Chapter 7 Depreciation Provisions and Reserves Solutions
Question - 11 : - Give four examples each of revenue reserve and capital reserves.
Answer - 11 : -
Four examples of revenue reserve are given below.
- General Reserve
- Retained Earnings
- Dividend Equalisation Reserve
- Debenture Redemption Reserve
Four examples of capital reserve are given below.
- Issues of shares at premium
- Profit or issue of shares
- Sale of fixed assets
- Profit on redemption of debentures
Question - 12 : - Distinguish between general reserve and specific reserve.
Answer - 12 : -
| Basis of Difference | General Reserve | Specific Reserve |
| Meaning | When the reserve is created without any specified purpose, the reserve is called general reserve. | When reserve is created for some specific purpose, the reserve is called specific reserve. |
| Usage | It can be used for any purpose. | It cannot be used for any purpose other than the specified purpose for which it is created. |
| Examples | Retained earnings, reserve funds, etc. | Debenture redemption reserve, dividend equalisation reserve, etc. |
Question - 13 : - Explain the concept of secret reserve.
Answer - 13 : -
Reserves that are created by overstating liabilities or understating assets are known as secret reserves. They are not shown in the balance sheet. These reduce tax liabilities, as the liabilities are overstated. It is created by management to avoid competition by reducing profit. Creation of secret reserve is not allowed by Companies Act, 1956 that requires full disclosure of all material facts and accounting policies while preparing final statements.
Question - 14 : - Explain the concept of depreciation. What is the need for charging depreciation and what are the causes of depreciation?
Answer - 14 : -
Every business acquires fixed assets for its use in the business over a period of time. As the benefits of these assets can be availed over a long period of time (due to their regular use), there exists continuous wear and tear and consequently fall in their value. This fall in the value of fixed assets (due to regular use or expiry of time) is termed as depreciation.
A machinery that costs Rs 1,00,000 and its useful life of 10 years, its depreciation will be calculated as:
1. To ascertain true net profit or net loss− Correct profit or loss can be ascertained when all the expenses and losses incurred for earning revenues are charged to profit and loss account. Assets are used for earning revenues and its cost is charged in form of depreciation from profit and loss account.
2. To show true and fair view of financial statements− If depreciation is not charged, assets are shown at higher value than their actual value in the balance sheet; consequently, the balance sheet does not reflect true and fair view of financial statements.
3. For ascertaining the accurate cost of production− Depreciation on plant and machinery and other assets, which are engaged in production, is included in the cost of production. If depreciation is not included, cost of production is underestimated, which will lead to low sale price and thus leads to low profit.
4. Distribution of dividend out of profit− If depreciation is not charged, which leads to overestimating of profit and consequently more profit is distributed as dividend, out of capital instead of the profit. This leads to the flight of scarce capital out of the business.
5. To provide funds for replacement of assets− Unlike other expenses, depreciation is not a cash expense. So, the amount of depreciation charged will be retained in the business and will be used for replacement of fixed assets after its useful life.
6. Consideration of tax− If depreciation is charged, then profit and loss account will disclose lesser profit as to when the depreciation is not charged. This depicts reduced profit and thus the business will be liable for lesser tax amount.
Below are given the causes for depreciation.
1. Constant use− Due to constant use of the fixed assets there exists normal wear and tear that leads to fall in the value of fixed assets.
2. Expiry of time− With the passage of time, whether assets are used or not, its effective life decreases. The natural forces like rain, weather, etc. lead to deterioration of the fixed assets.
3. Obsolescence− Due to the fast technological innovations and inventions today’s assets may be outdated by tomorrow’s sophisticated assets. This leads to the obsolescence of fixed assets.
4. Expiry of legal rights− If an asset is acquired for a specific period of time, then, whether the asset is put to use or not, its value becomes zero at the end of its useful life. For example, if a land is acquired for Rs 1,00,000 for 25 years on lease, then each year its value depreciates by of its gross value. At the end of the 25th year, the value of the lease will be zero.
5. Accident− An asset may lose its value and damage may happen to it due to mishaps such as a fire accident, theft or a natural calamity. The loss due to accident is permanent in nature.
6. Permanent fall in value− Generally, we do not record fluctuations in the market price of the fixed assets in the books. However, if the fall in market price is permanent, it is accounted, which leads to a fall in the value of fixed assets in the books.
Question - 15 : - Discuss in detail the straight line method and written down value method of depreciation. Distinguish between the two and also give situations where they are useful.
Answer - 15 : -
Straight Line method
It is a simple method of charging depreciation. Under this method, depreciation is charged on the original cost of an asset, at a fixed rate of percentage. In this method, amount of depreciation remains same from year to year and asset’s value becomes zero at the end of its useful life.
Amount of depreciation is calculated as under:
Advantages of Straight Line Method
1. It is simple to calculate.
2. Asset can be completely written off, i.e., asset can be depreciated until the net scrap value is zero.
3. Same amount of depreciation is charged every year. Therefore, it helps in easy comparison of Profit and Loss Account for different years.
4. It is used for assets that have low repairs and maintenance expenses and are continuously used over a period of time.
Limitations of Straight Line Method
1. Burden of deprecation is more on profit and loss account in the later years, when repair and maintenance costs increase, as asset becomes older.
2. Value of asset becomes zero in the books even if asset is still in usable condition in business.
Uses of Straight Line Method
1. This method is useful where repairs and maintenance expenses on asset are low.
2. It is also useful when an asset is continuously used from one year to another.
3. It is useful when the value of assets, such as patent, copyright, goodwill, etc., becomes zero
Written Down Value Method
This method is applicable where depreciation is charged on the diminishing balance, i.e., book value of the asset. In this method, asset’s value goes on diminishing year after year and the amount of depreciation declines.
Rate of depreciation is calculated as follows:
Where,
R represents rate of depreciation
n represents expected useful life of the asset
s represents the scrap value
c represents the cost of the asset
Advantages of Written Down Value Method
1. It is based on the logical assumption that asset is used more in the earlier years, so more cost is charged in form of depreciation.
2. It is suitable for the assets where repairs are more in the later years, as depreciation is lesser and on a whole the combined burden of depreciation and repairs exerts equal pressure on the net profit over years.
3. This method is accepted by the income tax authorities.
4. As more depreciation is charged in the earlier years, so the loss due to obsolescence of the asset is reduced.
Limitations of Written Down Value Method
1. It is difficult to calculate and is a time consuming process.
2. The value of an asset cannot be zero, thus the asset cannot be completely written off.
3. There arises shortage of funds for replacement of new asset. This happens due to the fact that the amount of depreciation is retained and used in the business. Consequently, at the end of the useful life of an old asset, business finds it difficult to arrange funds for its replacement.
Uses of Written Down Value Method
1. It is useful when assets have long life.
2. It is useful for those assets that require more repair and maintenance costs in the later years.
3. It provides easy calculation to provide depreciation of additional asset purchased during a year.
Difference between Straight Line Method and Written Down Value Method
| Basis of Difference | Straight Line Method | Written Down Method |
| Basis for calculation | Depreciation is calculated on the original cost of an asset. | Depreciation is calculated on the reducing balance, i.e., the book value of an asset. |
| Amount of depreciation | Equal amount is charged each year over the effective life of the asset. | Diminishing amount of depreciation (on the written down value of asset) is charged each year over the effective life of the asset. |
| Book value of asset | Book value of the asset becomes zero at the end of its effective life. | Book value of the asset can never be zero. |
| Suitability | It is suitable for the assets like, patents, copyrights, land and buildings, etc., which have lesser possibility of obsolescence and lesser repair charges. | It is suitable for assets that needs more repairs and maintenance costs in the later years like, plant and machinery, car, etc. |
| Effect of depreciation and repair on profit and loss account | Unequal effect over the life of the asset, as depreciation remains same over the years but repair cost increases in the later years. | Equal effect over the life of the asset, as depreciation is high and repairs are less in the initial years but in the latter years the repair cost increases and depreciation cost decreases. |
| Recognition under Income Tax Act | It is not recognised under the Income Tax Act. | It is recognised under the Income Tax Act. |
Describe in detail two methods of recording depreciation. Also give the necessary journal entries.
Answer - 16 : -
The two methods of recording depreciation are diagrammatically presented below.
1. Charging depreciation to Asset Account− Under this method, depreciation is directly credited to the asset account and no separate account is prepared for provision of depreciation. Under this method, the original cost of an asset and the total amount of depreciation cannot be determined from the Balance Sheet, as the Asset Account appears at its written down value.
Journal entries for depreciation are given below.
When depreciation is charged to Assets Account
Question - 17 : - Explain determinants of the amount of depreciation.
Answer - 17 : - 
1. Total cost of asset− The total cost of an asset is taken into consideration for ascertaining the amount of depreciation. The expenses incurred in acquiring, installing and constructing of assets and bringing the assets to their usable condition are included in the total cost of asset.
2. Estimated useful life− Every asset having it’s useful life other than it’s physical life, in terms of number of years, units, etc. are considered to estimate the effective life of a fixed asset. For example, land has indefinite life; however, if business acquires a piece of land on lease for 25 years, it’s useful life is considered to be 25 years.
3. Estimated scrap value− It is estimated as the net realisable value or sale value of an asset at the end of it’s effective life. It is deducted from the total cost of an asset. For example, furniture is acquired at Rs 50,000 with it’s effective life of 10 years.
After 10 years, furniture will be sold at Rs 10,000. So, depreciation is charged as:
Question - 18 : - Name and explain different types of reserves in details.
Answer - 18 : -
Reserves− Reserves are created for strengthening the financial positions and future growth. It is created out of profit earned by business.
The broad classification of reserve is diagrammatically presented below.
1. Revenue Reserve− It is created out of revenue profit, i.e., revenue earned from normal activities of the business. It can be used for either general purpose or specific purpose. It is of two types:
a. General Reserve− When the reserve is created without any specified purpose, then the reserve is called general reserve. It is a free reserve and so can be used for any purpose. It can also be used for future growth and expansion. For example, reserve funds, retained earnings, contingencies reserves, etc.
b. Specific Reserve− When reserve is created for some specific purpose, then the reserve is called specific reserve.
Examples of specific reserve are given below.
i. Debenture Redemption Reserve
ii. Investment Fluctuation Reserve
iii. Dividend Equalisation Reserve
iv. Workmen Compensation Fund
2. Capital Reserve− It is created out of capital profit, i.e., gain from other than normal activities of business operations, such as sale of fixed asset, etc. It is created to meet the capital loss. It cannot be distributed as dividend. The example of capital reserves are given below.
i. Premium on issue of shares
ii. Premium on issue of debentures
iii. Profit on redemption of debentures
iv. Profit on sale of fixed assets
v. Profit on reissue of forfeited shares
vi. Profit prior to incorporation
3. Secret Reserves− Reserves that are created by overstating liabilities or understating assets are known as secret reserves. They are not shown in the Balance Sheet. These reduce tax liabilities, as the liabilities are overstated. It is created by management to avoid competition by reducing profit. Creation of secret reserve is not allowed by Companies Act, 1956, which requires full disclosure of all materials facts and accounting policies, while preparing final statements.
Question - 19 : - What are provisions? How are they created? Give accounting treatment in case of provision for doubtful Debts.
Answer - 19 : -
Provisions are the amount that is created against profit to meet the known liability; however, the amount of liability is uncertain. It is created for specific liability. Creation of provision is compulsory even if, there is no profit. The underlying principle behind creation of provision is conservatism, viz., to prepare for future loss. The main rationale for making provisions is to provide cushion to the future business performance against the uncertain and unforeseen losses that may arise from the past transactions. A few examples of provisions are given below.
1. Provision for bad and doubtful debts
2. Provision for depreciation
3. Provision for taxation
4. Provision for discount on debtors
Provisions are made by debiting the Profit and Loss Account on estimate basis. The provisions are created on the basis of past experiences. Every year, a business may experience common losses, such as depreciation of fixed assets, taxation, etc., which are although known; however, their exact amount of future period is unknown. Thus, business creates provision of certain percentage every year, which is truly based on the intuitions and past experiences. These unascertained liabilities in form of provisions are kept aside, which help future business activities, undisturbed from the future losses.
Accounting treatment for provision for doubtful debts is:
| Profit and Loss A/c | Dr. |
| | To Provision for Doubtful Debts | |
| (Provision for doubtful debt made) | |
On April 01, 2010, Bajrang Marbles purchased a Machine for Rs 1,80,000 and spent Rs 10,000 on its carriage and Rs 10,000 on its installation. It is estimated that its working life is 10 years and after 10 years its scrap value will be Rs 20,000.
(a) Prepare Machine account and Depreciation account for the first four years by providing depreciation on straight line method. Accounts are closed on March 31st every year.
(b) Prepare Machine account, Depreciation account and Provision for depreciation account (or accumulated depreciation account) for the first four years by providing depreciation using straight line method accounts are closed on March 31 every year.
Answer - 20 : -
(a)
| Books of Bajrang Marbles | |
| Machinery Account |
| Dr. | | | | | | | Cr. |
| Date | Particulars | J.F. | Amount (₹) | Date | Particulars | J.F. | Amount (₹) |
| 2010 | | | | 2011 | | | |
| Apr.01 | Bank | | 2,00,000 | Mar.31 | Depreciation | | 18,000 |
| | (1,80,0000 + 20,000) | | | | Balance c/d | | 1,82,000 |
| | | | 2,00,000 | | | | 2,00,000 |
| | | | | | | | |
| 2011 | | | | 2012 | | | |
| Apr.01 | Balance b/d | | 1,82,000 | Mar.31 | Depreciation | | 18,000 |
| | | | | Mar.31 | Balance c/d | | 1,64,000 |
| | | | 1,82,000 | | | | 1,82,000 |
| | | | | | | | |
| 2012 | | | | 2013 | | | |
| Apr.01 | Balance b/d | | 1,64,000 | Mar.31 | Depreciation | | 18,000 |
| | | | | Mar.31 | Balance c/d | | 1,46,000 |
| | | | 1,64,000 | | | | 1,64,000 |
| | | | | | | | |
| 2013 | | | | 2014 | | | |
| Apr.01 | Balance b/d | | 1,46,000 | Mar.31 | Depreciation | | 18,000 |
| | | | | Mar.31 | Balance c/d | | 1,28,000 |
| | | | 1,46,000 | | | | 1,46,000 |
| | | | | | | | |
| | | | | | | | | |
Working notes: Calculation ofannual depreciation
| Depreciation (p.a.) | = | (Original cost – Scrap Value ) | | |
| Estimated Life of Asset (years) | | |
| | = | (1,80,000 + 10,000 + 10,000 – 20,000) | |
| 10 |
| | = | ₹ 18,000 per annum | |
Depreciation Account |
| Dr. | | | | | | | Cr. |
| Date | Particulars | J.F. | Amount (₹) | Date | Particulars | J.F. | Amount (₹) |
| 2011 | | | | 2011 | | | |
| Mar.31 | Machinery | | 18,000 | Mar.31 | Profit and Loss | | 18,000 |
| | | | | | | | |
| | | | 18,000 | | | | 18,000 |
| | | | | | | | |
| 2012 | | | | 2012 | | | |
| Mar.31 | Machinery | | 18,000 | Mar.31 | Profit and Loss | | 18,000 |
| | | | | | | | |
| | | | 18,000 | | | | 18,000 |
| | | | | | | | |
| 2013 | | | | 2013 | | | |
| Mar.31 | Machinery | | 18,000 | Mar.31 | Profit and Loss | | 18,000 |
| | | | | | | | |
| | | | 18,000 | | | | 18,000 |
| | | | | | | | |
| 2014 | | | | 2014 | | | |
| Mar.31 | Machinery | | 18,000 | Mar.31 | Profit and Loss | | 18,000 |
| | | | | | | | |
| | | | 18,000 | | | | 18,000 |
| | | | | | | | |
(b)
| Machinery Account |
| Dr. | | | | | | | Cr. |
| Date | Particulars | J.F. | Amount (₹) | Date | Particulars | J.F. | Amount (₹) |
| 2010 | | | | 2011 | | | |
| Apr.01 | Bank | | 2,00,000 | Mar.31 | Balance c/d | | 2,00,000 |
| | | | | | | | |
| | | | 2,00,000 | | | | 2,00,000 |
| | | | | | | | |
| 2011 | | | | 2012 | | | |
| Apr.01 | Balance b/d | | 2,00,000 | Mar.31 | Balance c/d | | 2,00,000 |
| | | | | | | | |
| | | | 2,00,000 | | | | 2,00,000 |
| | | | | | | | |
| 2012 | | | | 2013 | | | |
| Apr.01 | Balance b/d | | 2,00,000 | Mar.31 | Balance c/d | | 2,00,000 |
| | | | | | | | |
| | | | 2,00,000 | | | | 2,00,000 |
| | | | | | | | |
| 2013 | | | | 2014 | | | |
| Apr.01 | Balance b/d | | 2,00,000 | Mar.31 | Balance c/d | | 2,00,000 |
| | | | | | | | |
| | | | 2,00,000 | | | | 2,00,000 |
| | | | | | | | |
| Provision for Depreciation Account | |
| Dr. | | | | | | | Cr. | |
| Date | Particulars | J.F. | Amount (₹) | Date | Particulars | J.F. | Amount (₹) |
| 2011 | | | | 2011 | | | |
| Mar.31 | Balance c/d | | 18,000 | Mar.31 | Depreciation | | 18,000 |
| | | | | | | | |
| | | | 18,000 | | | | 18,000 |
| | | | | | | | |
| | | | | 2011 | | | |
| | | | | Apr.01 | Balance b/d | | 18,000 |
| 2012 | | | | 2012 | | | |
| Mar.31 | Balance c/d | | 36,000 | Mar.31 | Depreciation | | 18,000 |
| | | | 36,000 | | | | 36,000 |
| | | | | | | | |
| | | | | 2012 | | | |
| | | | | Apr.01 | Balance b/d | | 36,000 |
| 2013 | | | | 2013 | | | |
| Mar.31 | Balance c/d | | 54,000 | Mar.31 | Depreciation | | 18,000 |
| | | | 54,000 | | | | 54,000 |
| | | | | | | | |
| | | | | 2003 | | | |
| | | | | Apr.01 | Balance b/d | | 54,000 |
| 2014 | | | | 2014 | | | |
| Mar.31 | Balance c/d | | 72,000 | Mar.31 | Depreciation | | 18,000 |
| | | | 72,000 | | | | 72,000 |
| | | | | | | | |
| | | | | | | | | |
| Depreciation Account |
| Dr. | | | | | | | Cr. |
| Date | Particulars | J.F. | Amount Rs | Date | Particulars | J.F. | Amount Rs |
| 2011 | | | | 2011 | | | |
| Mar.31 | Provision for Depreciation | | 18,000 | Mar.31 | Profit and Loss | | 18,000 |
| | | | | | | | |
| | | | 18,000 | | | | 18,000 |
| | | | | | | | |
| 2012 | | | | 2012 | | | |
| Mar.31 | Provision for Depreciation | | 18,000 | Mar.31 | Profit and Loss | | 18,000 |
| | | | | | | | |
| | | | 18,000 | | | | 18,000 |
| | | | | | | | |
| 2013 | | | | 2013 | | | |
| Mar.31 | Provision for Depreciation | | 18,000 | Mar.31 | Profit and Loss | | 18,000 |
| | | | | | | | |
| | | | 18,000 | | | | 18,000 |
| | | | | | | | |
| 2014 | | | | 2014 | | | |
| Mar.31 | Provision for Depreciation | | 18,000 | Mar.31 | Profit and Loss | | 18,000 |
| | | | | | | | |
| | | | 18,000 | | | | 18,000 |
| | | | | | | | |