Depreciation & Provision and Reserves H.S. 1ST YEAR ACCOUNTANCY NOTES AHSEC ASSAM Higher Secondary UNIT -5

 

Unit – 5

Depreciation &  Provision and Reserves

 

DEPRECIATION

 

Q1. What is depreciation? What are its features?

Ans. Depreciation is a decline in the book value of depreciable asset during the estimated useful life of the assets. It may be due to wear and tear of assets, efflux ion of time, obsolescence, depletion etc.

         According to CIMA, London, “Depreciation is the permanent decrease in the value of an asset due to use and / or the lapse of the time.”

Following are the features of Depreciation:

a. Depreciation is a charge against profit for a particular accounting period.

b. Depreciation may be physical or functional.

c. Depreciation is a process of allocation of cost and not of valuation of fixed assets.

d. Depreciation is charged in respect of fixed assets only.

e. Depreciation is a continuous fall in the utility of a fixed asset till the end of its useful life.


Q2. What are the causes of Depreciation?

Ans. The causes of decline in the book value of fixed assets may be divided into two categories:

i. Physical  ii. Functional

The physical causes may be as follows:

a. wear and tear: Some assets physically deteriorate due to wear and tear in use.

b. Destruction: The physical destruction of an asset reduces its utility value. The causes of destruction may be due to an accident like fire, flood or similar other havocs.

c. Decay: It refers to lessening in the utility of an asset by the effect of nature e.g. rain, moisture, change in weather and other elements in nature.

The functional causes may be as follows:

a. Obsolescence: When an asset becomes out of date or it goes out of use due to new or improved technology or invention, this is referred to as obsolescence.

b. Inadequacy: It refers to the termination of the use of an asset due to increase in the volume of business activities.

c. Efflux ion of time: These are some assets e.g. lease, patents, licences, copyrights, etc. which loss their value simply with the efflux ion of time.

d. Depletion: In case of oil wells, mines etc the value is reduced with the extraction of oil and minerals.

e. Exhaustion: Assets like plantations, animals etc. loss their value gradually with the passage of time. They have their own age and exhaust in value after the expiry of certain period of their age.


Q3. What are the needs for charging Depreciation?

Ans.  Following are the needs for charging Depreciation:

a. To ascertain the true profit or loss: One of the objectives of calculating depreciation is to determine the true profits of business.

b. True and fair view in balance sheet: If depreciation is not provided in the books of accounts, the fixed assets will be shown in the balance sheet at a higher value than its real value. As such this overvaluation of fixed assets will not represent a true and fair view of the state of affairs of the business.

c. Distribution of dividend out of profits only: When depreciation is charged to profit and loss account the profit is reduced and the balance of profit left after depreciation is available for distribution as dividend to shareholders.

d. Replacement of assets: Assets used in the business need replacement after the expiry of their useful life. Fresh funds are required to replace old assets.

e. To reduce income tax liability: When depreciation is debited to profit and loss account the profits are reduced, consequently the tax liability on profit is also reduced.


Q4. What are the methods of charging Depreciation?

Ans. Following are the different methods of charging Depreciation:

a. Straight line method

b. Written down value method

c. Sum of the year’s digit method

d. Annuity method

e. Sinking fund method.

f. Insurance policy method

g. Machine hour rate method.

h. Depletion method

i. Revaluation method

j. Mileage method

 

a. Straight line method: under this method a fixed proportion of original cost of the asset in written off annually so that, by the time asset is worn out, its value in the books is reduced to zero or residual value. This method is also known as Fixed Instalment Method or Original Cost Method.

 

b. Written down value method: Under this method a fixed rate or percentage of depreciation is charged each year on the diminishing value of the asset till the amount is reduced to scrap value.

 

Q5. What are the differences between Straight line method and Written down value method?

Ans. Following are the differences between Straight line method and Written down value method:

Straight line method

Written down value method

a. The rate and amount of depreciation remains the same each year.

a. The rate remains the same but amount of depreciation reduces every year.

b. Depreciation is calculated on the original cost of asset.

b. Depreciation is calculated on the reducing balance of a fixed asset.

c. At the end of its life the value of asset is reduced to zero or scrap value.

c. Value of asset never reduces to zero at the end of its life.

d. Computation of depreciation is comparatively easy and simple.

d. Depreciation can be computed easily but the calculation of rate of depreciation is difficult.

e. This method is more suitable for assets which are fully depreciated on the expiry of its working life.

e. This method is more suitable for such assets which require more repairs in the later part of its working life.

 

PROVISIONS AND RESERVES


Q1. What is meant by reserve?

Ans. Reserve is an amount set aside out of profits meant to strengthen the financial position of a business and to meet contingencies which are indeterminate.


Q2. What are the objectives of creating reserve?

Ans.  Following are the objectives of creating reserve:

a. Expansion of business through internal sources i.e., ploughing back of profits.

b. To strengthen the financial position of business.

c. To increase working capital of business.

d. To meet future contingencies.

e. To meet any unknown liability or loss.


Q3. What are the features of reserve?

Ans.  Following are the features of reserve:

a. Reserves are appropriation of profits and they do not affect the current year’s profit.

b. Reserves are recorded on the liabilities side of the balance sheet.

c. Reserves may be classified as general reserve, specific reserve.

d. The amount representing the reserve does not constitute any liability or provision for depreciation.

Q4. What is provision?

Ans. Provision is a charge against the profits for the possible loss or liability, the amount of which cannot be determined exactly.


Q5. What are the differences between provision and reserve?

Ans.  Following are the differences between provision and reserve:

 

PROVISIONS

RESERVES

a. It is a possible loss. So it is created by debiting profit & loss account-it is a charge against profit. 

a. It is a portion of profit earned by a business. It is created by debiting profit & loss appropriation account-it is a charge out of profits.

b. profit & loss account will not disclose true profit/loss unless provision is created.

b. profit & loss account disclose true profit/loss even if no reserve is unless created.

c. Profit or loss is affected by its creation – profit decreases or loss increases.

c. It does not affect profit or loss, since it is created after ascertaining net profit.

d. Dividend to shareholders cannot be paid out of it.

d. Dividend can be paid out of it.

e. Its amount must be sufficient to meet the loss or liability.

e. Its amount is generally determined by management on the basis of the amount of profit earned.

 


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