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, thus, due to their regular use, there occurs continuous wear and tear and consequently fall in their value. This fall in the value of fixed assets, due to their regular use or expiry of time is termed as depreciation.

A machinery costing Rs 1,00,000 and its useful life is 10 years; so, depreciation is calculated as:

Question - 2 : -
State briefly the need for providing depreciation.

Answer - 2 : -

The needs for providing depreciation are given below.

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.

Question - 3 : -
What are the causes of depreciation?

Answer - 3 : -

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.
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.
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.
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.
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.
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 - 4 : -
Explain basic factors affecting the amount of depreciation.

Answer - 4 : -

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 asset and bringing the asset to its usable condition are included in the total cost of asset.
Estimated useful life− Every asset has its useful life other than its physical life (in terms of number of years, units, etc.), used by a business. The useful life of an asset is considered to estimate the effective life of a fixed asset. For example, land has indefinite life; however, if business acquiress a piece of land on lease for 25 years, then the useful life of the piece of land is considered to be 25 years.
Estimated scrap value− It is estimated as the net realisable value or sale value of an asset at the end of its effective life. It is deducted from the total cost of an asset. For example, furniture is acquired at Rs 50,000 and its effective life is 10 years.

After 10 years, the furniture will be sold at Rs 10,000. So, depreciation is charged as:

Question - 5 : - Distinguish between straight line method and written down value method of calculating depreciation.

Answer - 5 : -

Basis of Difference	Straight Line Method	Written Down Value 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, copyright, land and buildings, etc., which have lesser possibility of obsolescence and lesser repair charges.	It is suitable for assets that needs more repair 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 cost is high and repairs are less in the initial years but in the latter years the repair costs increase 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.

Question - 6 : -
In case of a long term asset, repair and maintenance expenses are expected to rise in later years than in earlier year. Which method is suitable for charging depreciation if the management does not want to increase burden on profits and loss account on account of depreciation and repair.

Answer - 6 : -

If the management does not want to exert undue burden on the profits due to high depreciation and repair costs in the latter years of the assets, then ‘written down method’ should be a preferred method to provide depreciation. This is because the cost of depreciation reduces; whereas, repair and maintenance expenses increase in the latter years. However, on the whole, it does not exert increasing burden on profits.

Question - 7 : -
What are the effects of depreciation on profit and loss account and balance sheet?

Answer - 7 : -

The effects of depreciation on Profit and Loss Account are given below.

Depreciation increases the debit side of profit and loss account and hence reduces net profit.
Depreciation increases the total expenses, leading to an excess of debit over credit balance.

The effects of depreciation on Balance Sheet are given below.

It reduces the original cost or book value of the concerned asset.
It reduces the overall balance of asset’s column in the balance sheet.

Question - 8 : -
Distinguish between provision and reserve.

Answer - 8 : -

Basis of Difference	Provision	Reserve
Meaning	It is created to meet the known liability.	It is created to meet unknown liability.
Nature	Provision is charged against profit.	Reserve is appropriation of the profit.
Purpose	It is created for a specific liability.	It is created for strengthening the financial position.
Mode of creation	It is created by debiting the profit and loss account.	It is created by debiting the profit and loss appropriation account.
Use for payment of dividend	It cannot be used for payment of dividends.	It can be used for payment of dividends.
Creation	Creation of provision is compulsory. It is created even if there is no profit.	Creation of reserve depends on the discretion of the management. It is created only when there is profit.

Question - 9 : -
Give four examples each of provision and reserves.

Answer - 9 : -

Four examples of provision are given below.

Provision for bad and doubtful debts
Provision for discount on debtors
Provision for depreciation
Provision for taxation

Four examples of reserve are given below.

General reserve
Capital reserve
Dividend equalisation reserve
Debenture redemption reserve

Question - 10 : -
Distinguish between revenue reserve and capital reserve.

Answer - 10 : -

Basis of Difference	Revenue Reserve	Capital Reserve
Source	It is created out of revenue profit, i.e., revenue earned from normal activities of business operations.	It is created out of capital profit, i.e., gain from other than normal activities of business operations, such as sale of fixed assets, etc.
Dividend	It can be used for dividend.	It cannot be used for dividend.
Purpose	It is created for strengthening the financial position of the business.	It is created for the purpose laid down in the Companies Act.

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