CHAPTER 7- DEPRECIATION
Q.I. Explain the concept of depreciation. What is the need for charging depreciation
and what are the causes of depreciation ?
Ans.With the exception of land. all fixed assets have a limited useful life. When a
fixed asset is put to use a part of its value is lost and cannot be recovered Such o loss in
the value of an asset is known as depreciation. Depreciation may be defined as a gradual
decrease in the value of a fixed asset from wear and tear. exhaustion. obsolescence etc.
According to Accounting Standard. "Depreciation is a measure of wearing out
consumption or other loss of value of depreciable asset arising from use. effluxion of time
or obsolescence through technology and market changes."
To provide depreciation is necessary for the follow ing purposes ;
(1)
To ascertain I rue income — As per matching principle. all costs must be
recorded which arc incurred to earn revenue. Since depreciation is an expense.
depreciation should be correctly estimated and charged to revenue so as to ascertain true
results of operations. The Profit and Loss Account will not present a Lure and fair view of
the results of operation if depreciation is not ascertained correctly.
(2)
To show true and fair view of financial position-The financial position of
an enterprise is depicted by the Balance Sheet. While preparing Balance Sheet. it is
necessary that fixed assets are shown at figures derived after deducting depreciation from
their book values. In the absence of depreciation charge. the asset will be shown at its
original cost
(3)
To ascertain the correct cost of production —A manufacturing enterprise
must know the correct cost of production for various purposes. If depreciation of assets is
not included in the cost. cost of production will be underestimated. Prices may be fixed
below actual cost. Further. management will not have reliable data for decision-making.
(4)
To comply with legal requirements —According to Section 205 of the
Companies Act. a company has to provide for depreciation before it declares dividend
Income Tax Act also provides for depreciation as a charge against revenues for
calculating tax liability.
Following arc the causes of depreciation :
(i) Wear and tear due to use
(ii) Passage of time.
(iii) Expiration of legal rights.
(iv) Obsolescence
(v) Abnormal factors.
Q.4. Explain the den determinants of the amount of depreciation.
Ans.Following arc the determinants of the amount of depreciation :
(1)Historical Cost — It is the historical cost of an asset which is allocated as an
expense during its useful life. Historical cost Includes the following.
(a)Purchase price and cost of transportation
(b)Cost of installation including the cost of repairs and improvements before the use of
the asset.
(c)Cost incurred on commissioning of the asset.
(2)Residual or Scrap Value —Depreciable amount of the asset is determined after
considering the estimated residual value. Residual value means an estimated sale value of
the asset at the end of the useful life. The sale value should be reduced by the amount
spent on its disposal and removal. if any.
(3)
Useful Life of the Asset —Useful life of the asset means the period over
which a depreciable asset is expected to be used by the enterprise. In other words. useful
life of an asset is the total service expected from the asset. In estimating the useful life.
the management takes into account physical deterioration. possibility of obsolescence.
intensity of use. maintenance etc.
Q.5. Name and explain different types of reserves in details.
Ans. Follow ing are two types of reserves on the basis of their nature
(a) Revenue Reserves.
(b) Capital Reserves.
(c)Revenue Reserves —Revenue reserves are the reserves which are created out of
the profits available for distribution as dividend. Revenue reserves are freely available for
distribution as dividends. Examples of revenue reserves are as under:
(i) General Reserve.
(ii) Dividend Equalisation Reserve.
(iii) Debenture Redemption Reserve.
(iv) Contingency Reserve.
(b)Capital Reserves —Capital reserve may be defined as the reserve which is created
out of the capital profits i.e.. the profits which are not available for the distribution of
dividend. Capital profits are not earned in the course of day-to-day business operations
and. therefore. such profits arc kept separate from revenue profits. It means that capital
reserve is not created through Profit and Loss Appropriation Account. Capital reserves
consist of capital profits. the important being as under:
(i) Profit prior to incorporation of a company.
(ii) Profit from reissue of shares forfeited by a company.
(iii) Profit on revaluation of the fixed assets and liabilities
(iv) Profit on the sale of fixed assets.
(v) Profit on redemption of debentures.
Capital reserves may be utilised for writing off intangible assets e.g.. goodwill.
copyrights. patents etc. Capital reserve is also available for writing off the capital losses.
It is not available for writing off revenue losses.
Following are two types of reserves on the basis of purpose
(a) General Reserve.
(b) Specific Reserve.
(a) General Reserve — General reserve is the reserve which is created for general
purpose and not for a specific purpose. Its purpose is to meet unforeseen losses and
liabilities and to improve overall financial position of an enterprise. It is created by
debiting the Profit and Loss Appropriation Account. It is not compulsory to create general
reserve. General reserve is created when the profits arc sufficient and management feels
the necessity of maintaining general reserve. General reserve increases the owners' equity.
(b) Specific Reserve — Specific reserve is the reserve which is created for a specific
purpose. For example. dividend Equalisation reserve is used to equalise the dividend
during the period of inadequate profit. Similarly. debenture redemption reserve is created
to redeem the debentures. Normally a specific reserve is available for use for the purpose
for which it has been created. But. sometimes. a specific reserve may be used for a
purpose other than one of its creation. l or example. dividend equalisation reserve may be
used to redeem preference shares or issuing bonus shares Following are some important
specific reserves :
(i) Dividend Equalisation Reserve.
(ii)Investment Fluctuation Reserve.
(iii) Debenture Redemption Reserve.
(iv) Asset Replacement Reserve.
Q.6. What are 'provisions' ? How are they created ? Give accounting treatment in case of
provision for doubtful debts.
Ans.According to Companies Act. the term 'Provision' has been defined as an amount
which is:
(a)Written off or retained by way of providing for depreciation. renewals. diminution in
the value of
assets or
(b)retained by way of providing for any known liability of which the amount cannot be
determined with substantial accuracy.
In simple words. a provision means the setting aside of an amount lo meet some expected
contingencies. Provision is created to meet known liability. the amount of which can not
be ascertained. If the amount of known liability can be ascertained accurately it is an
actual liability and not a provision. Thus. there is a sense of uncertainty in provision as far
as the actual amount of known liability is concerned.
Provisions arc created out of Profit and Loss Account because provisions are charged to
Profit and Loss Account. It implies that provisions will be created even if there is no or
inadequate profit. Following journal entry is passed to record the creation of provisions :
Profit and Loss Account
To Provisions far.........
When goods are sold on credit. the amounts receivable from all debtors may not be
recovered fully Some debt may become irrecoverable due to many reasons like death.
insanity. insolvency or dishonesty of Ihe