5. Depreciation, Provisions and Reserves Learning Objectives After studying this lesson you will beable to '@ Statethe meaning and concept of depre © Explain the causes of depreciation, ‘© Explain the methods of charging depreciation; ‘© Show the Accounting Treatment of Depreciation; 1gof Provision and Reserve; © Statethemeant © Differentiate between Provision and Reserve. ‘Teaching Method Teachers ae advised to use Vatious exatyples from daily life in orderto clear the conceptof depreciation, “Provison for Depreciation Aecount’ is to be taught through various exercises solved by both the Accounting Treatment of Depreciation, i.e Charging Depreciation in Asset Account and Charging Depreciation in Provision for Depreciation Account. Journal entries for ereating Provision for Depreciation are also to be explained, Depreciation: An Tatroduction Suppose you have purchased a car. After some time you noticed that if you want to sell this cay, its values is less than its cost price. Similarly value of all fixed assets are decreased due to passage of time and some other reasons. The reduetion in value of fixed assetsis known as depreciation. Expenditure on fixed assets of the business like furniture, fixtures and fittings of the shop, motor vans, machines and equipments are neither expenditure on purchase of goods nor expenses. Expenditure of this nature give service to the business for many years and thus called Capital Expenditure. Would you like to deduct the expenditure on the fixed assets from the profit of any one year ? It would be wrong to do so since their benefit is enjoyed by the business for more than one year. The correct thing will be to distribute their cost over the years of their useful life to the business ‘The portion of the cost of fixed assets charged each year as expense is known as depreciation, Depreciation: Concept Business enterprises require fixed assets for their business operations suchas furniture and fixtures, office equipments, plant and machinery, motor vehicles, land and building ete. In the process of converting Raw material into finished products, the fixed assets depreciate in value over a period of time, Le. its 65useful life. Depreciation is a part of the cost of a fixed asset which has expires © Onaccount of usage: + Lapseoftime. # Obsolescence * Accident Inother words, the process of allocation of the cost ofa fixed asset over its usefullifeis known as depreciation Need or objectives of providing Depreciation : 1, Ascertaining true profit or loss: (i) The true profit oF loss of an enterprise can be ascertained when all costs incurred for the punpose of earning revenues hawe been debited to the profit and loss account, (i) Fall in the value of assets used in business operations is a part of the cost and should be shown in the profit and loss aceount of concerned accounting period. (iii) Keeping this in view, depreciation must be debited to profit & Loss account, since loss in value of fixed assetsisalso an expense like other expenses. 2. Presentation of Trueand Fair value of assets: If depreciation is not provided, the value of assets shown in Balance sheet will not present the true and fair value of assets because assets are shown at the cost pricebut actual valueis less than.cost price of the assets, 3. Toasceriain theaceurate cost of the production Depreciation is an item of expense, the correct cost of production cannot be calculated unless itis also taken into consideration. Flence, depreciation must be providedto ascertain the correct cost of production, 4. Computation afeorreetineometax: (i) Income tax of an enterprise is determined after charging all the eosts of production, (ii) 1edepreciat tax will also be higher. (iii) Ifdepreciation is charged, Tax lability iseduced, Provision offunds.and replacement of assets : Deprecation is anon cash expense. So thatamountof depreciation charged to profit and loss accounts is retained in business every year. These funds are available for replacement of the assets when its useful life isover. Methods of providing depreciation : 1, Straightline method: (i) This method isalso know nas ‘original cost method" i) Under this method, depreciation is charged at fixed percentage on the original cost ofthe asset, throughout its estimated life n is nat charged, the profits will be higher and the ineome 66(iii) Under this method the amount of depreciation is uniform from year to year, That is why this method is also known as “Fixed Installment Method’ or SEqual Installment Method’. (iv) The annual amount of depreciation ean be easily calculated by the following formula Annual Depreciation = Original cost Estimated sorap value Estimated ie For example: A firm purchases a machine for €2,25,000.00 April 1, 2011. The expected life of this machine is 5 years. After 5 years the serap of this machine would be realized 25,000. Under straight Line method, the amount of depreciation can be calculated as under Arm Dares = 2.2500 25.000 - x. 999 Hence, & 40,000 will be charged each year as depreciation on this machine 2. Diminishing balance method: ‘Under this method, depreciation is charged asa fixed percentage on the book value ofthe asset every year: In first year the depreciation willbe charged atthe end of the year, onthe total cost ofthe asset. For example A machine is purchased for % 20,000 on April 1, 2008, 1 is decided to change depreciation on this machine @10"%p.a on diminishing balance method. The amounts of depreciation for first four years are as under: Year Book Value (®) Depreciation @ 10% (®) 2008.09 20,000 2,000 2010-10 20,000--2,000=18,000 1,800 2010-11 —_18,000--1,800=16,200 1,620 2011-12 16,200--1,620=14,580 1,458 Hence, in this method, rate of depreciation is same but amount of depreciation goes on decreasing every year. Therefore, this method is also known as Written Down Value Method” and ‘Reducing listallnent Method’ Mlustration 1. (On January 1, 2008, firm boughta machine For 90,000 and spend 6,000 on its installation and ® 4,000 on its carriage, Tis decided to charge depreciation @ 10% ‘on straightline method, Books are closed on December31, each year ‘Show Machinery Account forthe year 2008 to 2010. 7Solution Dr ‘Machinery Account Ge ate | Particulars [.r| | Date {Particulars ie] & 2008 208 Jan. 1] To Bank A’ | | 90,000 | Des 31) By Depreciation ve] | 10.000 Jan. 1] To Cash Ave 6,000 | Dee 31|By Balance ed 0,000 [isn 1) To Cash Alc 4,000 00,000 00,000, 2009 2009 Jan. 1] To Balance bid] | 90,000 | Dee 31) By Depreciation Ave] | 10.000 Dee 31}By Balance e/d 30.000 30,000 50.000 2010 2m0 jan 1 | To Balance bid] | 80,000 | Dec 31]By Depreciation Ave} | 10,000 Dec 31)By Balance cid 70.000 80,000 80.000 Mlustration 2 ‘Onthebasis of information given in Ilustration 1, show Machinery Account for the year 2008 to 2010 if depreciation is charged @ 10% on diminishing balance Solution De Machinery Account ce Date [Particulars [KF] © | Date [Particulars wy 2008 2008 Jan 1) To Bank A’e 99,000 | Dee 31] By Depreciation A'e 10.000 Jan 1] To Cash Alo 6,000 | Dec 31] By Balance eld 90,000 Jan 1] To Cash Ale 4,000 700,000 1,00,000 2009 2009 Jan. 1 To Balaace bd] | 99,000 } Dev 31) By Depreciation Alc 9,000 Dee 31]By Balance cid 1,000 36,000 90,060 2010 amo Jan 1 |To Balance bid] | 81,000 } Dee 31)By Depreciation Alc 8,100 Dee 31]By Balance eld 7,900 ‘31,000 31,000 6slustration 3 ‘OnApril, 1, 2008 Prakash & Sons bought furniture costing & 60,000, On July, 1, 2010. Fumiture was sold for 30,000 Prepare Furniture Account assuming depreciation was charged @ 10% per an- ‘num on March 31 each year. Solution ; Machinery Account Date| Particulars [sr] © [Date | Particulars [ar] © 2008 2009 Ape. To Bank Ale 60,000 | Mar31] By Depreciation 6000 Alc ‘Mar31} By Balance e/d 60,000 2009 2010 Ape. To Balance bid] | $4000 | Mar31) By Depreciation 6,000 Ale Mar31} By Balance eft 48,000 [54000— 2010 2010 Ape.) To Balance wid] | 43,000 | Jul.1 | By Bank Ale 30,100 Jul | By Depreciation Ale 1,500 Jul.1 | By Loss on Sale of 16.500 Machinery 48,000 48,000 ‘On the basis of information given in Illustration 3, prepare Funiture Account as- suming depreciation was charged (@ 15% per annum on reducing installment method. Solution; ‘Machinery Account Date[ Particulars [3] * [Date | Pariculrs [y] © 008 2009 [Ape 1) To Bank A’c 60,000 | Mar. 31] By Depreciation Ac 3,000 Mar. 31] By Balance eft 51,000 60,000 60,000 2009 2010 [Apel] To Balance wid| | 51,000 | Mar.31]By Depreciation Ale} | 7,650 Mar. 31) By Balance eft 43350 ‘31,000 31,000 69oT on [Apr. [To Balance wd 43350} Jul, 1 | Ry Bank Ae 30,000 Jul. | By Depreciation Ale 1626 Jul. /By Loss on Sale of 724 Machinery 5 43.350 3350 CREATION OF PROVISION FOR DEPRECIATION ACCOUNT: There is another treatment for charging Depreciation. In ths treatment, Provision {or Depreciation Account is opened and depreciation charged inthis account instead of Asset Account. Following Journal entries are passed atthe end ofeach accounting criod. Date[ Particulars LF [be @) [ee@] ‘Depreciation Account Dr ‘ToProvision for Depreciation Account ProfitandLossAccount Dr “ToDepreciation Account Ththis treatment the balance of Asset Account remains same throughout its use life. Provision for Depreciation is shown in the liabilities side of Balance Si Mustration S Krishns lifestyle limited purchasedla machine for® 1,25,000 including installation cost on January I, 2008, On October 1, 2010, machine was sold for & $0,000. Depteciation was provided @ 20% p.a. on Fixed Instalinent method and accounts ate closed on December 31 each year, Show the Machinery Account and Provision for Depreciation Account forthe year 2008 t0 2010 Solution : Machinery Account [Date] Particulars [EF] [Date | Particulars ule 2008 2008 Hin. 1} To Bank Ale 125,000 | Dec. 31)By Balance eid 1,25,000 2009 209 lian. 1] To Balance wid) [1,25,000 _} Dec. 31] By Balance eid 1.25,000 2010 2010 lian, } To Balance bia] |1,25,000 | Oct. |By Provision for 68,150 Dep. Ave Oct 1 [By Bank Ale ct. 1 [By Loss on Sale oF MachineryProvision for Depreciation Account pate | Particulars [sr] | pate | Particulars lar] = 2008 2008 Dee3}] To Balance eld | [25,000] Dee.31| By Depreciation Aie | | 25,000 2009 2009 Dee.3i| To Balance cid | {50.000} Jan.1 | By Balance bid 25,000 Dec.31 | By Depreciation 25,000 Ale [50,000 30,000 2010 2010 loct. 1] To Machinery | {68,750} Jan.1 | By Balance bid 50,000 Ae Oe. 1 | By Depreciation Ave} | 18,750 [68,750 68,750 portant Point : Total Depreciation chaeg Mlustration 6 On the basis of information given in Illustration 5, show the Machinery Account and Provision for Depreciation is provided @ 20% p.a,o= Written Down Value Method sd. on Machine : 25,000+25,000+18,750 = 68,750 Solution : Machinery Account [Date [Particulars [ie] % | Date | Particulars [OF] % 2008, 2008 Jian. 1 | To Bank Alc 1,25,000) Dec.31 | By Balance cid 1.25000 2009 2009 lian. 1| To Balance bia) | 1,25,000] Dee. 31] By Balance cfd 1.25000 l2o10 2010 Jian. 1|'To Balance bid} | 1,28,000] Dee. 31] By Provision 57,000 for Dep. Ale et. 1 | By Bank Ale 30,000 Oct 1 | By Loss on Sale of 18000 Machinery Ale 725,000) 125,000Provision of Depreciation Account Date | Particulars JF] % [Date | Particulars [SF] & 2oas 2008 Dee.31} To Balance eid} | 25,000_| Der. 31]By Depreciation Are] | 28.000 2009 2009 [Dee.31} To Balance eid] | 45,000 | Jan. 1 | By Balance bict 25,000 Dec. 31|By Depreciation Ale} | 20.000 5,000 45,000 2010 2010 JOct. 01] To Machinery | | $7,000 | Jan.1 By Balance biel 45.000 Ale ct. 1_|By Depreciation Ale |_| 12,000 57,000 57,000 Important Poin Total Depreciation is charged on Machine : 25000+20,000+12,000 Mlustration 7 A Company purchased a machine for 40,000 on January 1,2010, On July 1 2011 it was sold for 13000. The company charges depreciation @ 10% pa. on straight Finernetod. Show Machinery Account, Provision for Depreciation Account and Machinery Disposal accountittbooks are closed on Decemeber 31 each year Solution Machinery Account [pate] Particulars | FF] % [Date [Particulars | IF] @ laoi0 2010 lun.t| To Cash Ale 40,000 _| Dec. 31] By Balance ciel 40000 aor ami lian. “To Balancebr 40,000 | July | By Machinery 40,000 Disposal Ale Provision for Depreciation Account Date [Particulars [IF] % [Date |Pariiculars url? 2010) 2010 Dee.3i] To Balance eid} — | 4000_| Dec.31 | By Depreciation Ave 4000 2011 2m Dec.31} To Machinery 6000 |ien.t | By Balance bid 4000 Disposal Aic July |_| By Depreciation AJe 2,000 6,000 6.000)Machinery Disposal Account Dr. ce. Date| Particulars [4] © | Date] Particulars ae 2011 2011 July | ToMachinery | |40,000] July | By Prov. ForDep. 6,000 Ae Ale July! | ByCash Ale 13,000 Julyl| ByLassonsate of | — |21,000 Machinery Ae [40,000] 40,000 Important Point: ‘Total Depreciation charged on Machine : 4,000+2,000. Mlustrartion 8: (On July 1,208, Porwal Auto Limited purchased Furniture for | 00,000 and spent 4,000 towards its installation. On April |, 2009, the Furniture was disposed off For & 59,820 and on the same day furniture costing 8 1 60,000 were puchased ‘Show th Furniture Account, Provission for Depreciation Account and Furniture Dis- posal Account forthe year 200%, 2009 and 2010 if the rate of Depreciation is 15% per annum by Diminishing Balance method, Furniture Account Dr. cr. [Date | Particulars |. | Date [Particulars [SF] % 2008 2008 July 1] To Bank Ale 100.000 | Dec.31 |By Balance eid 1,03,000 To Cash Alc 4,000 TOO TOOT 2009 2009 Jan, 1} ‘To Balance b/d) | 104000 | Ape 1 [By Fuimitrue 1.04000 Disposal Ale Apr. I] To Bank Ale 1,60,000 | Dec, 31|By Balance ed 1,60,000 2.64.00, 2.64.00 2010 2ai0 Jian 1 | To Balance biq| | 1.60000 | Dec 31 |By Balance eld 1,60,000Provision for Depreeiation Account Dr Cr Date [Particulars [JF] % [Date | Particulars [ar] © 2008 2008 Dec.31] To Balance cid] —|_7800_| Dec31 | By Depreciation Ale 7.800 2009) 2m ‘Ape31| To Furniture Jan. 1 | By Balance bie 7,800 Disposal Ae ‘To Balance eid] | 18,000 | Apr. 1 | By Depreciation Ale 3,608, Dee. 31] By Depreciation A‘e| | 18,000 29,408 29,408 2010 Dee.31] To Balance eid} | 39,300 |Jan1 | By Balance bid 18000 Dee,31| By Depreciation Ale | | 21,300 5307 33300 Furniture Disposal Account Dr. Cr Date [Particulars [LF[ _@ [Date | Particulars TL 2009 2009 Ape. | To Furmicure 1104000 | Ape. 1 | By Prov. For Dep. 11408 Ale Ne Apr. | By Bank Ale 59820 Apr. L| By Loson ale of 3277 Furniture Ale 104/000 1,04,000 Important Poin “Total Depreciation charged on Machine sold: €7,800+€ 3,608 =€ 11,408 Mlustration 9 “A machine was purchased on Ist January, 2008 for € 1,00,000. On Ist July 2010, machinery purchased on Ist January, 2008 was sold for € 60,000 at 20% po ‘The following balances appearin the books ofthe Co. ason Ist January 2010. z Machinery Account 5,00,000 Provision for Depreciation Account 150,000 4You are required to prepare the machinery A/e and provision for depreciation A‘c forthe year2010, Note : Depreciation is charged @ 20% per annum on Fixed Installment Method. Solution Machinery Agcount Dr. ce [Date [Particulars [J.F[Amount® [Date [Particulars TE ]Amount 2010 2010 Jan.1 | To Balance 5,00,000 July 1 | By Bank Ave 60,000 bia Sly 1] toProfton Sale July 1 | By Provision for ot bactinery A 10,000 Depreciation Ale 50,000 Dee 31] By Balance eld 4.00,000 SOON 310,000 Provision for Depreciation Account D [Date iF Date_| Particulars [1] 2010 2010 Jul.t To Machinery Jan.1 | By Balance bid 1.50.00 Account 50,000 | July 1 ] By Depreciation esi] To Balance cid] | 1,90,000 Ale 10,000 (Machinery Sold) 1Dee.3i] By Depreciation 80,000 am ae ao Working Note : 1. Calculation of Depreciation on Machinery sold z Depreciation for the year 2008 20 & 1,00,000 x 20 20,000 Depreciation for the year 2009 20,000 Depreciation far the year 2010 (5 months) 10,000 752. Profit on Sale of Machinery = © 60,000 x20 = = 10,000 Provisions : 1. Provision is to be made in respect of a liability, which is certain to be incurred, butits accurateamountis not known. 2. A provision is ereated to meet a known depletion of diminution in the valueofasset 3. tis charged in the Profit and loss Account on estimate basis. It should be clearly understood that if the amount of a known liability can be determined with reasonable accuracy, itean not bea provision. Note : Provision is a charge against profits it means provision has to be made irrespective of business enterprise is eaming enuogh profit or loss, Examples of Provisisons + 1. Provision for Depreciation of assets, 2. Provision for Repairs and Renewal 3. Provision for Taxation. of assets. 4, Provision for Discount on Debtors 5. Provision for Bad and doubtful Debis. Reserves: © Reserves are the amount set aside out of profits. It is an appropriation of profits and not a charge on the profits. The amount of profit retained is used in the businesss when difficult time comes. © Since reserves are neither expenses nor losses, so these are not charged to Profit & Loss Account rather these are debited to Profit & Loss Appropriation Account which is prepared after Profitand Loss Account. © Reserves are also known as *Ploughing Back of Profits’. Reserves are created for strengthening the financial positions of the business enterprise Examplesare General Reserve, Dividend Equalization Reserveete. Ifthe amount of reserve is Invested outside the business then, itis called “ReserveFund’, © Creation of reserve does not reduce the net profit but only reduces the divisible profits, 16Types of Reserve General Reserve: Specific teservesare those reserves which are created fora specific purpose and can be utilized only for that purposed, Dividend Equalization Reserve and “Reserve for Replacementof Asset’are the examples of Specific Reserve. General Reserve: Ifthe purpose creating the reserve is to meet any unforeseen contingency (Liability which is not known) in future, the reserve is called ‘General Reserve’, These are retained for strengthening the financial position of the enterprise, Specifie Reserve: Specific reservesaare those reserves which are ereated for'a specific purpose and can be utilized only for that purposed. ‘Dividend Equalization Reserve" and ‘Reserve for Replacement of Asset are the examples of Specilic Reserve. Capital Reserve: In addition to the normal profits, capital profits are also eamed in the business from many sources. Reserves created outof capital profits w hick are 1. Notofrecurringnature 2. Not readily available for distribution as dividend among the shareholders. 3. These reserve can be utilized for writing off capital losses. Capital Reserves may be created out ofsuch profits as : 1. Profitan sale ofany fixedasset. IL. Profit from forfeiture of shares, IL, Profitprior to incorporation of company. IV, Profitan redemption of debentures Secret Reserve : A secret reserve is created by undervaluing the fixed assets. Existence of seeretreserve 1. Reduce the profits ofthe business enterprise and Reducesitstax liability. cretin the sense thatit isnot known to the outsiders. Secretresenveil Such reserves are created by showing the assets ata loweramount and (esata higher amount ”Difference between Provisions and Reserve Basis Provision Reserve, I, Meaning | [viscreated tomecta | Itisereated tostrengihen the nan ‘known liability. cial position of business enterprise. 2, Charge or | Provisionsarecharge | Reserve is an appropriation of Appropriation} against profits. profit. 3. Objective | The objective isto provide Itiscreatedto strengthen the forknown liability but | financial position andto meet camotbecaleulated | unforeseen lability. accurately. 4. Effecton | Itisdebitedtothe Profit | It is debited to Profit and Loss Profit & Loss Account, Hence, | Appropriation Account. profitis reduced. Reserve reduces divisible profits 5. Creation | Provisionsaretobe | Reserveis created out of adequate created even ifthereare | profits only insufficient profit only. 6. Modeof | Provisionare created by | Itiscreated through Profit & creation _| dcbitingthe Profit & loss | Lass Appropriation Account. ‘account 7. Investment | Itcannot beinvested | Reservecanbe invested ‘outsidethe business. | outsidethe business. 8 Necessity | Creation ofprovision is | Its creation isnot necessary. necessaryasperlaw. | Itiscreated asamatter of prudence, Points to Remember: Fixed assetsare those assets which are used for many years, Depreciation means reduction in value of tangible fixed assets. Through accounting treatment of depreciation we ean distribute the total costof fixedassets over the years of their useful life There are two main methods of charging depreciation : Straight Line Method and D iminishing Balance Method. 1810. Depreciation is charged on fixed assets only and at the end of accounting period, In Staight Line Method, depreciation is charged on original costand the amountof depreciation remains same year after year In Diminishing Balance Method the amount of depreciation is reducing ‘year after year becaused depreciation is charged on apening balance of the asset in every year8. In Staight Line Method, the book valueofasset cean be reduced to zero but in Diminishing Balance Method, the book valueof assetean notbe reduced to zero, Provisions are made for knowa liabilities which can not be calculated accurately Reserves are created for strengthening the financial position of enterprise but can be created ifadequated profits are available.