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Depreciation: Provisions and Reserves

Depreciation: Provisions and Reserves

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Study Action Plan (Sorted by Difficulty)
Asset Disposal Accounting
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Depreciation Accounting
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Depreciation Methods Comparison
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Factors Affecting Depreciation
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Journal Entries for Depreciation
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Provision and Reserves
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Statutory Compliance in Depreciation
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Learning Objectives

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Learning Objectives

After studying this chapter, you will be able to:
  • Explain the meaning of depreciation and distinguish it from amortisation and depletion.
  • State the need for charging depreciation and identify its causes.
  • Compute depreciation using straight line and written down value methods.
  • Record transactions relating to depreciation and disposition of assets.
  • Explain the meaning and purpose of creating provisions and reserves.
  • Distinguish between reserves and provisions.
  • Explain the nature of various types of provisions and reserves including secret reserve.

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Revision Notes & Summary

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Chapter Notes: Depreciation, Provisions, and Reserves

1. Introduction to Depreciation

  • Definition: Depreciation is the decline in the value of a tangible fixed asset.
  • Purpose: It allocates the depreciable cost over the useful life of the asset.

2. Need for Depreciation

  • Matching Principle: Revenue of a period must match expenses of the same period.
  • True Profit Calculation: Essential for ascertaining true and fair profit or loss.
  • Tax Deduction: Depreciation is a deductible cost for tax purposes.

3. Causes of Depreciation

  • Wear and Tear: Deterioration from use or passage of time.
  • Expiration of Legal Rights: Loss of value after agreements expire (e.g., patents).
  • Obsolescence: Becoming out-of-date due to technological advancements.
  • Abnormal Factors: Accidental losses (e.g., fire, floods).

4. Methods of Calculating Depreciation

4.1 Straight Line Method

  • Description: Equal depreciation charge over the asset's useful life.
  • Characteristics: Fixed annual charge.

4.2 Written Down Value Method

  • Description: Depreciation based on book value, which declines each year.
  • Characteristics: Higher depreciation in earlier years.
Basis of DifferenceStraight Line MethodWritten Down Value Method
Basis of chargingOriginal costBook Value
Annual depreciationFixedDeclines year after year
Total chargeUnequalAlmost equal
Recognition by lawNot recognisedRecognised
SuitabilityLow repair costsHigh repair costs

5. Provisions and Reserves

5.1 Provisions

  • Definition: A charge against profit for known liabilities with uncertain amounts.
  • Examples: Provision for doubtful debts, taxation, repairs.
  • Accounting Treatment: Debited to profit and loss account.

5.2 Reserves

  • Definition: Appropriations of profit to strengthen financial position.
  • Examples: General reserve, capital reserve, workmen compensation fund.
  • Accounting Treatment: Shown under Reserves and Surpluses on liabilities side.

6. Key Terms Introduced

  • Depreciation: Decline in asset value.
  • Depletion: Reduction in natural resources.
  • Amortisation: Writing off intangible assets.
  • Salvage Value: Estimated residual value at the end of useful life.
  • Secret Reserve: Excessive provision leading to hidden reserves.

7. Conclusion

  • Understanding depreciation, provisions, and reserves is crucial for accurate financial reporting and compliance with accounting standards.
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Practice Test – MCQs, True/False

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Multiple Choice Questions

A.

₹20,000

B.

₹18,000

C.

₹16,200

D.

₹15,000
Correct Answer: C

Solution:

The depreciation for the second year is calculated as: ₹1,80,000 (book value at the end of the first year) x 10% = ₹18,000.

Chapter Concept:

Journal Entries for Depreciation

A.

₹3,50,000

B.

₹4,00,000

C.

₹4,50,000

D.

₹3,80,000
Correct Answer: A

Solution:

The annual depreciation is calculated as: ₹5,00,000−₹50,00010=₹45,000\frac{₹5,00,000 - ₹50,000}{10} = ₹45,000. After three years, the total depreciation is ₹1,35,000. Therefore, the book value at the end of the third year is ₹5,00,000 - ₹1,35,000 = ₹3,65,000.

Chapter Concept:

Depreciation Accounting

A.

To match costs with revenues

B.

To increase the value of assets

C.

To comply with tax regulations

D.

To reduce cash outflows
Correct Answer: A

Solution:

Depreciation is charged to match the cost of an asset with the revenue it generates over its useful life.

Chapter Concept:

Depreciation Accounting

A.

To calculate the depreciation expense for the period

B.

To consolidate all transactions related to the sale of an asset

C.

To record the purchase of new assets

D.

To determine the original cost of the asset
Correct Answer: B

Solution:

An Asset Disposal Account is used to consolidate all transactions related to the sale of an asset, including original cost, accumulated depreciation, and sale proceeds.

Chapter Concept:

Asset Disposal Accounting

A.

₹ 9,000

B.

₹ 10,000

C.

₹ 11,000

D.

₹ 12,000
Correct Answer: A

Solution:

The annual depreciation is calculated as: Cost of asset−Residual valueUseful life=50,000−5,0005=9,000\frac{\text{Cost of asset} - \text{Residual value}}{\text{Useful life}} = \frac{50,000 - 5,000}{5} = 9,000.

Chapter Concept:

Factors Affecting Depreciation

A.

₹50,000

B.

₹45,000

C.

₹40,000

D.

₹30,000
Correct Answer: C

Solution:

The annual depreciation charge is calculated as: ₹5,00,000−₹50,00010=₹45,000\frac{₹5,00,000 - ₹50,000}{10} = ₹45,000.

Chapter Concept:

Depreciation Methods Comparison

A.

Straight Line Method

B.

Written Down Value Method

C.

Sum of Years Digit Method

D.

Double Declining Balance Method
Correct Answer: B

Solution:

The Written Down Value Method results in a higher depreciation charge in the earlier years because it applies a fixed percentage to the reducing book value of the asset.

Chapter Concept:

Depreciation Methods Comparison

A.

On the original cost of the asset

B.

On the book value of the asset at the beginning of the year

C.

On the salvage value of the asset

D.

On the market value of the asset
Correct Answer: B

Solution:

In the Written Down Value Method, depreciation is charged on the book value of the asset at the beginning of the year.

Chapter Concept:

Depreciation Methods Comparison

A.

Cost of the asset

B.

Useful life of the asset

C.

Market value of the asset

D.

Net residual value of the asset
Correct Answer: C

Solution:

Accounting Standard-6 specifies that the cost, useful life, and net residual value are factors affecting depreciation. Market value is not considered.

Chapter Concept:

Statutory Compliance in Depreciation

A.

₹9,000

B.

₹10,000

C.

₹9,500

D.

₹8,000
Correct Answer: A

Solution:

The annual depreciation expense is calculated as: Cost of Asset−Residual ValueUseful Life=1,00,000−10,00010=9,000\frac{\text{Cost of Asset} - \text{Residual Value}}{\text{Useful Life}} = \frac{1,00,000 - 10,000}{10} = 9,000

Chapter Concept:

Depreciation Accounting

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Depreciation: Provisions and Reserves

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True or False

Correct Answer: False

Solution:

When provision for depreciation account is maintained, depreciation is accumulated in a separate account, and the asset account remains at its original cost.

Chapter Concept :

Journal Entries for Depreciation

Correct Answer: True

Solution:

Depreciation is determined by three main factors: the cost of the asset, its estimated useful life, and its estimated net residual value.

Chapter Concept :

Factors Affecting Depreciation

Correct Answer: True

Solution:

According to Accounting Standard-6, depreciation is defined as a measure of the wearing out, consumption, or other loss of value of a depreciable asset arising from use, effluxion of time, or obsolescence.

Chapter Concept :

Depreciation Accounting

Correct Answer: True

Solution:

When an asset is disposed of, the accumulated depreciation is transferred from the provision for depreciation account to the asset disposal account, which is credited with this amount.

Chapter Concept :

Asset Disposal Accounting

Correct Answer: False

Solution:

Under the straight line method, the depreciation charge remains constant throughout the asset's useful life, whereas the written down value method results in higher depreciation charges in the earlier years.

Chapter Concept :

Depreciation Methods Comparison

Correct Answer: False

Solution:

Depreciation is not charged to reduce the value of an asset to its market value; it is charged to allocate the cost of the asset over its useful life.

Chapter Concept :

Depreciation Accounting

Correct Answer: False

Solution:

Depreciation is the allocation of the depreciable amount of an asset over its useful life, not to reduce it to market value.

Chapter Concept :

Depreciation Accounting

Correct Answer: True

Solution:

Depreciation is recorded by debiting the depreciation account and crediting the asset account, reflecting the reduction in asset value.

Chapter Concept :

Journal Entries for Depreciation

Correct Answer: True

Solution:

Depreciation is a non-cash expense representing the expired cost of an asset, and is deducted to ascertain taxable profits.

Chapter Concept :

Depreciation Accounting

Correct Answer: False

Solution:

The amount of depreciation depends on three factors: cost, estimated useful life, and net residual value.

Chapter Concept :

Factors Affecting Depreciation

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