1. Type of Asset
  2. Nature of Use
  3. Business Circumstances

Straight Line Method

• The Straight Line Method is one of the most commonly used methods for calculating depreciation.
• This method assumes that an asset is used equally throughout its entire useful life.
• It is referred to as "straight line" because the depreciation amount plotted over time forms a straight line.
• This method is also known as the fixed installment method, as the depreciation amount remains constant each year.
• Annual depreciation is calculated to reduce the asset's original cost to its scrap value by the end of its useful life.
• It can also be termed as the fixed percentage on original cost method.
• The annual depreciation amount is calculated using the following formula:
  • Annual Depreciation = (Cost of Asset - Scrap Value) / Useful Life
• Example: If the original cost of the asset is ₹2,50,000, the useful life is 10 years, and the net residual value is ₹50,000:
  • Annual Depreciation = (₹2,50,000 - ₹50,000) / 10 = ₹20,000

Advantages of the Straight Line Method:

• Simplicity and Ease of Understanding: It is straightforward to comprehend.
• Full Depreciable Cost Distribution: Allows for the distribution of the full depreciable cost over the asset's useful life.
• Consistent Annual Charges: The same amount is charged each year, aiding in profit comparison.
• Suitability for Certain Assets: Ideal for assets with a well-defined useful life and consistent usage.

Limitations of the Straight Line Method:

• Assumption of Uniform Utility: It assumes an asset's utility remains constant, which is often not true.
• Decreasing Work Efficiency: As an asset ages, its efficiency typically declines, making this method less accurate over time.

Written Down Value Method

• In the Written Down Value Method, depreciation is charged on the book value of the asset.
• This method is also known as the reducing balance method because the book value decreases each year.
• Depreciation is calculated using a fixed percentage of the book value at the beginning of each accounting period.
• Example: If the original cost of the asset is ₹2,00,000 and depreciation is charged at 10% per annum:
  • Year 1: Depreciation = ₹2,00,000 * 10% = ₹20,000, Book Value = ₹1,80,000
  • Year 2: Depreciation = ₹1,80,000 * 10% = ₹18,000, Book Value = ₹1,62,000
• The rate of depreciation is computed as follows:
  • Rate of Depreciation = (Cost - Scrap Value) / Useful Life
• Example: For a truck costing ₹9,00,000 with a salvage value of ₹50,000 after 16 years:
  • Rate of Depreciation = (₹9,00,000 - ₹50,000) / 16 = ₹53,125 per year (initially)

Advantages of Written Down Value Method:

• Realistic Cost Allocation: This reflects the diminishing utility of an asset over time.
• Balanced Expense Burden: Results in an equal burden of depreciation and repair expenses.
• Tax Acceptance: This method is accepted by the Income Tax Act for tax purposes.
• Reduced Obsolescence Loss: This minimises loss due to obsolescence as a larger portion is written off earlier.
• Suitable for Long-lasting Assets: Effective for fixed assets with long lifespans that incur increasing repair costs.

Limitations of the Written-Down Value Method:

• Incomplete Cost Recovery: Depreciation is calculated as a fixed percentage of the written-down value, which means the asset’s value can never fully reach zero.
• Difficulty in Setting Depreciation Rate: Determining an appropriate depreciation rate for the asset can be challenging.

Straight Line Method vs. Written Down Value Method

Basis of Charging Depreciation:

• In the straight-line method, depreciation is based on the original cost or historical cost of the asset.
• In the Written Down Value Method, depreciation is charged on the net book value, which is the original cost minus accumulated depreciation at the beginning of the year.

Annual Charge of Depreciation:

• Under the Straight Line Method, the annual depreciation amount remains fixed each year.
• In the Written Down Value Method, the annual depreciation amount is highest in the first year and decreases in subsequent years.

Total Charge Against Profit and Loss Account:

• Under the Straight Line Method, total charges for depreciation and repair expenses increase in later years due to fixed annual depreciation and rising repair expenses.
• In contrast, under the Written Down Value Method, depreciation charges decrease in later years, leading to consistent total charges year after year.

Recognition by Income Tax Law:

• The Straight Line Method is not recognized by Income Tax Law.
• The Written Down Value Method is recognized by Income Tax Law.

Suitability:

• The Straight Line Method is suitable for assets with low repair charges and low obsolescence risk, such as freehold land, buildings, patents, and trademarks.
• The Written Down Value Method is suitable for assets affected by technological changes and that incur increasing repair expenses over time, such as plant, machinery, and vehicles.

Methods of Recording Depreciation

Charging Depreciation to Asset Account:

• Depreciation is deducted from the depreciable cost of the asset.
• The asset account is credited with the depreciation amount, and the same amount is charged to the profit and loss account.

Balance Sheet Treatment:

• The fixed asset appears at its net book value (cost less depreciation charged to date) on the asset side of the balance sheet.

Creating Provision for Depreciation Account:

• This method accumulates depreciation in a separate account, known as the provision for depreciation account.
• The asset account remains at its original cost throughout its useful life.
• This method provides a clear picture of the asset’s value and the total depreciation accumulated over time.

Balance Sheet Treatment:

• The fixed asset continues to appear at its original cost on the asset side of the balance sheet.
• The depreciation charged appears in the provision for depreciation account, shown either on the liabilities side or deducted from the original cost of the asset on the asset side.

Example of Recording Depreciation:

M/s Singhania and Bros. purchased a plant for ₹5,00,000 and spent ₹50,000 for installation. The salvage value is estimated to be ₹10,000 after 10 years. Depreciation is charged using the straight-line method.

Depreciation Calculation:

• Original Cost = ₹5,00,000 + ₹50,000 = ₹5,50,000.
• Annual Depreciation = (Original Cost - Salvage Value) / Useful Life = (₹5,50,000 - ₹10,000) / 10 = ₹54,000.

Disposal of an Asset:

• Disposal can occur at the end of an asset’s useful life or during its life due to obsolescence.
• If sold at the end of its useful life, the amount realized as scrap is credited to the asset account, and the remaining balance is transferred to the profit and loss account.
• If using the provision for depreciation account, the balance is transferred to the asset account before recording the sale.

Asset Disposal Account:

This account provides a clear view of all transactions involved in the sale of an asset.

Key factors include:

• Original cost of the asset.
• Accumulated depreciation up to the date of sale.
• Sale price of the asset.
• Value of any retained parts of the asset.
• Resultant profit or loss on disposal.

The balance in this account is transferred to the profit and loss account.

Effect of Additions or Extensions to Existing Assets

• When an existing asset requires additions or extensions to be operational, the costs incurred are capitalized and depreciated over the asset's life.
• These costs are distinct from regular repair and maintenance expenses.
• According to AS-6 (Revised)Guidelines:
  • If an addition or extension becomes an integral part of the asset, it should be depreciated over the asset's useful life.
  • Depreciation for such additions/extensions can occur at the same rate as the existing asset.
  • If an addition retains its separate identity and can be used after the asset is disposed of, it should be depreciated independently based on its own useful life.
• Example: M/s Digital Studio bought a machine for ₹8,00,000 on April 01, 2013. Depreciation was provided on a straight-line basis at a rate of 20% on original cost. On April 01, 2015, a modification was made at a cost of ₹80,000, which is to be depreciated at 20% on a straight-line basis. Routine maintenance expenses for the year 2013-14 amounted to ₹2,000.

Provisions and Reserves

• Provisions are made for expenses or losses related to the current accounting period but whose amounts are uncertain because they have not yet been incurred.
• An example of this is a Provision for Doubtful Debts, created to account for expected losses.
• Other examples of provisions include:
  1. Provision for depreciation
  2. Provision for bad and doubtful debts
  3. Provision for taxation
  4. Provision for discount on debtors
  5. Provision for repairs and renewals
• The importance of provisions lies in ensuring the proper matching of revenue and expenses, which is essential for calculating true profits.
• Provisions are created by debiting the profit and loss account and can be presented in the balance sheet as:
  1. A deduction from the concerned asset on the assets side (e.g., provision for doubtful debts is deducted from sundry debtors).
  2. On the liabilities side of the balance sheet,t along with current liabilities (e.g., provision for taxes and repairs).

Accounting Treatment for Provisions

• Good Debtors: Debtors from whom the collection of debt is certain.
• Bad Debts: Debtors from whom collection is not possible, leading to certain losses for the business.
• Doubtful Debts: Debtors who may or may not pay the full amount owed. A certain percentage of these debtors are unlikely to pay, necessitating a provision for doubtful debts.
• To account for the potential loss from non-payment, a provision for doubtful debts is typically calculated as a percentage of the total amount due from sundry debtors after deducting known bad debts.
• To create this provision, the required amount is debited to the profit and loss account and credited to the provision for doubtful debts account.
• Example: For Trehan Traders on March 31, 2014, if bad debts amounted to ₹8,000, and the provision is to be maintained at 10% of debtors (₹68,000), then the provision is calculated as ₹60,000 (₹68,000 - ₹8,000).

Reserves

• A portion of profit may be set aside as reserves to provide for future needs like growth, expansion, or to meet contingencies such as workmen's compensation.
• Unlike provisions, reserves are appropriations of profit designed to strengthen the financial position of the business and are not a charge against profit.
• Reserves reduce the amount of profit available for distribution among owners of the business and are shown under the head Reserves and Surpluses on the liabilities side of the balance sheet after capital.
• Examples of reserves include:
  1. General reserve
  2. Workmen compensation fund
  3. Investment fluctuation fund
  4. Capital reserve
  5. Dividend equalization reserve
  6. Reserve for the redemption of a debenture

Difference between Reserve and Provision

• Basic Nature: Provision is an expense deducted from profit, while a reserve is a portion of profit set aside.
• Purpose: Provisions are made for known liabilities or expenses in the current accounting period, while reserves are created to strengthen the financial position of the business.
• Presentation in Balance Sheet: Provisions are presented by deducting from related asset items or on the liabilities side. Reserves are shown on the liabilities side after capital.
• Effect on Taxable Profits: Provisions reduce taxable profits, whereas reserves do not impact taxable profit.
• Element of Compulsion: Creating a provision is necessary to ensure a true and fair profit or loss, while reserves are typically at management's discretion.
• Use for Dividend Payment: Provisions cannot be used for dividend distribution, whereas reserves can be utilized for this purpose.

Types of Reserves

• A reserve is formed by retaining the profits of a business and can be designated for either a general or specific purpose.

General Reserve

• Created without a specified purpose.
• Also known as a free reserve because it can be used for any purpose.
• Enhances the financial position of the business.

Specific Reserve

• Created for a particular purpose and can only be used for that purpose.
• Examples include:
  1. Dividend Equalisation Reserve: Stabilizes the dividend rate by transferring amounts during high-profit years to maintain the dividend rate during low-profit years.
  2. Workers Compensation Fund: Established to cover claims made by workers due to accidents or incidents.
  3. Investment Fluctuation Fund: Addresses declines in the value of investments due to market fluctuations.
  4. Debenture Redemption Reserve: This is set up to provide funds for redeeming debentures.
• Reserves are categorized into revenue reserves and capital reserves based on the nature of the profit from which they are created.

Revenue Reserves

• Created from revenue profits arising from the normal operating activities of the business.
• Generally available for distribution as dividends.
• Examples include:
  1. General Reserve
  2. Workmen Compensation Fund
  3. Investment Fluctuation Fund
  4. Dividend Equalisation Reserve
  5. Debenture Redemption Reserve

Capital Reserves

• Created from capital profits that do not arise from normal operating activities.
• Not available for distribution as dividends.
• It can be used for writing off capital losses or issuing bonus shares.
• Examples of capital profits include:
  1. Premium on the issue of shares or debentures
  2. Profit on the sale of fixed assets
  3. Profit on the redemption of debentures
  4. Profit on the revaluation of fixed assets and liabilities
  5. Profits prior to incorporation
  6. Profit on the reissue of forfeited shares
• Difference between Revenue and Capital Reserve
• Source of Creation
  1. Revenue Reserve: Created from revenue profits, which come from normal operating activities and are available for dividend distribution.
  2. Capital Reserve: Created from capital profits, which do not arise from regular business activities and are not available for dividend distribution.
• Purpose
  • Revenue Reserve: Established to strengthen the financial position, address unforeseen contingencies, or for specific purposes.
  • Capital Reserve: Set up to comply with legal requirements or accounting practices.
• Usage
  • A specific revenue reserve can only be used for its designated purpose, while a general reserve can be used for any purpose, including dividend distribution.
  • Capital Reserve: Can be used for specific purposes as per the law, like writing off capital losses or issuing bonus shares.
• Importance of Reserves
  • Helps businesses protect themselves from unknown expenses and losses they may face in the future.
  • Allows businesses to conserve resources by reducing the amount drawn as profit for future significant demands, such as expansion.
  • Reserves serve multiple purposes, including:
    1. Meeting future contingencies
    2. Strengthening the general financial position of the business
    3. Redeeming long-term liabilities like debentures
• Secret Reserve
  • A secret reserve is a hidden reserve that is not shown in the balance sheet.
  • Helps reduce disclosed profits and tax liability.
  • During lean periods, secret reserves can be combined with profits to show improved financial results.
  • Management may create secret reserves by:
    1. Charging higher depreciation than necessary.
    2. Undervaluing inventories or stock.
    3. Charging capital expenditure to the profit and loss account.
    4. Making excessive provisions for doubtful debts.
    5. Showing contingent liabilities as actual liabilities.
  • Creating secret reserves within reasonable limits is justifiable for expediency, prudence and to prevent competition from other firms.