2. Depreciation
Depreciation is the process of spreading the cost of
fixed assets over the different periods which derive
the benefit from their use. Depreciation is a
permanent decline in the value of an asset. The
gradual decrease, both in the value and usefulness, of
an asset due to its nature and usage is termed as
depreciation.
It is common experience that whenever an asset is
used it reduce in value. The net result of depreciation
is that sooner or later, the asset becomes useless. So,
it can be stated that depreciation is that portion of the
cost of an asset which is reduced from revenues for
the services of the asset in the operation of a
business.
3. Definitions
•According to spicer and pegler “Depreciation is the
measure of the exhaustion of the effective life of an
asset from any cause during a given period”.
•According to International Accounting Standards
Committee “Depreciation is the allocation of the
depreciable amount of an asset over its estimated
useful life. Depreciation for the accounting period is
charged to income either directly or indirectly”.
5. Needs for Depreciation
(i)Ascertainment of net profit or loss:
(ii) Presentation of true financial position:
(iii) Replacement of assets:
(iv) Restriction on distribution of dividend out of
capital:
(v) Reduction in income tax:
(vi)Ascertainment of true cost of production:
6. Basic factors affecting Depreciation
(i)Cost of the Asset:
(ii)Estimated life of the Asset:
(iii)Scrap value of an Asset:
(iv)Chance of obsolescence:
(v)Capital expenditure:
7. Methods of Providing Depreciation
1. Straight line Method or Original Cost Method
2. Diminishing balance Method or Written down value
Method
3. Annuity Method
4. Depreciation Fund or Sinking Fund Method
5. Insurance Policy Method
6. Machine Hour Rate Method
7. Depletion or Output Method
8. Revaluation Method
8. 1. Straight Line Method: Under this method, amount of
depreciation is fixed and equal every year and is deducted
from the original cost of the asset as well as written off
from the Profit and Loss A/c. The amount of depreciation
is either ascertained at a fixed rate or is ascertained by
dividing the original cost less scrap value of the asset by
the estimated life(in years).In this method amount of
depreciation remain the same every year.
2. Diminishing Balance method: Under this method the rate
of depreciation is given in percentage and the
depreciation is charged on the opening balance of the
asset i.e. on its book value every year. Depreciation is
charged at a specific rate every year. This process goes on
till the end of life period of an asset.
9. 3. Annuity Method: Under this method the amount of depreciation
this includes the cost of the asset and also the interest, is written off by
equal annual instalments over the life-time of the asset. At the end of
the life of the asset, its book value is reduced to zero or to its residual
value. The amount of depreciation can be ascertained by reference to
the annuity table. This method is best suited to those assets which
require considerable investment.
4. Sinking Fund method: This method besides providing
depreciation also accumulates sufficient amount for replacement of
the asset on the expiry of its useful life. These methods ensure that
when the replacement of the asset is due, ready funds are available.
Thus, under this method, the amount of depreciation is set aside and
invested outside the business along with the investments. Investment
are realized when the asset is to be replaced. The amount of
depreciation to be provided every year is calculated by making
reference to readily available Sinking Fund Table.
10. 5. Insurance Policy Method: Under this method, an
insurance policy is taken for investing the amount of
depreciation. This policy will provide the required
amount for the replacement of an old asset at the
end of its life. The method and accounting entries
are similar to depreciation fund (Sinking Fund)
method except that no interest is received from
investment.
6. Machine Hour Rate method: In this method
depreciation is charged at an hourly rate for the
number of hours the machine worked/used during
the year. The method is used by those companies
which are highly mechanized and where the actual
working hours of the machine are noted and
observed.
11. 7. Depletion Method: In the case of wasting assets
such as mines, quarries and oil wells etc.,
depreciation is charged on the basis of quantity of
output extracted. It means, depreciation represents
the cost of expired capital outlay in respect of
quantity of output extracted from the mines, etc.
8. Revaluation method: Under this method, the
asset is revalued at the at the end of each financial
year. The difference between the opening and
closing values of asset is treated as depreciation and
charged to the profit and loss account. This method
is suitable in case of losses tools livestock, packages,
crockery, sacks, etc
12. RESERVE
Reserve is the fund meant for meeting unknown
liability and losses in the future. Reserve mean the
amount set aside out of profit and other surpluses,
which are not earmarked in any way to meet any
particular liability, known to exist on the date of
Balance Sheet. The main objective to make the
reserve is to increase the working capital of business
and strengthen the financial position of the business.
If the reserves are invested outside the business,
then they are called as “Reserve Fund”.
13. Features of Reserve
• It is created out of net profit or divisible profit. Therefore,
reserves are also termed as Retained Earning or
Undistributed profits.
• Creation of reserves is not a legal necessity, it is created
voluntarily.
• Reserve is created for strengthening the financial position of
the business and for meeting an unanticipated situation in
the future.
• Reserve is created for unknown liabilities.
• When amount of Reserve is invested outside the business
it’s called as Reserve fund.
• Reserves belong to the proprietors, just as capital. So it’s
shown on the liabilities side of the Balance Sheet.
14. Importance of Reserve
1. Strengthening the financial position of the
business:
2. Helpful in meeting the unforeseen
liabilities or losses in future:
3. Equalization of dividends over the year
4. Reserve for specific purpose:
15. Types of Reserve
1. Revenue Reserves:These reserves are created out of profit which
has been earned by normal course of business operation. Therefore, the
revenue reserves represent undistributed profit and as such are available for
distribution of dividend. Revenue Reserves may be of the following two types:
(i)General Reserve: Usually the businessmen do not withdraw the entire
profits from business but retain a part of it in the business to meet the
unforeseen future uncertainties. Such reserves are also called as
“Contingency Reserves” or “Free Reserves” because these are not created for
any specific purpose and can be freely used for any purpose.
(ii)Specific Reserves: Such reserves are created for a specific purpose and
can be utilized only for that purpose. For example, Debenture Redemption
Reserve, Staff welfare Reserve, Asset Replacement Reserve etc.
16. 2. Capital Reserves: In business there are various sources to
receive the capital profit. Capital reserves are that types of reserves which
are created out of capital profit. This amount is not available for
distribution of dividend to the shareholders. Sources of capital profit are
as follows:
• Profit on sale of fixed assets.
• Profit on revaluation of assets and liabilities.
• Profit on purchase of running business.
• Premium on issue of shares and debenture.
• Profit on reissue of forfeited of shares.
17. PROVISION
A provision is an amount set aside to meet a
future expense or loss whose occurrence or
exact amount is uncertain. A Provision means
‘any amount written off or retained by way of
providing for depreciation, renewal or
diminution in value of assets or retained by way
of providing for any known liability of which the
amount cannot be determined with substantial
accuracy’.
18. Features of Provision
•Provision is created to meet the known liability.
•The liability is known but the amount of such
liability cannot be determined with reasonable
accuracy. For example, it is almost certain that some
debts will prove irrecoverable but the exact amount
of bad debts cannot be predicted with certainty.
•Provision is a charge against profit and as such
reduces the profit of the year in which it is created.
The loss when actually occurs will be written off
against such provision and thus the profit of the
year in which such loss occurs will not be affected.
19. Importance of Provision
•To provide for known losses in the
future:
•For the equitable distribution of
expenses and losses:
•To ascertain the true net profit of the
business:
•To ascertain the true financial position
of the business:
20. Reserve vs provision
Reserves Provisions
1. It is created to meet an unknown
liability.
2. Creation of reserve is discretionary.
It can be created only it adequate profit
have been earned.
3. The object of reserve is to
strengthen the financial position of the
business.
4. It is created through Profit and Loss
Appropriation A/c. Therefore, it
reduces the divisible profit.
1. It is created to meet a Known liability.
2. Creation of provision is a legal
necessity. Provisions have to be provided
even if there are losses.
3. The object is to provide for
depreciation, doubtful debts and other
specific liabilities.
4. It is created through Profit and Loss
A/c; hence it reduces the net profit.
21. Reserve vs provision
Reserves Provisions
5. Reserve can be invested outside the
business
6. It is shown in the liabilities side.
Under the head “Reserves and Surplus.
7. It can be utilized for distribution of
dividend among share holders.
8. It is not created to provide for a
specific loss and hence can be used for
any purpose.
5. Provision never been invested outside
the business
6. It is either shown on the assets side by
way of deduction from the assets for
which it is created or as a distinct item
on the liabilities side.
7. It cannot be utilized for distribution of
dividend among share holders.
8. It is created to provide for a specific
loss and can only be used for meeting
that loss.
