Chapter 7-Depreciation, Provisions and Reserves

(c) Depreciation

Explanation- Depreciation means fall in the value of an asset because of usage or with efflux of time or due to obsolescence or accident.

(a) Fixed assets

Explanation- Depreciation is a reduction in the book value of fixed assets.

(b) Tangible

Explanation- The term is not used in the case of wasting and fictitous assets such as depletion of natural resources and amortisation of goodwill respectively.

(d) Depreciation

Explanation- It is not the process of valuation of an asset; it is a process of allocation of cost of the asset to the period of its life.

(a) Depreciation

Explanation- Depreciation’s characteristic is to reduce the book value of the asset but not its market value. The market value is independent of book value.

(d) Balance sheet

Explanation- The balance sheet is a statement of assets, liabilities and capital.

(b) Depreciation

Explanation- Depreciation is a permanent, continuing and gradual shrinkage in the book value of a fixed asset.

(a) Land

Explanation- Land is not depreciated because its useful life is not limited to few years.

(c) Depletion

Explanation- The term depletion is used in respect of the extraction of natural resources like quarries mines etc. that reduces the availability of the quantity of material or assets.

(d) Depreciation

Explanation- Depreciation refers to a reduction in the value of all kinds of fixed assets arising from their wear and tear. Wear and tear happens due to the regular use of asset.

(a) Obsolescence

Explanation- Obsolescence refers to decrease in usefulness caused on account of the asset becoming out of date, old fashioned etc.

(c) Amortisation

Explanation-Amortisation refers to writing off of the proportionate of the intangibles such as goodwill, copyright, patents etc.

(b) Depreciation

Explanation- Depreciation refers to the writing off of the expired cost of the tangible assets like machinery, building, furniture and fixtures etc.

(a) Debit Balance

Explanation- If the debit side total is greater, it is called a Debit Balance.

(d) Depreciation

Explanation- Depreciation is non-cash expenditure because it does not involve any cash outflow.

(b) Cause of depreciation.

Explanation- Use of Asset is one of the cause of depreciation which means constant use of asset leads to its wear and tear and thus fall in value.

(c) Objective of depreciation

Explanation- The first objective of depreciation is to ascertain the correct profit or loss. If depreciation is ignored, the loss that is occurring in respect of fixed assets will be ignored.

(b) Historical cost of the asset

Explanation- Original (Historical) Cost of the Asset: Cost will include all expenses incurred like freight and installation charges up to the point the asset is ready for use.

(c) Historical cost of the asset

Explanation- Original Cost = Purchase Price + Freight + Installation Cost. The cost of fixed assets includes all the cost incurred to put the asset to use.

(d) Estimated Residual Value

Explanation- The Estimated Residual or Scrap Value at the end of its life- Residual value is an estimated sale value of the asset at the end of its economic life to the firm.

Amount to be Written off= Cost of Asset – Residual or Scrap Value

(b) Objective of depreciation

Explanation- Compliance of Legal Provisions- It is necessary to charge depreciation to comply with the provisions of the Companies Act and the Income Tax Act.

(a) Two

Explanation- The two main methods for computing depreciation are:

1. Straight Line Method

2. Written- Down Value Method.

(a) Straight Line Method

Explanation- Fixed Instalment Method can be known as Fixed Percentage on Original Cost or Fixed Instalment or Straight Line Method.

(d) Straight Line Method

Explanation- Under this method, a suitable percentage of original cost of the asset is written off every year. It means that the amount of depreciation is uniform from year to year.

(b) Straight Line Method

Explanation- In this method, the amount to be written off every year is arrived at as under:

Amount of Depreciation = Cost – Estimated scrap value

Number of years of expected life

The depreciation charged remains same year after year.

(a) Straight line method

Explanation- Every year, the profit and loss account is debited by the same amount of depreciation, so there is the same effect on the profit and loss account every year. It is one of the merits of Straight Line Method.

(c) FixedAssets

Explanation- On the date of the sale of the fixed asset-

Cash/ Bank/ Party’s A/c ...Dr.

To Fixed Asset A/c

(Being the fixed asset sold)

(b) Asset

Explanation- Provision for Depreciation Account is transferred to the Asset A/c because it is no longer required. The entry is:

Provision for Depreciation A/c ....Dr.

To Asset A/c

(Being the provision for depreciation transferred to Asset A/c)

(a) Profit & Loss A/c

Explanation- If profit is earned on sale. The entry is –

Asset A/c .....Dr.

To Profit and Loss A/c

(Being the profit on sale of asset transferred to Profit and Loss A/c)

(d) Profit and Loss A/c

Explanation- In case of loss on sale of fixed asset. The following entry is passed-

Profit and Loss A/c ......Dr.

To Asset A/c

(Being the loss on sale of asset transferred to Profit and Loss A/c)

(d) Written down value method.

Explanation- Under this method, a fixed rate on the written down value of the asset is charged as depreciation every year over the expected useful life of the asset.

(c) Written down value method

Explanation- Rate of depreciation can be determined on the basis of cost, scrap value and useful life of the asset as follows:

Where R= Rate of Depreciation in percent

N= Useful life of the asset

S= Scrap value at the end of the useful life

C= Cost of the asset.

(b) Written down value method

Explanation- This method is accepted under the Income-tax act. It is one of the merit of Written down value method.

(a) Written down value method

Explanation- In this method, the value of assets can never be zero because the depreciation is charged on the reducing balance.

(b) Diminishing balance method

Explanation- Diminishing Balance Method or Written Down Value Method of depreciation assumes that the asset should be depreciated more in the earlier years and less in the later years of use.

(d) Diminishing balance method

Explanation- Under Written Down Value Method, it is difficult to calculate the rate of depreciation. But it is easy to calculate the rate of depreciation under Straight Line Method.

(c) Straight Line Method

Explanation- Given the same rate percent assets depreciate faster by the Straight Line Method as compared to the Diminishing Balance Method because in diminishing balance method amount of depreciation keeps on reducing year after year.

(d) Zero

Explanation- At the expiry of the working life of the asset, the balance in the asset account reduces to zero under Straight Line Method because same amount is charged year after year.

(b) Straight Line Method

Explanation- Under Straight Line Method, the amount of depreciation remains the same for all years. But in Written down Value Method, the amount of depreciation reduces every year.

(c) Straight line method

Explanation- Under Straight Line Method, the combined cost on account of depreciation and repairs is lower in the initial years and higher in the later years.

(d) Net Method

Explanation- Under Net Method, assets are shown at book value minus depreciation written off during the year.

(b) Gross Method

Explanation- Under Gross Method, assets always appear at original cost minus total depreciation provided from the date of purchase to the date of Balance Sheet.

(b) Depreciation

Explanation- Under Net Method, Assets Account is shown at book value minus depreciation. The assets are shown at net value.

(d) Gross Method

Explanation- When we talk about Gross Method then in this Assets Account always appear at original cost year after year. The Depreciation a/c is maintained separately.

(c) Net Method

Explanation- Under Net Method, no information is given about accumulated depreciation.

(c) Balance Sheet

Explanation- Under Gross Method, information about original cost of the asset and total amount of depreciation (accumulated depreciation) can be obtained from the Balance Sheet.

(d) Assets - Capital

Explanation- Liabilities are debts, they are amounts owed to creditors. Thus, the claims who are not owners are called ‘‘Liabilities.’’

(d) Asset Disposal Account

Explanation- In the event of an asset being sold, a new account titled ‘Asset Disposal Account’ is opened in the ledger for the purpose of calculating profit or loss on the sale of an asset.

(b) Assets - Liabilities

Explanation- Capital is also known as Owner’s Equity, proprietorship and net worth. Owner’s Equity means owner’s claim against the assets of the business. It will always be equal to assets less liabilities.

(c) Assets

Explanation- The equation says that the assets of a business are always equal to the claims of owners and the outsiders.

(d) Asset Disposal Account

Explanation- The gross value of the asset being sold is transferred to the debit of this account by passing the following entry:

Asset Disposal A/c ...Dr.

To Asset A/c

(For original cost of the asset sold)

(d) Asset Disposal Account

Explanation- The amount of accumulated depreciation is transferred to this account by passing the following entry:

Provision for Depreciation A/c ...Dr.

To Asset Disposal A/c

(For transferring accumulated depreciation)

(c) Asset Disposal Account

Explanation- In case of Amount of Sale Proceeds the following entry will be passed-

Cash/Bank A/c ....Dr.

To Asset Disposal A/c

(For sale value of the asset sold)

(b) Balancing of account

Explanation- For example, if total of credit side is more than the debit side of any account the difference of amount will be recorded as Balance c/d on debit side and vice versa on the credit side.

(d) Balance brought down

Explanation- Assets will show a debit balance. Such accounts will be opened and the relevant amounts written on the debit side as ‘‘To Balance brought down.’’

(a) Balance carried down

Explanation- It is normally treated as a closing entry.

(b) Profit and Loss Account

Explanation- In case of Profit the following entry is passed-

Asset Disposal A/c ........Dr.

To Profit and Loss Account

(For profit on sale of the asset)

(d) Stock and prepaid expenses

Explanation- Current assets are those assets which can be converted into cash within a period of one year.

(d) Profit and Loss Account

Explanation- In case of loss the following entry is passed-

Profit and Loss A/c .....Dr.

To Asset Disposal A/c

(For loss on sale of the asset)

(b) 6

Explanation- As per Accounting Standard-6, ‘‘ Any addition or extension which becomes an integral part of the existing asset should be depreciated over the useful life of that asset.’

(a) Objective of depreciation

Explanation- Objectives of providing depreciation are to:

(i) Ascertain correct profit or loss.

(ii) Show a true and fair view of the financial position.

(iii) Show the assets at their correct values.

(iv) Retain funds out of profit for replacement.

(d) Efflux of time

Explanation- Depreciation arises due to efflux of time. Assets like plant and machinery may not have a definite life in this case the life is estimated.

(b) Rs 1, 12,500.

Explanation- Under written down value method, depreciation is charged at a fixed rate on the reducing balance every year. Depreciation will be Rs. 50,000 and Rs. 37,500 respectively.

(b) Replacement

Explanation- Depreciation provides funds for replacement of fixed assets at the end of its useful life.

(c) Fluctuation

Explanation- Temporary rise or fall in the value of an asset is called Fluctuation. But when we talk about depreciation then it is a fall in the value of an asset.

(b) Fixed assets

Explanation- Fixed assets are for long term use in the business therefore depreciation is provided on them year after year.

(a) Provision

Explanation- Provision means an estimated amount to meet an uncertain loss or expense in future. Provision is made on the basis of estimates.

(b) Provision

Explanation- Provision is a charge against profit for the purpose of providing for any liability or loss.

(d) Liability

Explanation- For example, December’s wages totalling Rs. 20,000 are payable on 31^st December. The enterprise will debit Wages Account and credit Wages Outstanding Account as it is a defined liability.

(a) Bad debts

Explanation- When a debtor becomes bankrupt, i.e. unable to pay one’s debts, the entire amount due from him is not realised. The unrealised amount is a loss to business, the same is called Bad Debts.

(d) Debtors

Explanation- Sometime insolvent debtor whose account had been earlier written off as ‘Bad Debts’ pays some amount.The amount so received is a gain to the business and is known as Bad Debts Recovered.

(d) Old provision

Explanation- If the amount of the provision for doubtful debts is given on the credit side of the Trial Balance then from the accounting point of view it is known as old provision.

(b) Further bad debts

Explanation- Bad debts given below the Trial balance in the form of adjustments are known as further bad debts.

(a) New provision

Explanation- New provision is the amount to be provided calculated as a percentage of debtors less the amount of old provision.

(d) Good debts

Explanation- Good debtors are those who pay to the trader in the stipulated period or shall be recovered for sure.

(c) Reserves

Explanation- It is an appropriation of profits or accumulated profits to strengthen the financial position of the business.

(b) Reserve fund

Explanation- It is important to note that if the amount equal to the reserve is invested in outside securities, the reserve will be named ‘Reserve Fund.’

(d) Profit and Loss Appropriation account

Explanation- General reserve, reserve for expansion and Dividend Equalisation Reserve are shown in the profit and loss appropriation account and not in the Profit and Loss Account because these are not the expenses of the business.

(a) Two types

Explanation- Reserves are of two types:

1. Revenue reserve

2. Capital reserve

(c) Importance of reserve

Explanation- Reserves are important in a business to strengthen the financial position of the business.

(d) Revenue reserve

Explanation- Revenue reserves are created out of revenue profits which are available for distribution as dividend.

(b) Revenue reserve

Explanation- Examples of Revenue Reserves are:

(i) General Reserves

(ii) Dividend Equalisation Reserve

(iii) Debenture Redemption Reserve

(iv) Investment Fluctuation Reserve etc.

(a) Capital Reserve

Explanation- Examples of capital reserve are:

(i) Profit prior to incorporation.

(ii) Premium on issue of shares or debentures.

(iii) Profit on forfeiture of shares etc.

(b) Revenue reserve

Explanation- Revenue reserve can be used for distribution of dividends without any precondition.

(c) Capital reserve

Explanation- It can be used for distribution of dividends only if the company satisfies certain conditions prescribed by the Companies Act.

(d) General reserve

Explanation- It is available for any future contingency or expansion of business. Such reserve strengthens the financial position of the business.

(b) Capital reserve

Explanation- It is created for meeting losses or to be used for purposes specified by the Companies Act.

(c) General reserve

Explanation- It is to be noted that General Reserve and Contingency Reserve generally mean the same thing.

(a) Specific reserve

Explanation- It is that reserve which is created for a specific purpose and can be utilised only for that purpose.

(a) Secret reserve

Explanation- A secret reserve is a reserve the existence and/or the amount of which is not disclosed in the Balance Sheet.

(d) Hidden reserve

Explanation- Specific Reserve is also called a ‘Hidden Reserve.’

(c) Hidden reserve

Explanation- Secret Reserve is also called a ‘Hidden Reserve’ or ‘Internal Reserve.’

(b) Capital reserve

Explanation- They are created out of capital profit and can be utilised for specific purpose only.

(a) Shareholders

Explanation- Reserves other than capital reserves can be distributed to shareholders/partners.

(b) Reserve

Explanation- Unutilised part can be distributed as dividend. It reduces divisible profits.

(d) Provision

Explanation- It cannot be used for distribution as profit dividend. It reduces net profit.

(c) Reserve

Explanation- Creation ofReserves out of profits is a matter of prudence.

(b) Secret reserve

Explanation- It increases the working capital of the concern and also strengthens its financial position. It is one of the advantage of Secret Reserve.

(a) Secret reserve

Explanation- Value of shares goes down in the market is one of the disadvantage of a secret reserve.

(c) Secret reserve

Explanation- It enables the directors to tide over unfavourable time. As and when profit reduces, the directors can maintain the rate of dividend by utilising it.

(d) Secret reserve

Explanation- Secret reserve can be created by showing a contingent liability as a real liability.

(b) Capital reserve

Explanation- Examples of Capital Reserve are:

1. Profit on forfeiture of shares

2. Profit on sale of fixed assets

3. Capital Redemption reserve etc.

(d) Debtors

Explanation- The following entry will be passed-

Bad Debts A/c ......Dr.

To Sundry Debtors

(a) Secret Reserve

Explanation- Heavy Losses of an exceptional nature can be met without disclosing the fact in the published statements and without disturbing the normal business profit.

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