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a. Obsolescence: When an asset becomes out of date or it goes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. |
