Class 11-commerce NCERT Solutions Accountancy Part I Chapter 7 - Depreciation, Provisions and Reserves

Depreciation means fall in book value of depreciable fixed asset because of

wear and tear of the asset

1. passage/efflux of time
2. obsolescence
3. accident

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

Annual Depreciation per annum

= Cost of Asset-Estimated Scrap Value/Expected or Estimated life of Asset

=100000/10= Rs.10,000

The needs for providing depreciation are given below.

1. To ascertain the correct profit or 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 will be shown at higher value than their actual value in the balance sheet. Consequently, the balance sheet will not reflect true and fair view of financial statements.
3. For ascertaining the accurate cost of production: Depreciation on the assets, which are engaged in production, is included in the cost of production. If depreciation is not charged, the cost of production is underestimated, which will lead to low selling price and thus leads to low profit.
4. To provide funds for replacement of assets: Unlike other expenses, depreciation is non cash expense. So, the amount of depreciation debited to the profit and loss account will be retained in the business. These funds will be available for replacement of fixed assets when its useful life ends.
5. To meet the legal requirement: To comply with the provisions of the Companies Act and Income Tax Act, it is necessary to charge depreciation.

1. Use of asset: Because of constant use of the fixed assets there exists a normal wear and tear which leads to fall in the value of the assets.
2. Passage of time: Whether assets are used or not, with the passage of time, its effective life will decrease.
3. Obsolescence: Because of new technologies, innovations and inventions, assets purchased currently may become outdated later which leads to the obsolescence of fixed assets.
4. Accident: An asset may lose its value due to mishaps such as a fire accident, theft or by natural calamities and they are permanent in nature. 

1. Original cost of asset: The total cost of an asset is taken into consideration for ascertaining the amount of depreciation.  The total cost of an asset include all expenses incurred up to the point the asset is ready for use like freight expenses and installation charges.

   Total Cost= Purchase Price+ Freight Expenses+ Installation Charges.

2. Estimated useful life: Every asset has its useful life other than its physical life in terms of number of years and units used by a business. The asset may exist physically but may not be able to produce the goods at a reasonable cost. For example, an asset is likely to lose its useful value within 15years, its useful life, i.e., life for purpose of accounting should be considered as only 15years.

3. Estimated scrap value: It is estimated as the net realisable value of an asset at the end of its useful life. It is deducted from the total cost of an asset and the difference is written off over the useful life of the asset. For example, Furniture acquired at Rs.1,30,000, its useful life is estimated to be 10years and it is estimated scrap value Rs.10,000.

   Depreciation per annum= 1,30,000-10,000/10 years= 12,000

The written down value method is most appropriate to overcome the burden of the profit and loss account because of high depreciation and repair costs over the years of the asset. The cost of depreciation reduces and the repair and maintenance expenses increase over the years. However, the entire burden will not get ease to the management.

The effects of depreciation on Profit and Loss Account are as follows:

1. An increase in depreciation will be debited in the profit and loss account which reduces net profit.
2. Hence total expenses increase which leads to an excess of debit over credit balance.

The effects of depreciation on Balance Sheet are as follows:

1. The original cost or book value of the concerned asset gets reduced.
2. The overall balance of asset's column in the balance sheet gets reduced.

Four examples of provision are given below.

1. Provision for bad and doubtful debts
2. Provision for discount on debtors
3. Provision for depreciation
4. Provision for tax

Four examples of reserve are given below.

1. General reserve
2. Capital redemption reserve
3. Dividend equalisation reserve
4. Debenture redemption reserve

Examples of revenue reserve are as follows:

1. General reserve
2. Investment equalisation reserve
3. Dividend equalisation reserve
4. Debenture reserve

Examples of capital reserve are as follows:

1. Issues of shares at premium
2. Profit on forfeiture of shares
3. Profit on sale of fixed assets
4. Profit on redemption of debentures

Secret reserves are created by overstating liabilities or understating assets which are not shown in the balance sheet. This will reduce tax liabilities, because 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 material facts and accounting policies while preparing final statements.

Depreciation means fall in book value of depreciable fixed asset because of

1. wear and tear of the asset,
2. passage/efflux of time,
3. obsolescence, or
4. accident.

The need for providing depreciation is:

1. To ascertain the correct profit: 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 the financial position: If depreciation is not charged, assets will be shown at higher value than their actual value in the balance sheet. Consequently, the balance sheet will not reflect true and fair view of financial statements.
3. To retain, out of profit, funds for replacement: Unlike other expenses, depreciation is non cash expense. So, the amount of depreciation debited to the profit and loss account will be retained in the business. These funds will be available for replacement of fixed assets when its useful life ends.
4. To ascertain correct cost of production: Depreciation on the assets, which are engaged in production, is included in the cost of production. If depreciation is not charged, the cost of production is underestimated, which will lead to low selling price and thus leads to low profit.
5. To meet the legal requirement: To comply with the provisions of the Companies Act and Income Tax Act, it is necessary to charge depreciation.

The causes of depreciation are as stated below:

1. Use of Asset i.e., wear and tear: Due to constant use of the fixed assets there exist a normal wear and tear that leads to fall in the value of the assets.
2. Passage/Efflux of Time: Whether assets are used or not, with the passage of time, its effective life will decrease.
3. Obsolescence: Due to new technologies, innovations and inventions, assets purchased today may become outdated by tomorrow which leads to the obsolescence of fixed assets.
4. Accidents: An asset may lose its value due to mishaps such as a fire accident, theft or by natural calamities and they are permanent in nature.

The two methods of depreciation are

1. Fixed percentage on original cost or straight line method
2. Fixed percentage on diminishing balance or written down value method

Straight Line Method

According to this method, a fixed and equal amount is charged as depreciation for every accounting period during the life time of an asset. This method is based on the assumption of equal usage of time over asset's entire useful life. Hence, the amount of depreciation is same from period to period over the life of the asset.

Depreciation amount can be calculated by using the following formula:

If the asset has a residual value at the end of its useful life, the amount to be written of every year is as follows:

Depreciation = Cost of asset - Estimated net residual value / No. of years of expected life

If the annual depreciation amount is given then we can calculate the rate of depreciation as follows:

Rate of depreciation = Annual depreciation amount / Cost of asset * 100

Advantages of Straight Line Method

1. Simple to calculate the depreciation amount
2. Assets can be depreciated up to the estimated scrap value
3. Easy to understand the amount of depreciation
4. Every year, the same amount of depreciation is debited to profit and loss account, and hence the effect on profit and loss account will remain the same.

Disadvantages of Straight Line Method

1. Interest on capital invested in assets is not provided in this method.
2. Over the years, the work efficiency of assets decreases and repair expenses increases. Therefore, there is burden on the profit and loss account.
3. Book value of the assets becomes zero but still the assets are used in the business.

Written Down Value Method

In this method depreciation is charged on the book value of the asset and the amount of depreciation reduces year after year. It implies that 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. The rate of depreciation is applicable to the book value but not to the cost of asset.

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

Where, R is the rate of depreciation in percent, n is the useful life of the asset; S is the scrap value at the end of useful life and C is the cost of the asset.

Advantages of Written Down Value Method

1. The profit and loss account of depreciation and repair expenses has same weightage throughout the useful life of asset because depreciation decreases with an increase in repair expenses. 
2. Since the benefits from asset keep on decreasing, the cost of asset is allocated rationally.
3. This method is most favorable for those assets which require increased repairs and maintenance expenses over the years.
4. This method is widely accepted under the Income Tax Act.

Disadvantages of Written Down Value Method

1. The value of assets can never be zero even though it is discarded.
2. In this method, it is difficult to calculate depreciation.
3. There is no provision of interest on capital invested in use of assets.

Difference between Straight Line and Written Down Value Method

The two methods of recording depreciation are as follows:

1. When Depreciation is Charged or Credited to the Assets Account

In this method, depreciation is deducted from the asset value and charged (debited) to profit and loss account. Hence the asset value is reduced by the amount of depreciation.

In the Balance sheet, asset appears at its written down value which is cost less depreciation charged till date. In this method, the original cost of an asset and the total amount of depreciation which has been charged cannot ascertain from this balance sheet.

2. When Depreciation is Credited to Provision for Depreciation Account

In this method, depreciation is credited to the provision for depreciation account or accumulated depreciation account every year. Depreciation is accumulated in a separate account instead of adjusting into the asset account at the end of each accounting period. In the balance sheet, the asset will continue to appear at the original cost every year. Thus, the balance sheet shows the original cost of the asset and the total amount of depreciation charged on asset.

Types of Reserves

1. Revenue Reserve: It is an amount set aside out of revenue profits for distribution of dividends. For example, general reserve, investment fluctuation fund, capital reserve and workmen compensation fund. It is not a charge against profit but it is appropriation of profit shown in the profit and loss account. It is beneficial for the smooth function of the business. The retention of profit in the form of reserves reduces the amount of profit to distribute among the business owners. This is further classified in to general reserve and specific reserve.
1. General reserve means a reserve which is not maintained for specific purpose. It helps to strengthen the financial status of the business. It is also known as free reserve and contingency reserve.
2. Specific reserve means a reserve which is maintained for specific purpose. For example, dividend equalisation reserve is created to maintain dividend rate. This reserve amount is utilised to maintain the rate dividend in the year of low profit. Likewise, the workmen compensation fund is maintained to provide claims of the workers, investment fluctuation fund is used at times of decline in the value of investment and debenture redemption reserve is used to provide funds for redemption of debentures.

2. Capital Reserve: It is an amount set aside out of capital profits which is not available for distribution as dividend among the shareholders. It is used for writing capital losses/issue of bonus share in a company. Examples of capital reserves are
1. Profit prior to incorporation
2. Premium on issue of shares or debentures
3. Profit on redemption of debenture
4. Profit on forfeiture of share
5. Profit on sale of fixed assets
6. Capital redemption reserve
7. Profit on revaluation of fixed assets and liabilities

Provision is an amount which is set aside by charging it to profit for the purpose of providing for any known liability or uncertain loss or expense. The amount of which cannot be determined with certainty is also referred to as provision. Few examples are provision for depreciation, provision for doubtful debts and provision for discount on bad debtors.

The main objective of provision is to account all expenses and losses. Through the creation of provision account, the amount of liability, losses and expenses are estimated and accounted for the accounting period. Therefore, the true profit and loss is ascertained, liabilities and assets are presented with correct values.

Importance of Provision

1. To meet anticipated losses and liabilities: Provision is created to meet the anticipated losses and liabilities such as provision for doubtful debts, provision for discount on debtors and provision for taxation.
2. To meet known losses and liabilities: Provision is created to meet known losses and liabilities such as provision for repairs and renewals.
3. To present correct financial statements: To present a true and fair view of profit and financial statement, the business must maintain provision for known liabilities and losses.

Therefore, provision is necessarily to be created to ascertain the current income or profit. Also, it is considered as a charge against revenue or profits.

Accounting Treatment

Provision is a charge against the profit which is debited in the profit and loss account. In the balance sheet, the amount of provision may be shown on the asset side by deducting from the relevant asset or on the liability side along with the current liabilities.

1. Treatment on asset side- Provision for doubtful debts is deducted from the amount of sundry debtors and the provision for depreciation is deducted from the relevant asset.
2. Treatment on liability side- Provision for repairs and charges are shown along with the current liabilities.

Working notes :

1. Calculation of annual depreciation

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Working Notes :

1. Calculation of annual depreciation

Working notes:

Working Notes :