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CHAPTER 5

Depreciation Provisions and Reserves

LEARNING OBJECTIVES After studying this chapter, you will be able to: ●

explain the meaning of depreciation and other similar terms;

●

state the need for providing depreciation and identify its causes;

●

compute depreciation according to different methods (in terms of Accounting Standard VI);

●

record transactions relating to disposition of assets;

●

define ‘Provision’ and ‘Reserves’ and distinguish between them;

●

discuss the different type of ‘Provisions’ and ‘Reserves’ and the accounting thereof.

depreciation and

DEPRECIATION PROVISION AND RESERVES

139

Depreciation, provisions and reserves are two separate topics, therefore, they are being presented as two different sections. First section deals with depreciation and section two deals with provisions and reserves.

depreciation accounting, defines the depreciation as follows: “Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, ef fluxion of time or obsolescence through technology and market changes. Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortization of assets whose useful life is predetermined.” Thus, the subject matter of depreciation, or its base, are ‘depreciable’ assets which: ● “are expected to be used during more than one accounting period; ● have a limited useful life; and ● are held by an enterprise for use in production or supply of goods and services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.” Further, depreciation is the allocation of ‘depreciable amount’ which is the “Historical Cost,” or other amount substituted for historical cost less estimated salvage value. Another point in the allocation of depreciable amount is the ‘expected useful life’ of an asset. It has been described as “either (i) the period over which a depreciable asset is expected to be used by the enterprise, or (ii) the number of production or similar units

SECTION I

Depreciation This section of the chapter deals with the determination of the cost of fixed assets; the allocation of this cost to appropriate accounting periods; the disposal of assets, and accounting treatment thereof according to the Accounting Standard VI of the Institute of Chartered Accountants of India. In the preparation of financial statements, depreciation on fixed assets has a special significance. It lies in the fact that depreciation involves relatively large amounts as expenses, which are crucial for the ascertainment of net profit and determination of the balances of fixed assets, which are to be shown in the balance sheet. Depreciation, in general, is concerned with the manner in which capital expenditure gradually converts into revenue expense for calculating net income over a period of time. 5.1 Meaning of Depreciation Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is the cost of assets consumed in business. The Accounting Standard VI, which lays down guidelines for

140

expected to be obtained from the use of the asset by the enterprise.” According to Accounting Terminology Bulletin No.1 of the Committee on Accounting Procedures of American Institute of Certified Public Accountants depreciation accounting is, “ A system of accounting which aims to distribute cost, or other tangible value, of capital asset, less salvage if any, over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation and not of valuation”. The analysis of the foregoing definition derives one to conclude that depreciation is the cost of doing business representing consumption of facilities and loss in value for production decisions. 5.2 Depreciation and Analogous Terms There are some terms-like depletion, obsolescence and amortization, which are also used in connection with depreciation. This has been due to the similar treatment given to them in accounting on the basis of similarity of their outcome, since they represent the expiry of the usefulness of different assets. 5.2.1 Depletion It refers to the process of estimating and recording the periodic charges to operations owing to the exhaustion of natural resource such as oil, coal or standing timber. The main difference

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between depletion and depreciation is that the former is concerned with the utilization of a bundle of economic resources, but the latter relates to the usage of an asset. In spite of this, the result is erosion in the volume of natural resources and expiry of the service potential. Therefore, depletion and depreciation are given similar accounting treatment. 5.2.2 Obsolescence It refers to a state of an existing asset becoming out of date on account of the availability of a better model due to improvements in technology or changes in demand pattern. Obsolescence is the outcome of events external to the asset, which significantly reduces the net economic value of the physical output, provided by it. However, depreciation is physical deterioration that arises from change in asset itself, e.g., an engineer can observe changes in machine’s output per period with the passage of time like reduced machine speed, more frequent breakdowns or higher scrap rates. Yet their end-result is the same, i.e., the shortening of their estimated useful life, for being put together for accoun-ting treatment. 5.2.3 Amortization It is often used as a general term to write off intangible assets such as patents, copyrights, franchises, leasehold mines which have entitlement to use for a specific contracted time. The procedure for amortization or periodic write off, of a portion of the cost

DEPRECIATION PROVISION AND RESERVES

of intangible assets is the same as for recording depreciation of fixed assets. 5.3 Need for Depreciation The need for providing depreciation in accounting records arises from conceptual, legal, and practical business considerations. These considerations impart to depreciation a particular significance as a business expense. 5.3.1 Matching of Costs and Revenue The rationale of the acquisition of fixed assets in business operations is that these are used in the earning of revenues. Every asset is bound to undergo some wear and tear, and loss in value, once it is put to use in business. Therefore, consumption of the value of an asset is as much an expense as any other expense incurred in the normal course of business like salary, carriage, postage and stationary, etc. It is a charge against the revenues of the corresponding period before arriving at net profit according to ‘generally accepted accounting principles’. 5.3.2 Consideration of Tax Depreciation is deductible expense for tax purposes. This helps in reducing the tax liability of the entity. Therefore, tax authorities make their own rules for the calculation of depreciation. These rules need not necessarily be similar to current business practices or regulations other than taxation.

141

5.3.3 Fair Financial Position If depreciation on assets is not provided for, then the assets will be over valued and the balance sheet will not depict the correct financial position of the business. Also, this is not per mitted either by established accounting practices or by specific provisions of law. 5.3.4 Recording the True Impact of an Expense Depreciation is a device for maintaining a proper record of capital and revenue expenditure of a business entity. This becomes quite clear when an outright purchase of an asset is compared with taking of an asset on hire rent or fee which is charged against period’s revenue assuming for at net profit. Therefore, purchase of an asset indirectly implies that the asset has been given on hire by capital to revenue. Recording of this crucial expense goes a long way in providing more complete information for the computation of product cost of goods manufactured. 5.3.5 Compliance with Law Apart from tax regulations, there are certain specific legislations that indirectly compel some business organizations like corporate enter-prises to provide depreciation on fixed assets. 5.4 Factors Affecting Depreciation These have been very cogently spelt out as part of the definition of depreciation in the Accounting Standard VI and are being elaborated here.

142

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5.4.1 Wear and Tear Wear and tear means deterioration, and the consequent diminution in its value, arising from its use in business operations for earning of revenue. It reduces the asset’s technical capitalizes to serve the purpose for, which it has been meant. Another aspect of wear and tear is the physical deterioration. A asset deteriorates simply with the passage of time, even though they are not being put to any use. This happens especially when the assets are exposed to the rigours of nature like weather, winds, rains, etc. 5.4.2 Expiration of Legal Rights Certain categories of assets lose their value after the agreement governing their use in business comes to an end after the expiry of pre-determined periods. Examples of such assets are patents, copyright, leases, etc. whose utility to business is extinguished immediately upon the removal of legal backing to them. 5.4.3 Obsolescence Obsolescence is another factor leading to depreciation of fixed assets. In ordinary language, obsolescence means the fact of being “out of date”. Obsolescence has reference to an existing asset becoming out of date an account of the availability of better type of asset. It arises form such factors as: ● ● ●

technological changes; improvements in production methods; change in market demand for

●

the product or service output of the asset, and legal or other description.

5.5

Determinants of Depreciation

The determination of deprecation focusses on the parameters involving cost, estimated useful life and probable salvage value — in estimating its amount. 5.5.1 Cost of Asset Installed The cost of the asset generally includes its purchase price plus all the expenditure required to secure title to it and to get it ready for operational use. Thus, the cost of land also consists of legal charges, broker’s fees and transfer taxes; the cost of building as well comprises per mit fee, engineering fees, remodelling costs; the cost of machinery is represented by additional expenses of transportation, installation and all other costs incurred in putting it into a position to start its operations. Similarly, when an old plant is acquired, all expenditures incurred in bringing it to its full operational level — paint overhauling, replacement parts, etcare treated as cost of the asset.For example, a pressing machine was purchased for Rs.10,000 at 2 per cent discount net condition. Rs.250 were paid for its transportation to the workshop site, Rs. 150 was the wiring cost incurred on it and special foundation for it required an expenditure of Rs. 220. The cost of the machine for use in operations would include following:

DEPRECIATION PROVISION AND RESERVES

Rs Purchase price Less 2% cash discount Net purchase price Add installation costs: Transportation Wiring Special foundation

250 150 220

Total cost of the asset

Rs 10,000 200 9,800

620 10,420

The jour nal entry for the purchase of machine would be: Rs. Machinery A/c Dr. Cash/Bank A/c (Cash purchase of machine)

Rs.

10,420 10,420

5.5.2 Estimated Useful Life Depreciation denotes the cost of an asset allocated to accounting period either according to a time-bound programme or as per production capacity of the asset. The estimated useful life of the asset is of critical importance as a deter minant of depreciation. Useful life of the asset is represented by the number of years of estimated serviceable life span of an asset. Thus, if an asset is expected to last for ten years before completely losing its usefulness for business operations, its useful life is taken to be ten years. The useful life of a depreciable asset is shorter than its physical life and is: ●

●

pre-deter mined by legal or contractual limits, such as, expiry dates of leases; directly governed by extraction or consumption;

143 ●

dependent on the extent of use and physical deteriorations on account of wear and tear which again depends on operational factors, such as, the number of shifts for which the asset is to be used, repairs and maintenance policy of the enterprise, etc.

Determination of the useful life of the asset is a matter of estimation. These days such estimates are provided by the supplier of the asset himself to the buyer at the time of purchase. Such estimation is more difficult for an asset using newtechnology or used in production of a new-product due to rapidity of inventions and innovations. In the case of inter nally generated assets, depreciation is provided on the peculiar operational features of the asset concerned or standard operating policies of the enterprise in this connection by using management’s estimate about the life of an asset. 5.5.3 Estimated Salvage Value When the useful life of the asset comes to an end, it may either become entirely value less or may fetch a very small amount when sold in the market as scrap. The value of the asset that is so realized is referred to as ‘Residual’, ‘Breakup’ or ‘Salvage’ value.’ Determination of the residual value is normally a difficult matter. If such a value is considered insignificant, it is generally regarded as nil. In case the residual value is likely to be significant, it is estimated at the time of

144

acquisition/ installation or at the time of the subsequent revaluation of assets. It is mostly regarded that experience alone will enable a business to arrive at a salvage value factor. 5.6 Methods of Depreciation The depreciation to be provided for during an accounting year is the function of depreciable amount and the method of allocation. For this, two methods are mandated by law and enforced by professional accounting practice in India, these are the Straight Line Method and Written Down Value Method. These methods are discussed hereunder:

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The depreciation to be provided under this method is computed by using the following formula: Depreciation = Acquisition Cost of Asset - Estimated Amount Scrap Value Estimated Life of the Asset

Total amount of depreciation to be provided would be equal to cost of acquisition less scrap value. Rate of depreciation, under straight line method is the per cent of the portion of depreciation to the total cost of the asset to be provided during the useful lifetime of the asset. Rate of depreciation is calculated as follows: Rate of = Annual Depreciation Amount ∞ 100 Depreciation Cost of Assets

5.6.1 Straight Line Method Straight Line Depreciation Depreciation

This is the earliest and one of the most widely used methods of providing depreciation. It is based on the assumption of equal usage of the asset over its entire useful life. This is also called Straight Line Method for the reason that if the amount of depreciation and corresponding time period is plotted on a graph, it will result in a straight line (figure 5.1). It is also called fixed installment method because the annual charge of depreciation remains constant from year to year over the useful life of the asset. According to this method, a fixed and an equal, amount is charged as depreciation in every accounting period during the life-time of an asset. The amount annually charged to depreciation is such that it reduces the original cost of the asset to its scrap value, at the end of its serviceable life.

6000 4000 Series1 2000 0 1

2

3

4

5

Life of Asset

Fig 5.1: Showing straight line depreciation when plotted on a graph

5.6.2 Written Down Value Method Under this method, depreciation is charged on the book value of the asset. Since book value keeps on reducing by the annual charge of depreciation. It is also known as reducing balance method. This method involves the application of a predeter mined proportion /percentage of the book value of asset at the beginning of every

DEPRECIATION PROVISION AND RESERVES

145

accounting period, so as to reduce the asset to its break-up value at the end of its useful life. Thus, the rate of depreciation remains fixed but the amount of depreciation charged on the asset goes on diminishing with the passage of time. This is due to the reason that a pre-determined percentage is applied to a gradually shrinking balance on the asset account every year. Under this method, large amount is recovered as depreciation charge in the earlier years than in the later years.

January 2001.Depreciation is to be provided annually according to straightline method. The useful life of the plant is 10 years and its scrap value after 10 years is estimated to be Rs.10,000. Compute the amount of depreciation to be charged every year and also calculate the rate of depreciation. Solution

Rate of Depreciation Under Written Down Value Method, the rate of depreciation is computed by using the following formula:

Annual Depreciation Amount: Acquisition Cost of Asset - Estimated Scrap Value = ––––––––––––––––––––––––––––––––––––––––––––– Estimated Life of the Asset Rs. 2,50,000 - Rs.50,000 = ––––––––––––––––––––––––––– 10 = Rs. 20,000 Rate of Annual Depreciation Amount × 100 Depreciation = –––––––––––––––––––––––––––––––––– Acquisition Cost

Rate of Depreciation = Rs. 2,40,000×100/2,50,000

Rate of Depreciation = [ 1- n S ] × 100 (in percentage) C Where : n = expected useful life s = scrap value c = cost of an asset. Box 1: Computation of rate of depreciation under written down value method

Illustration 1 Nagi Company Ltd purchased a cold storage plant for Rs 2,50,000 on 1

= 9.6%

Illustration 2 Gourav Bros. acquired a machine on 1 July 1990, at a cost of Rs.28,000 and spent Rs.2,000 on its installation. The firm writes off depreciation at 10% of the original cost every year. The books are closed on 31 December every year. Show the Machinery Account and Depreciation Account for three years.

Solution: Books of Gourav Bros Machinery Account Dr. Date

Cr. Particulars

J.F.

Amount Rs.

Date

28,000 2,000

Dec 31

1990 July 1 July 1

Particulars

J.F.

Amount Rs.

1990 Bank Bank Installation

Depreciation Balance c/f

1,500 28,500

Dec 31 30,000

30,000

146 1991 Jan 1

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Balance b/f

28,500 28,500

1992 Jan 1

Balance b/f

25,500

1991 Dec 31 Dec 31 1992 Dec 31 Dec 31

Depreciation Balance c/f

3,000 25,500 28,500

Depreciation Balance c/f

3,000 22,500 25,500

25,500 1993 Jan 1

Balance b/f

22,500 Depreciation Account

Dr.

Cr.

Date 1990

Particulars

J.F.

Amount Rs.

Dec 31 1991 Dec 31 1992 Dec 31

Machinery

1,500

Machinery

3,000

Machinery

3,000

Illustration: 3 Raj Washing House purchased washing equipment for Rs. 2,00,000 on 1 January 1999. On 1 January 2000, an additional machinery was purchased for Rs.20,000. Prepare the

Date 1990

Particulars

J.F.

Amount Rs.

Dec 31 1991 Dec 31 1992 Dec 31

Profit & Loss

1,500

Profit & Loss

3,000

Profit & Loss

3,000

asset account in the book of Raj Washing House for three years, providing depreciation at 10% p.a. using straight line method. The firm close its book on 31 December every year.

Solution Books of Raj Washing House Washing Equipment Account Dr. Date 1999

Cr. Particulars

Jun. 1 Bank

J.F.

Amount Rs. 2,00,000

Date 1999

Particulars

J.F.

Dec 31

Depreciation Balance c/f

`

2,00,000 2000 Jan 1

Balance b/f Bank

1,80,000 20,000

Balance b/f

1,78,000 1,78,000

20,000 1,80,000 2,00,00

2000 Dec 31

Depreciation Balance c/f

2,00,000 2001 Jan 1

Amount Rs.

22,000 1,78,000 2,00,000

2001 Dec 31

Depreciation Balance c/f

22,000 1,56,000 1,78,000

DEPRECIATION PROVISION AND RESERVES Book Value of Machine

Working Notes Calculation of Amount of Depreciation: I Year: 10% on Rs 2,00,000 Rs. 20,000 II Year: Depreciation on equipment Rs. 20,000 Purchased on 1 January 1999 10% on Rs 20,000 addition made on 1 Jan 2000

Rs. 2,000 Rs. 22,000

Illustration 4 (Rate of Depreciation Value Method)

Written Down

On 1 January 2001, Shivam Printing Press purchased a printing machinery costing Rs. 50,000. Its scrap value is Rs. 2,000 and expected life is 10 Years. It is decided to depreciate printing machinery by written down value method for initial 3 years. Calculate the rate of depreciation under this method and show the written down value (book value) at the end of the year. Solution Depreciation for I year (31 Dec 2001)

147

= Rs.50,000 x 27.5 100 = 13,750

= Rs. 50,000- Rs.13,750 = Rs. 36,250 Depreciation for II year = Rs.36,250 x 27.5 (31 Dec 2002) 100 = Rs.9968.75 Book value of machine = Rs. 36,250 - Rs. 9968.75 = Rs. 26,281.25 Depreciation for III year = Rs. 26,281.25 x 27.5 (31 Dec 2003) 100 = Rs. 7,227.34 Book value of machine = Rs. 26,281 - Rs. 7,227.34 = Rs. 19,053.91 Calculation of Rate of Depreciation: Rate of depreciation = [ 1- n S ] × 100 c = 1-10 2,000 × 100 50,000 = .275 = 27.5%1

Illustration 5 (Written Down Value Method) Atul Transport Company purchases a truck for a sum of Rs. 2,00,000 on 1 January 2001. It charges 20% depreciation per annum according to the written down value method. The truck was sold on 1 July 2002 for a sum of Rs. 1,60,000. You are required to prepare the T ruck Account for 2001-2002.

Solution Books of Atul Transport Company Truck Account Dr. Date 2001

Cr. Particulars

July 1 Bank

J.F.

Amount Rs. 2,00,000

Date 2001

Particulars

J.F.

Dec 31 Dec 31

Depreciation Balance c/f

`

2,00,000 2002 Jan 1

Balance b/f

Dec 31 P&L (Profit on Sale)

1,60,000 16,000 1,76,000

Amount Rs. 40,000 1,60,000 2,00,000

2002 Jul 31

Bank (sale Proceed) Depreciation (for 6 Months)

1,60,00 16,000 1,76,000

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5.7 Straight Line Method and Written Down Value Method: A Comparative Description 5.7.1 Annual Charge of Depreciation Under straight-line method of depreciation, a fixed portion of asset is written down annually with respect to the original cost. Thus, a fixed amount is charged every year during the life-time of an asset. Under written down value method the charge of depreciation declines every year with respect to book value because depreciation is charged on the book value and not on the original cost which is a reducing base.

5.7.3 Charge on Profit and Loss Account Under straight line method charge to profit and loss account in respect of depreciation and repairs are put together as unequal charge against income because of the constant amount of depreciation charge during the useful life of the asset whereas in written down method such charge to profit & loss account remains equal because of amount of depreciation being reduced in the later years and repairs cost increases due to decline in efficiency and wear and tear of the asset due to advancing age of the asset. 5.7.4 Deferment

5.7.2 Basis of Charge This basis of charge under straight line method is the cost of acquisition/original cost of the asset whereas the basis of charge is under written down value method book value of the asset.

In straight line method, it is not possible to defer the tax liability whereas in written down method tax liability can be deferred (but during the entire life span of an asset tax liability remains the same in both the methods). See figure 5.2 .

S. Basis No.

Straight Line Method

Written Down Value Method

1.

Annual Charge of Depreciation

It is constant

It declines with respect to book value

2.

Basis of Charge

It is based on cost of acquisition

It is based on written down value

3.

Charge to Profit and Loss Account

Charge will go on increasing year after year

Charge remains almost uniform over years

Deferment of Tax

It is not possible

It is possible

Fig. 5.2 : Comparison of Straight Line Method and Written Down Value Method

DEPRECIATION PROVISION AND RESERVES

149

Illustration 6 (Comparative Presentation of Methods) Vishal Plastics acquired a machine on 1 July 1998 at a cost of Rs.1,00,000 on 31 March 2001. The machine was sold for Rs.55,000. You are required to prepare machinery account and

depreciation account in the books of the firm according to both the straight line and the written down value assuming the rate of depreciation is 10%. Methods: The account are balanced on 31 December every year on its installation.

Solution Books of Vishal Plastics Machinery Account Dr.

Cr.

Date

Particulars

S.L.M. Amount Rs.

W.D.V. Amount Rs.

1998 Jul 1

Bank (Purchase)

1,00,000

1,00,000 1998 Depreciation Dec 31 for 6 months Dec 31 Balance c/f

1,00,000 1999 Jun 1

2000 Jan 1

2001 Jan 1

Balance b/f

Balance b/f

Balance b/f

Date

Particulars

1,00,000

S.L.M. Amount Rs.

W.D.V. Amount Rs.

5,000

5,000

95,000

95,000

1,00,00 1,00,000

95,000

1999 95,000 Dec 31 Depreciation Dec 31 Balance c/f

10,000 85,000

9,500 85,500

95,000

95,000

95,000

95,000

85,000

2000 85,000 Dec 31 Depreciation Dec 31 Balance c/f

10,000 75,000

8,500 76,500

85,000

85,000

85,000

85,000

55,000

55,000

2,500

1912

17,500

19,588

75,000

76,500

75,000

75,000

2001 76,500 Mar 31 Bank-Sale Price Mar 31 Depreciation for 3 months Mar 31 Profit and Loss Account (Loss on Sale) 76,500

●

SLM = Straight Line Method

●

WDV = Written Down Value Method

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5.8 Methods of Recording Depreciation There are two types of arrangement for keeping record of depreciation on fixed assets viz: ● depreciation is directly charged to the asset account; and ● depreciation annually provided and accumulated in a separate account, especially maintained for the purpose. 5.8.1 Depreciation on Asset Account According to this arrangement, depreciation is provided by being credited to the asset account every year. That is, the depreciation, as a business expense, is transferred to Profit and Loss Account. Journal entries under this recording technique are as follows: Purchase of Asset (Year of purchase) Asset A/c Dr. Bank/Supplier A/c (Cash or credit purchase of asset) Depreciation Charged to an Asset Depreciation A/c Dr. Asset A/c (Depreciation provided on asset)

(Every Year)

Transfer of Depreciation as Business Expense Profit and Loss Account A/c Dr. Depreciation A/c (Depreciation debited to profit and loss account)

(Every Year)

Sale of Asset as Scrap Bank A/c Asset A/c (Asset sold as scrap) Closure of Asset Account

(Year of Sale) Dr.

(At End)

It is possible that, after an asset has been completely depreciated and its scrap value is realized, some balance might be left on the asset account. Such a balance is debited or credited, as the case may be, to Profit and Loss Account denoting profit or loss on sale of the asset. If there is Profit Asset A/c P&L A/c

Dr.

If there is Loss Profit and Loss A/c Asset A/c

Dr.

Balance Sheet Presentation Throughout the period of its service tenure, the asset is listed in the balance sheet at its book value at the beginning of every year, less depreciation provided on it at the end of the year. 5.8.2 Depreciation Accumulated on a Separate Account This method is designed to accumulate depreciation provided in an asset on a separate account generally called ‘Depreciation Provision’ or ‘Accumulated Depreciation’. Such accumulation of depreciation enables that the asset account need not be disturbed in any way and it continues to be shown at its original cost over the successive years of its useful life. There are some basic characteristics of this method of recording depreciation, which must be focused upon” ● asset account continues to appear at its original cost year after year of its service tenure. ● depreciation is accumulated on a separate account instead of

DEPRECIATION PROVISION AND RESERVES

151

being adjusted into the asset account at the end of the accounting period. ● recording mechanism has to be used together with the two methods of providing depreciation because it is only a mode of accounting representation. The pattern of journal entries for this method of recording depreciation is as follows:

denotes either under provision or excess provision as the case may be, in respect of depreciation on the asset. It is, therefore, transferred to profit and loss account.

Purchase of Asset Asset A/c Bank/Supplier A/c (Cash or credit purchase of asset) Depreciation Provided and Accumulated Depreciation A/c Accumulated Depreciation A/c (Depreciation provision accumulated on a separate account)

(Time of purchase) Dr.

(Every year) Dr.

Accumulated Depreciation A/c Asset A/c (Transfer of accumulated depreciation to asset) Sale of Asset as Scrap Bank A/c Asset A/c (Scrap value of asset realized)

Asset is shown at its original cost in the balance sheet throughout its serviceable life and the balance on the accumulated depreciation account is shown as a deduction from its original cost. This representation in the balance sheet is more informative as it gives both the original cost of, the asset and the depreciation accumulated up to the date on the asset account. Illustration 7 (Methods of Recording Depreciation)

Depreciation as Business Expense (End of year) Profit and Loss Dr. Account A/c Depreciation A/c (Depreciation charged to profit and loss) Retirement of Asset

Balance Sheet Presentation

(Year of retirement) Dr.

(Year of sale) Dr.

Closure of Asset Account Some balance is normally left on the asset account after an asset has been complety depreciated and its scrap value is realized. Such a balance

On 1 January 1998, Max GB Limited, whose accounting year ends on 31 December, purchased ten machines of Rs.2,000 each. On 31 March 1999, one machine was sold for Rs.1,600 and, on 30 September 2000 another machine was sold for Rs.1,500. A new machine was purchased on 30 June 2001 for Rs. 2,400. The Company has adopted the practice of providing depreciation at 10 per cent per annum on original cost of machines. You are required to prepare the necessary ledger accounts incorporating the above transactions of machines, and providing appropriate depreciation on them, where: ● depreciation is written of f through machinery account ● depreciation is accumulated on a separate account

152

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Solution 1. Depreciation written off to machinery account Books of Max GB Limited Machinery Account Dr.

Cr.

Date

Particulars

J.F.

Amount Rs.

1998 July 1 Bank (Purchase)

20,000

Date

Particulars

1998 Dec 31 Dec 31

Depreciation Balance c/f

20,000 1999 Jan 1

Balace b/f

18,000

Mar 31 Mar 31

Bank (sale) P&L (Loss on Sale) Depreciation Depreciation Balance c/f

18,000 Balance b/f Profit & Loss

14,400 50

11,200 2,400

20,0001 18,000

1,600 1502 50 1,800 14,400 18,000

Mar 31 Dec 31 Dec 31

Bank (Sale) Depreciation Balance c/f

14,450 2001 Jan 1 Balance b/f Jun 30 Bank (Purchase)

Amount Rs.

20,000

Mar 31 Dec 31

2000 Jan 1 Sep 30

J.F.

1,500 1,750 11,200 14,450

Dec 31 Dec 31

Depreciation Balance c/f

13,600

1,720 11,880 13,600

Working Notes: Calculation of Depreciation amount for 1998 On Rs. 20,000 at 10 per cent for 1 year (a) Loss on Sale of First Machine

Rs. 2,0001

Original Cost of Machine Sold

Rs. 2,000

Less depreciation provided: 1998 - On Rs. 2,000 at 10% for one year 1999 - On Rs. 2,000 10% for 3 months Book value on 31 March 1999 Less scrap value on sale Loss on sale

Rs. 200 Rs. 50

Rs. 250 Rs. 1,750 Rs. 1,600 Rs. 1502

DEPRECIATION PROVISION AND RESERVES

(b)

(c)

153

Depreciation amount for 1999: On Rs. 18,000 (Rs. 20,000) at 10 per cent for year On Rs. 2,000 at 10 per cent for three months

Rs. 1,800 Rs. 50

Total

Rs. 1,850

Profit on sale of second machine Original cost of machine sold Less depreciation provided: 1998 - Rs. 2,000 at 10% for 1 year 1999 - Rs. 2,000 at 10% for 1 year 2000 - Rs. 2,000 at 10% for 9 months Book value on 30 September 2000 Less scrap value on sale

Rs. 2,000 Rs. 200 Rs. 200 Rs. 150

Rs. 550 Rs. 1,450 Rs. 1,500

Profit on sale (d)

(e)

Rs. 50

Depreciation amount of 2000 On Rs. 16,000 (Rs. 20,000 - Rs. 4,000) at 10% for 1 year On Rs. 2,000 at 10% for 9 months

Rs. 1,600 Rs. 150

Total

Rs. 1,750

Depreciation amount for 2001 On Rs. 16,0001 at 10% for 1 year On Rs. 2,400 at 10% for 6 months

Rs. 1,600 Rs. 120

Total

Rs. 1,720

II. Depreciation Accumulated on a Separate Account Machinery Account Dr. Date

Cr. Particulars

1998 July 1 Bank (Purchase)

J.F.

Amount Rs.

Date

Particulars

Balance b/f

Amount Rs.

1998 20,000

Balance c/f

20,000 1999 Jan 1

J.F.

20,000

20,000 1999 Mar 31 Mar 31

Mar 31 Mar 31 20,000

20,000

Bank (sale) Accumulated Depreciation (Transfer) P&L (Loss on Sale) Balance c/f

1,600 250

150 18,000 20,000

154

Jan 1 Sep 30

ACCOUNTANCY

Balance b/f Profit & Loss on Sale

18,000 50

Mar 31 Dec 31 Dec 31

Bank Accumulated (Transfer)

1,500 550 16,000

18,050 2001 Jan 1 Balance b/f Jun 30 Bank Purchase

16,000 2,400

18,050 2001 2001

Balance c/f

18,400

18,400

18,400

Books of Max GB Limited Depreciation Account Dr. Date

Cr. Particulars

1998 July 31 Balance c/f

J.F.

Amount Rs. 2,000

Date 1998 Dec 31

Particulars

Profit and Loss (Provision)

2,000 1999 Mar 31 MachinesTransfer Dec 31 Balance c/f

2,000

1999 250 Dec 31 3,600

Balance b/f Provision & Loss (Provision)

3,850 550

2000 Jan 1 Dec 31

4,800

6,520

Balance b/f Profit & Loss (Provision)

5.9 Asset Disposal Account Asset disposal account is designed to provide a complete and clear view of all the transactions involved in the sale

3,600 1,750 5,350

2001 Jan 1 Dec 31

6,520

2,000 1,850

3,850

5,350 2001 Dec 31 Balance c/f

Amount Rs.

2,000

Dec 31

2000 Sep 30 MachineDec 31 Transfer Balance c/f

J.F.

Balance b/f Profit & Loss (Provision)

4,800 1,720 6,520

of an asset under one account head. The concer ned variables are the original cost of the asset, depreciation accumulated on the asset up to date,

DEPRECIATION PROVISION AND RESERVES

155

sale price of the asset, value of the parts of the asset used for retained, if any, and the resultant profit or loss on disposal. The balance of this account is transferred to the profit and loss account. An important point about asset disposal account is that it is of a temporary nature and has to be closed as soon as its purpose is achieved. Therefore, it has to be prepared every time an asset is sold, as its balance is not carried over. The journal entries required for operating the Asset Disposal Account are as follows:

disposal, or inadequacy of depreciation provided, and would be dealt with as follows:

Transfer from Asset Account Asset Disposal A/c Asset A/c

Dr.

(Transfer from asset account for sale) Transfer of Depreciation Provision Account Depreciation Provision/Accumulated Depreciation A/c Dr. Asset Disposal A/c (Balance of depreciation provision transferred) Sale of Asset Bank A/c Asset Disposal A/c (Sale of asset)

Dr.

Retained Parts of Asset Stores/New Asset A/c Dr. Asset Disposal A/c (Value of retained parts brought into account) Closure of Asset Disposal Account

Asset disposal account may ultimately show a debit or credit balance depending upon the details entered in it. The debit balance on the account would indicate either loss on

Profit and Loss A/c Asset Disposal A/c

Dr.

(Loss on disposal transferred to profit and loss a/c)

The credit balance of the account, may be taken either as pr o f i t o n d i s p o s a l o r e x c e s s i v e provision of depreciation on asset, and would be closed by the following Journal entry: Asset Disposal A/c Profit and Loss A/c

Dr.

(Profit on disposal transferred to profit and loss a/c)

Illustration 8: (Disposal of Assets) On 1 January 1999, Nagi Bros. purchased six machineries for Rs. 15,000 each. Depreciation at the rate of 10 per cent on original cost of machines has been provided and accumulated on ‘Depreciation Provision Account’. On 1 January 2000, one machine was sold for Rs.12,500 and, on 1 January 2001, a second machine was also sold for Rs.13,000. An improved model with a cost of Rs.28,000 was purchased on 1 July 2000 and the arrangement for providing depreciation was kept to be the same as for older machines. You are required to show of Machinery A/c, Depreciation Provision and Asset Disposal A/c.

156

ACCOUNTANCY

Solution Books of Nagi Bros Machinery Account Dr. Date 1999 Jan 1

Cr. Particulars

J.F.

Bank (Purchase)

Amount Rs. 90,000

Date

Particulars

1999 Dec 31

Balance c/f

J.F.

90,000

90,000 2000 Jan 1

Balance b/f Bank (Purchase)

90,000 28,000

Amount Rs.

90,000 2000 Jan 1 Dec 31

Machine Disposal (transfer) Balance c/f

15,000

1,03,000 1,18,000 2001 Jan 1

1,03,000 Balance b/f

1,18,000 2001 Jan 1 Dec 31

Machine Disposal (transfer) Balance c/f

15,000 88,000

1,03,000

1,03,000

Machinery Disposal Account Dr. Date 2000 Jan 1

Cr. Particulars

Machine (Purchase)

J.F.

Amount Rs. 15,000

Date 2000 Jan 1 Jan 1 Jan 1

Particulars

Depreciation Provision Bank Profit & Loss (loss on sale)

15,000

J.F.

Amount Rs. 1,500 12,500 1,000 15,000

2001 Jan 1 Jan 1

Machinery (transfer) Profit and Loss (gain on sale)

15,000

Jan 1

Depreciation Provision

1,000

Jan 1

Bank (sale price)

16,000

3,000 13,000 16,000

DEPRECIATION PROVISION AND RESERVES

157

Depreciation Provision Account Dr.

Cr.

Date

Particulars

1999 Dec 31

Balance c/f

J.F.

Amount Rs. 9,000

Date

Particulars

1999 Dec 31

Depreciation

J.F.

9,000 2000 Jan 1

Dec 31

Machine Disposal (Transfer) Balance c/f

1,500

16,400

Dec 31

Machine Disposal (transfer) balance c/f

3,000

22,200

9,0001 9,000

2000 Jan 1

Balance b/f

9,000

Dec 31

Depreciation

8,9002

17,900 2001 Jan 1

Amount Rs.

17,900 2001 Jan 1

Balance b/f

16,400

Dec 31

Depreciation

8,8003

25,200

25,200

Working Notes:

Sale Price Realized

Rs. 12,500

Calculation of Amount of Depreciation amount

Loss on Sale

Rs. 1,0004

1999

III Profit on Sale of Second Machine Original Cost on 1 January 1999 Rs.15,000 Less Depreciation at 10% for two year Rs. 3,000

10% on Rs. 90,000 for one year

Rs. 9,0001

2000 10 % on Rs. 75,000 for one year Rs. 7,500 10 % Rs 28,000 for six months Rs. 1,400 Rs. 8,9002

Book Value on 1 January 2001 Sale Price Realized Profit on Sale

12,000 Rs. 13,000 1,0005

2001 10 % on Rs. 60,000 (Rs. 75,000-Rs. 15,000) for one year Rs. 6,000 10 % on Rs 28,000 for one year Rs. 2,800 Rs. 8,8003 II Loss on sale of First Machine Original Cost on 1 January 1999 Less Depreciation at 10% for the year Book Value on 1st January 2000

Rs. 15,000 Rs. 1,500 Rs.13,500

Illustration 9 On 1.4.2001, following balances appeared in the books on M/s Anil Traders: Furniture account Rs. 20,000, Provision for Depreciation on Furniture Rs. 12,000.On 1.10.2001 a part of furniture purchased for Rs.8,000 on 1.4.99 was sold for Rs.3,000. On the same date a new

158

ACCOUNTANCY

fur niture costing Rs.12,000 was purchased. The depreciation was provided @ 10% p.a. on original cost of the asset and no depreciation was

charged on the asset in the year of same. Prepare furniture account, provision for depreciation on furniture account for the year ending 31.3.2002.

Solution: Books of Anil Traders Furniture Account Dr.

Cr.

Date 2001

Particulars

Apr 1 Oct 1

Balance c/f Bank

J.F.

Amount Rs.

Date 2001

Particulars

20,000 12,000

Oct 1 Oct 1 Oct 1 Mar 31

Bank Provision Loss on Sale Balance b/f

J.F.

Amount Rs. 3,000 1,600 3,400 24,000

32,000

32,000

Depreciation Provision Account Dr.

Cr.

Date 2001

Particulars

Apr 1

Furniture

J.F.

Amount Rs.

Date 2001

Particulars

1,600

Apr 4

Balance c/f

12,000

Depreciation

1,800

2002 May 31

J.F.

Amount Rs.

2002 Balance c/f

12,200 13,800

Illustration 10 (Asset Disposal Account) Solve problem 3, if asset disposal

May 31

13,800

account is to be prepared along with fur niture account and pr ovision for depreciation on furniture account.

DEPRECIATION PROVISION AND RESERVES

159

Solution: Books of Anil Traders Furniture Account Dr.

Cr.

Date

Particulars

2001 Apr 1

Balance c/f

J.F.

Amount Rs. 20,000

2001 Oct 1

Date 2001 Oct 1

Particulars

J.F.

Furniture Disposal A/c

Amount Rs. 8,000

2002 Bank

12,000

Mar 31

Balance c/f

24,000

32,000

32,000

Depreciation Provision Account Dr. Date 2001 Oct 1

Cr. Particulars

J.F.

Furniture disposal

Amount Rs. 1,600

2002 May 31

Date

Particulars

J.F.

Amount Rs.

2001 Apr 1

Balance c/f

12,000

Depreciation

1,800

2002 Balance c/f

12,200

May 31

13,800

13,800

Furniture Disposal Account Dr.

Cr.

Date

Particulars

2001 Oct 1

Furniture

J.F.

Amount Rs. 8,000

8,000

Date

Particulars

J.F.

Amount Rs.

2001 Oct 1

Depreciation

1,600

Bank Profit & Loss (loss on sale)

3,000 3,400 8,000

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ACCOUNTANCY

Illustration 11 (Loss by Fire) On 1.1.98, Neha Ltd purchased from M/s Varun Br os plant costing 2,00,000 on instalment basis payable as follows: On On On On

1.1.98 1.7.98 1.1.99 1.1.00

50,000 50,000 50,000 50,000

The company spent Rs. 5,000 on transportation and installation of the plant. It was decided to provide for depreciation on straightline method. For this purpose, the useful life of the

plant was estimated at 5 years. It was also estimated that at the end of the useful life, realizable value of the plant would be Rs.6,000 (Gross) and dismantling cost of the plant, to be paid by the company was estimated at Rs. 1,000. The plant was destroyed by fire on 31-12-01 and an insurance claim of Rs. 25,000 was admitted by the insurance company. Prepare plant Account, Accumulated Depreciation Account, Plant Disposal Account and Loss on Sale of Plant assuming that the company closes its books on 31 December every year.

Books of Neh Ltd Plant Account Dr. Date

Cr. Particulars

1998 Jan 1 M/s Varun Bros. Bank

J.F.

Amount Rs. 2,00,000 5,000

Date

Particulars

1998 Dec 31

Balance c/f

2,05,000 1999 Jan 1 Balance b/f

2,05,000

2,05,000

1999 Dec 31

Balance c/f

2,05,000 2,05,000

2,05,000

2,05,000 2,05,000

2000 Dec 31

Balance c/f

2,05,000 2001 Jan 1 Balance b/f

Amount Rs.

2,05,000

2,05,000 2000 Jan 1 Balance b/f

J.F.

2,05,000 2,05,000

2001 Dec 31

Plant Disposal A/c

2,05,000 2,05,000

DEPRECIATION PROVISION AND RESERVES

161

Accumulated Depreciation Account Dr.

Cr.

Date

Particulars

1998 Dec 31

Balance c/f

J.F.

Amount Rs. 40,000

Date 1998 Dec 31

Particulars

J.F.

Depreciation A/c

40,000

40,000 1999 Dec 31

Balance c/f

80,000

40,000 1999 Jan 1 Dec 31

Balance c/f Depreciation

40,000 40,000

80,000 2000 Dec 31

Balance c/f

80,000

1,20,000 Jan Dec 31

Balance c/f Depreciation

80,000 40,000

1,20,000 2001 Dec 31

Amount Rs.

Plant Disposal A/c

1,60,000

1,20,000 2001 Jan 1 Dec 31

Balance b/f Depreciation

1,20,000 40,000

1,60,000

1,60,000

Plant Disposal Account Dr.

Cr.

Date

Particulars

2001 Dec 31

Plant

J.F.

Amount Rs. 2,05,000

Date 2001 Dec 31

Particulars

J.F.

Accumulated Depreciation Insurance Co, Profit & Loss (Loss on Sale)

Amount Rs. 1,60,000 25,000 20,000

2,05,000

2,05,000

Loss on Sale Account Dr. Date

Cr. Particulars

1998 Dec 31 Plant Disposal

J.F.

Amount Rs. 20,000 20,000

Date

Particulars

1998 Dec 31

Profit and Loss

J.F.

Amount Rs. 20,000 20,000

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ACCOUNTANCY

SECTION II Provisions and Reserves In the previous section, we had discussed about depreciation accounting and this section deals with Provisions and Reserves. Every business enterprise, irrespective of its form of organization, likes to conduct its operations in a prudent manner so as to be able to meet all eventualities — both expected and unexpected. This is done, among other things, by making provisions, and creating reserves, at the time of the preparation of financial statements. 5.10 Meaning of Provisions The term ‘provision’ means an amount, which is: written off, or retained, by way of providing for depreciation, renewals, diminution in the value of assets; or retained by way of providing for any unknown future liability of which the amount cannot be determined with reasonable accuracy. Oviously, where the amount of a liability is known, or can be ascertained, a definite liability should be created, e.g., liability for outstanding interest. Examples of provisions are provision for doubtful debts, provision for depreciation, provision for repairs, provision for discount on debtors, provision for taxation, provision for legal damages likely to arise from a pending suit. Provision is a charge against the profit of the year and hence, it is debited to profit and loss account before calculating the net profit for the year,

and is shown in the balance sheet after the certain liabilities on the liability side. It is to be noted that provision has to be made irrespective of the fact whether a firm make a profit or not, othervise it leads to breach of prudential business behaviour. 5.11 Meaning of Reserves Reserve means amount set aside out of profits (as calculated by the profit and loss account) or other surpluses which are not meant to cover any liability, contingency, commitment or legal requirement. Thus, reserve covers the case of amount which is neither a liability nor a provision. It is allocation of the profit and not a charge against the current revenues. It, in fact, belongs to the proprietors over and above the capital contributed by them. In case amount equal to a reserve is invested in outside securities, it is called ‘Reserve Fund’ but the absence of this conditions entitles it to be called simply ‘reserve’. When it is called fund and meant for a given purpose, it is called “Specific Reserve”, otherwise “General Reserve”. Examples of reserves are Capital Reserve, General Reserve, Contingency Reserve, Dividend Equalization Reserve, Debenture Redemption Fund, etc. 5.12 Importance of Provisions and Reserves A business firm in general, and a corporate enterprise in particular may consider it proper to set up some mechanism to protect itself from the consequences of known liabilities and

DEPRECIATION PROVISION AND RESERVES

losses it may be required to bear in future. It may also regard it as more appropriate in certain cases to reduce the amount that can be drawn by the proprietors as profit in order to conserve business resources to meet certain significant demands for them in future. An example of such a demand is the much-needed expansion in the scale of business operations. This is presented as the justification for the role of provisions and reserves in business activities and in accounting. The amount so set aside may be meant for the purpose of: ●

● ●

●

fulfilling some specific requirements like repairs and renewals of an asset; meeting a future liability or loss; strengthening the general financial position of an undertaking; redeeming a long-term liability like debentures.

5.13 Distinction The identification and understanding of the precise scope of ‘provisions’ and ‘reserves’ require explanation of dif ferences between them for clarification of their respective roles in business and in accounting. 5.13.1 Purpose A provision is created for some specific liability in view but reserve is meant to meet the future legal obligations or investment requirements of business for development.

163

5.13.2 Mode of Creation A provision is a charge against profit and loss account of the year and has to be created even when profits are not expected. A reserve is an appropriation of profits and can be made out of either profits earned during a year or from already existing surplus, e.g. contingency reserve. 5.13.3 Presentation in Balance Sheet A provision is generally presented as a deduction from the item for which it has been created on the asset side of the balance sheet or as a liability after current liabilities as part of external equities. Reserve is listed as distinct item on the liabilities side of the balance sheet. 5.13.4 Utilization Very rigid restrictions are enforced in practice on the use of provisions in business operations to make them adhere to the purpose for which they have been meant. Contrary to this, the balance of general reserve, or any account of such a nature, is always available for any bonafide requirements of business. However, reserves created under specific legal obligations such as “Capital Redemption Reserve or Debenture Redemption Reserve” is to be used within the framework of the law only. 5.13.5 Identification with Operations A provision is made for meeting a particular liability or likely loss on a specific item. Therefore, they cannot be distanced from business operations

164

and their investment outside the business is just not possible. Reserves, being of a general nature, can be invested outside the business to avoid the possibility of their non-availability in the event of need as well as to earn some additional income with their help. However, outside investment of reserves by business is not mandatory in all situations. 5.13.6 Inter Transfers Provision cannot directly be transferred to any reserve but reserves, where required, can be transferred to provisions to boost their balances. 5.13.7 Support for Profit Distribution The severely restrictive rules governing provisions do not make it possible for them to provide a helping hand in as genuine a business need as distribution of profits to proprietors. However, the balances on reserves are freely available, and are commonly used, for distribution of profits especially in the case of corporate enterprises. 5.13.8 Demonstration Effect The maintenance of provisions creates a distinct impression of the entity’s affairs having been looked after in a business like manner with due care being taken of asset values as part of the exercise of conservation of resources. All this is in conformity with management’s accountability of stewardship accounting. On the other hand, the creation of reserves build a positive image of the enterprise in general, and

ACCOUNTANCY

its management in particular, for their prudent and progressive financial policies. It is of far reaching significance from the viewpoint of long-ter m interests of the undertaking in attracting long-term investors. 5.14 Types of Provisions The number of provisions maintained by a business undertaking depends upon its requirements, which are governed by the volume, range and nature of its operations. Generally, a business firm creates and maintains provisions for taxations, repairs and renewals, depreciation, discount on debtors, bad and doubtful debts. But provision for doubtful debts and provision for discount on debtors has been discussed at appropriate stages in concerned chapters of the book. 5.14.1 Provision for Doubtful Debts When business transaction take place on credit basis, debtors may be of three types: ● Good Debtors are those from where collection of debt is certain. ● Bad Debts are those debtors from where collection of money is not possible and the amount of credit is a loss. ● Doubtful Debts are those who may pay but firm is not sure about cent per cent collection from them. In fact, as a matter of business experience, some percentage of such debtors are not likely to pay, hence treated as doubtful debts. When it is certain that a debt will not be recovered, the amount is written

DEPRECIATION PROVISION AND RESERVES

off as bad debts. But it is also likely that some of the remaining debts may not be recovered in full. This will be a loss to the business. Hence, it is a common practice to make a suitable provision for doubtful debts at the time of ascertaining the profit or loss. The balance sheet will not show the true position of sundry debtors. The provision for doubtful debts is usually calculated as a certain percentage of the total amount due from sundry debtors after writing off all known bad debts. Provision for doubtful debts is also called ‘Provision for Bad Debts’, or ‘Provision for Bad and Doubtful debts’. Such a provision is made by debiting the amount of doubtful debts to the profit and loss account and crediting the account of provision for doubtful debts. Thus, the journal entry for creating such a provision is as follows: Profit and Loss A/c Provision for Doubtful Debts A/c

Dr.

The bad debts arising during the year are first written off from the ‘provision for doubtful debts’ account. In doing so, the opening balance standing to the credit of the provision for doubtful debts account may not be sufficient to meet the current amount of bad debts as also the requirements of future doubtful debts. This deficit is to be provided for at the end of the year by a charge to the profit and loss account. In case, the annual amount provided for is to be adjusted for any unused surplus representing credit balance. The following are the jour nal entries required when the provision for

165

bad debts exists in the books: For writing off further bad debts given outside the trial balance: Bad Debts A/c Sundry Debtors A/c

Dr.

For transferring the total bad debts to the provision for Bad Debts Account: Provision for Doubtful Debts A/c Bad Debts A/c

Dr.

For debiting the Profit and Loss Account with the amount of new provision plus the excess of bad debts over the old provision: Profit and Loss A/c Dr. Provision for Doubtful Debts A/c For crediting the Profit and Loss Account with excess of the old provision over the total bad debts plus new provision, if any: Provision for Doubtful Debts A/c Profit and Loss A/c

Dr.

Illustration 12 (Provision for Doubtful Debts) An extract of trial balance on 31 December 2001 is given below: Name of the Account

Debit Amount Rs.

Sundry Debtors. Bed Debts Provision of Bad Debts

80,000 4,000

Credit Amount Rs.

7,000

Additional Information: ● Bad Debts proved bad but not recorded amounted to Rs. 5,000 ● Provision to be maintained at 10% of Debtors. Prepare necessary accounting entries for writing off the bad debts and creating the provision for doubtful debts account.

166

ACCOUNTANCY

Solution Dr.

Journal

Date

Particulars

Dec 31

Bad Debts A/c Sundry Debtors (Bad Debts written off) Provision for Doubtful Debts A/c Bad Debts A/c (Bad Debts written off) Profit and Loss A/c Provision for Doubtful Debts1 (Charged short-fall and provision for doubtful debts) Total

Dec 31

Dec 31

Cr. L.F

Amount Rs.

Dr.

Amount Rs.

5,000 5,000

Dr.

9,000 9,000

Dr.

9,500 9,500

23,500

23,500

Bad Debts Account Dr. Date

Cr. Particulars

J.F.

Amount Rs.

2001 Dec 31 Dec 31

Date

Particulars

J.F.

Amount Rs.

2001 Balance c/f

4,000

Sundry Debtors

5,000

Dec 31

Provision for Bad and Doubtful Debts

9,000

9,000

9,000

Provision for Bad and Doubtful Debts Account Dr. Date

Cr. Particulars

J.F.

Amount Rs.

2001 Dec 31 Dec 31

Date

Particulars

J.F.

Amount Rs.

2001 Bad Debts

9,000

Jan 1

Balance b/f

7,000

Balance c/f

7,500

Dec 31

P&L

9,500

16,500

16,500

DEPRECIATION PROVISION AND RESERVES

167

Profit and Loss Account for the year ended 31 December, 2001 Dr.

Cr.

Date

Particulars

J.F.

Amount Rs.

Provision for Bad and Doubtful debts

Date

Particulars

J.F.

Amount Rs.

9,500

Balance Sheet as at 31 December, 2001* Assets

Amount Rs.

Liability

Amount Rs.

Sundry Debtors Less: Bad Debts Less: Provision for Bad and Doubtful Debts Working *RelevantNotes items only 7,500

required to be maintained Add: Short fall of the 7,000 (9,000)

Discount is allowed to debtor: Discount Allowed A/c Debtors A/c

Dr.

Discount allowed transferred to P&L A/c Profit and Loss A/c Dr. Provision for Discount on Debtors A/c

current provision: Less Bad Debts

67,500

Accounting Treatment

Provision for Doubtful Debts

Opening Balance

80,000 5,000 75,000 7,500

2,000 9,000

5.13.2 Provision for Discount on Debtors. In practice, business enterprises allow cash discount to their customers. The tenure of the cash discount period may spilt-over into the following accounting year for the sales made during the current year. This requires a provision to be made on debtors. and is treated as a loss for the current year. The accounting treatment is given hereunder;

Total bad debts transferred to provision for doubtful debts. Provision for Discount on Debtors A/c Discount Allowed A/c

Illustration 13 (Provision for

Dr.

Discount on Debtors)

Following is the extract of Trial Balance as at March 31, 2001 Name of Account

Debit Amount (Rs)

Sundry Debtors Discount Allowed Provision for Discount Allowed

2,50,000 2,000

Credit Amount (Rs)

1,500

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ACCOUNTANCY

Additional information ●

Provision for Discount Allowed is to be maintained at 2%.

Solution Journal Dr. Date

Cr. Particulars

J.F.

Debit Amount Rs.

Credit Amount Rs.

2001 March 31

Provision for Discount on Debtor A/c Discount Allowed A/c (Discount Allowed written off)

Dr.

March 31

Profit and Loss A/c Dr. Provision for Discount on Debtors A/c (Provision for discount on debtors)

2,000 2,000

Total

5,500 5,5001 7,500

7,500

Discount Allowed Accounts Dr.

Cr.

Date

Particulars

2001 Mar 31

Balance b/f

J.F.

Amount Rs.

Date

Particulars

2,000

2001 Mar 31

Provision for Discount on Debtors

J.F.

Amount Rs. 2,000

2,000

2,000

Provision for Discount on Debtors Accounts Dr.

Cr.

Date

Particulars

200 Mar 31

Discount Allowed

Mar

Balance c/f

J.F.

Amount Rs.

Date

Particulars

2,000

2000 Apr 1 2001

Balance b/f

1,500

5,000

Mar 31

Profit & Loss

5,500

7,000

J.F.

Amount Rs.

7,000

DEPRECIATION PROVISION AND RESERVES

169

Profit and Loss Account for the year ended March 31, 2001 Dr. Date

Cr. Particulars

J.F.

Amount Rs.

Provision for Discount on Debtors

Date

Particulars

J.F.

Amount Rs.

5,500

Balance Sheet as at 31 March 2001 Assets

Amount Rs.

Liability

Amount Rs.

Debtors Less Provision for Discount on Debtors

Provision for discount on debtors: Provision required for discount allowed on debtors

Rs. 5,000

2,45,000

1,500 500

Provision to be charged to Profit and Loss Account Alternative Calculation:

Reserves are broadly of two types— Capital Reserve and Revenue Reserve 5.14.1 Capital Reserve

2,000

Less Opening Balance of Provision for discount allowed

Rs. 5,000

5.14 Types of Reserves

Working Notes

Discount Allowed

Rs. 2,50,000

5,500 Rs.

Provision required for discount on debtoRs. as on March 31, 2001

5,000

Add Discount Allowed during the year as per Trial Balance

2,000

Total amount received

7,000

Less Provision for discount of debtors. as per Trial Balance

1,500

Provision to be charged to Profit and Loss account for the Year ended March 31, 2001

5,500

‘Capital Reserve’ is an accounting mechanism for conserving profits. The amount so set apart as ‘Capital Reserve’ imparts an element of stability to the over all finances of a business enterprise. Capital reserve arises either as a gain on sale of long-term assets or an settlement of liabilities. Again of capital nature may also arise due to the basic transaction of being of capital nature. For example: sale of equity shares at a premium. Further, allocation of revenue reserve may be made to capital reserve due to legal obligations. Capital reserve does not include any free balance that might be used for the distribution of profits. It

170

ACCOUNTANCY

is this crucial factor alone which tends to provide the much-needed financial stability to an corporate undertaking. Capital reserve comes into existence from out of the capital profits arising from: ● profits emerging from the revaluation of fixed assets after observing all restrictions; ● profits accruing on the sale of fixed assets; ● profits from the re-issue of share once forfeited by a company’s ● issue of shares at premium ● profits arising at the time of amalgamation and absorption of companies ● profit prior to incorporation of a company; ● Creation of capital Redemption Reserve upon the redemption preference shares. Capital reserves, always have credit balance which are shown on the liabilities side of the balance sheet. Whenever this reserve is utilized, capital reserve account is debited. It is also required that the manner of the utilization of capital reserve during an accounting period must be

clearly stated in the balance sheet either in its body itself or by way of a foot-note to the financial statements. This is due to the reason that there are rigid restrictions, both laid down by law and enforced by accounting standards, on the use of capital reserve. 5.14.2 Revenue Reserves Revenue reserves are created out of revenue profit which are usually distributable profits. All distributable profits are not always available for paying dividend since a certain amount may be required to be kept aside either by law (minimum) or as a managerial decision (higher amount) for business needs. It is only after this that profit will be available for distribution by way of dividend. Examples of revenue reserves are: ● General Reserve ● Dividend Equalisation Reserve ● Debenture Redemption Reserve (only after complete redemp-tion of those debenture under whose trust deed this reserve were created).

5.15 Distinction between Revenue Reserve and Capital Reserve Basis

Revenue Reserve

Capital Reserve

Creation

It is created out of revenue profits

It is created out of capital gains and revenue profits.

Distribution of Dividend

It can be used for distribution of dividends.

It can not be used for cash dividend distribution.

Objective

Its objective is to strengthen the financial position, meeting unforeseen contingencies or some specific purpose.

It is created for meeting the legal requirements or accounting practice.

Usage as well as capital purposes

It can be used for revenue as of capital loss or other

It can only be used for setting purposes specified by law

DEPRECIATION PROVISION AND RESERVES

General Reserve A general reserve is a retention of a portion of revenue profits for the improvement of the overall financial status of an enterprise and to improve its health in general. An important point about general reserve is that it is a salient feature of corporate finance. The creation and maintenance of general reserve helps in realizing certain well recognized purposes especially from the viewpoint of financial management. ● Improvement of the general financial position of the business by conserving resources, which would have otherwise been frittered away at the expense of prudent management. ● Arrangement for meeting unforeseen and abnormal losses irrespective of their nature. ● Providing avenues for the further expansion of business operations. General reserve is created by debiting the profit and loss appropriation account and crediting general reserve account. The latter account is placed on the liabilities side of the balance sheet. When the balance on this account is used for any purpose, general reserve account is debited. Any such use of general reserve has to be stated in some way in the balance sheet. A number of provisions have been included in the companies Act for the regulation, creation and utilization of general reserve. This underlines the

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importance attached to it in the functioning of corporate enterprises. A word of caution about the commonly perceived role of general reserve is necessary. General reserve is widely regarded as a means of strengthening the overall financial position of the business entity. However, this depends upon the proper valuation of the assets and liabilities of the business. In case assets and liabilities are properly valued, the balance on general reserve is indicative of the financial health of an enterprise but it is not so in the absence of this vital condition. Specific Reserves A business undertaking in contemporary times is involved in a range of business activities in pursuance of its goal of creating value of the organization. Some of the of contingency situations can be looked after and financially managed by the creation of provisions for known or expected contingencies. Management may as well like to provide a second line of deface against some of these contingencies as a measure of abundant caution. A specific reserve is created for a given purpose. It cannot be used for any other purpose except for which they are created. There can possibly be any number of reserves in business, every one of them characterized by some peculiar feature dictated by the specific purpose which they are meant to serve. However, there is an under current of common characteristics shared by them.

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They are sharply focussed from the viewpoint of their use because they are built up for some specific purpose or the other. ● A business-like approach to the management of these reserves may require that their balances be invested outside the business. All specific reserves are presented on the liabilities side of the balance ●

sheet, as they are credit balances. When any specific reserve is utilized, the amount drawn upon is debited to the account of the r eserve concerned. The reserves are credited at the time of the preparation of financial statements by allocations decided to be made to them by management and the corresponding credit is given to profit and loss appropriation account.

TERMS INTRODUCED IN THE CHAPTER ● ● ● ● ● ● ● ● ●

Depreciation Depletion Obsolescence Amortization Salvage value/ Residual value/ Scrap value Written down value/Reducing value/Diminishing value Straight line/Fixed Instalment Asset Disposal Accumulated Depreciation SUMMARY WITH REFERENCE TO LEARNING OBJECTIVES

1. Meaning of Depreciation Depreciation is a permanent and gradual diminution in the value of an asset caused by usage and effluxtion of time. 2. Factors Affecting Depreciation ● ● ●

Wear and Tear Expiration of legal rights Obsolescence

3. Determinants of Depreciation ● ● ●

Cost of asset installed Estimated useful life Estimated salvage value

4. Accounting Treatment The accounting treatment is designed to record all transactions of purchase and sale of an asset and charging of depreciation with the objective of reducing the value of an asset to zero or its residual value as the case may be.

DEPRECIATION PROVISION AND RESERVES

5. Methods of Calculating Amount of Depreciation— ● ●

Straight Line method: Under this, the fixed amount is charged as depreciation every year during the lifetime of asset. Written Down Value Method: In this method, a fixed percentage is applied to the book value of an asset at the beginning of every accounting period, rather than the original cost.

6. Methods of Depreciation There are two methods of recording depreciation in the books of accounts ● ●

By maintaining a provision for depreciation account Without maintaining a provision for depreciation account.

7. Asset Disposal Account This account prepared to provide a complete and clear view of all the vari-ables involved in the sale of an asset. 8.

Provision It is an amount written off or retained by way of providing depreciation, renewals, diminution in the value of assets and for known liabilities. It is a charge on profits and must for the ascertain-ment of true profits of business.

9.

Reserve It is allocation of profit. It is an amount set aside out of profits and is meant to strengthen, the general financial position of a business enterprise.

10. Types of Reserves ● ●

Capital reserve: It is a mode for retaining profits in business, which are not available for distribution as dividends. It is always a credit balance. General reserve: It means retention of a portion of profit, not for any particular purpose, but for the improvement of overall financial position of an enterprise.

11. Types of Provisions ●

●

Provision for doubtful debts: This provision is made on certain percentage of total debtors appearing in the trial balance. It is meant for the recovery of doubtful overdue account. Provision for discount on debtors: This provision is also made on debtors and is treated as a loss for the current year.

EXERCISES I

Multiple Choice Questions (a)

Depreciation arises due to:

(i)

Physical wear and tear of the asset

(ii)

Fall in the market value of asset

(iii)

Fall in the value of money

(iv)

None of these

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(b)

Under diminishing balance method of charging depreciation, it: (i) (ii) (iii) (iv)

(c)

Under straight line method, depreciation is calculated on: (i) (ii) (iii) (iv)

(d)

current liabilities owners equity long-term liabilities none of these

Fill in the blanks (i) (ii) (iii)

(iv) (v) 3.

Fixed assets Intangible assets Natural resources None of these

Resources are the items of: (i) (ii) (iii) (iv)

2.

Written down value Original cost Cost less scrap value Original Cost less scrap value.

The term depletion is used for: (i) (ii) (iii) (iv)

(e)

Increase every year Decrease every year Constant every year None of these

Depreciation represents a__________________ in the value of fixed assets. Scrap value of an asset means the ___________ that it fetched on sale at the end of its ______________. The assumption underlying the fixed instalment method of depreciation is that of ___________________ of the asset over different years of its useful life. Capital reserve are those which are generally not distributed as________________. The purpose of reserve is generally to ___________ the financial position of a business enterprise.

True and False (i) (ii) (iii) (iv) (v)

Depreciation can not be provided increase of loss, in a financial year. Under written down value method, depreciation is charged on the original cost of the asset. Provision are the charges against profits for all apprehended losses. Capital reserves are freely distributed as profits. All reserves appear on the liability side of the balance sheet.

Short Answer Questions 4. 5.

Define depreciation? What are the factors effecting depreciation?

DEPRECIATION PROVISION AND RESERVES

6. 7. 8. 9.

Why should depreciation on fixed assets be brought into account? Explain, in brief, the determinants of providing depreciation? What is the purpose of capital reserves? What is provision for doubtful debts? Why it is created?

Essay Type Questions 10. Define depreciation as per Accounting Standard VI? Explain the need and significance of providing depreciation? 11. Explain the determinants of providing depreciation? 12. Name and explain different types of provisions? Also write their accounting treatment? 13. State the meaning of reserves? Explain the different types of reserves? 14. Distinguish between: (i) Provision and Reserve (ii) Capital Reserve and Revenue Reserve Problems Q. 15 On 1 Jan 2001, Alpha Fabrics Limited purchased a machine for Rs.52,000 and spent Rs. 3,000 on its carrige and Rs.1,000 on its erection. On the date of purchase it was estimated that the effective life of the machine will be 10 years and after 10 years it scrap value will be Rs. 6,000. Prepare Machine Account and Depreciation Account for four year. Depreciation is charged on Straight Line basis Account are closed on 31 Dec each year. Q. 16 Dinesh Garments purchased a machinery on 1 April 1997 for Rs.80,000. On 1 July 1997 another machinery costing Rs.2,00,000 was purchased. The machinery purchased on 1 April 1997 was sold on 30 September 2001 for Rs.9,850. The company charges depreciation @ 15% per annum on straight line method. You are required to prepare machinery account for the years 1997-98 to 2001-02. Q. 17 ACC Ltd purchased a machinery costing Rs. 60,000 on 1 April 1999. Another machinery costing Rs. 40,000 was acquired on 1 Oct 1999. On 1 July 2000, another machinery for Rs. 20,000 was purchased. On 1 Jan 2001, one third of the machinery , which was installed on 1 April 1999 became obsolete and was sold for Rs. 6,000. Prepare machinery account as it would appear in the books of accounts. The depreciation is provided at 10% p.a. on straight line basis. The books are closed on 31 March every year. Q. 18 Excel Company Limited has a debit balance in its machinery account Rs. 15,000 (Original Cost of Rs. 50,000) as on 1 Jan 2000. On 1 April 2000, it purchased a machinery costing Rs.30,000. It further purchased machinery on 1 Oct 2000 costing Rs. 20,000. On 1 Jan 2001, machinery purchased on 1 April 2000 became obsolete and was sold for Rs. 2,000 and on 1 July 2001, an additional machinery was purchased for Rs.10,000. Show how machinery account would appear in

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the books of Excel Company. The machinery is depreciated on Straight line basis @ 10% p.a. Calculate the value of machinery as on 31 Dec 2000. The books are closed on 31 December every year. Q. 19 Nagi Road Transport Corporation (NR TC) purchased 25 Mini buses at Rs. 2,00,000 each on 1 April 2000. On 1 Oct 2002, one of the buses met with an accident and was completely destroyed. Insurance Co. paid Rs. 90,000 in full settlement of the claim. On the same day, NRTC purchased a used Mini-Bus for Rs. 1,00,000 and spent Rs. 20,000 on its overcharging. Prepare Mini-Bus Account for 3 year ending on 31 Dec 2002. The depreciation is charged @ 20% on Straight line basis. Q. 20 Nandan Milk Foods Ltd. purchased the dairy machinery for Rs. 15,00,000 on 1 April 1995. The cost of installation was Rs. 1,00,000. On 1 July 1995, under its expansion programme, the company purchased old machinery from Gopal Milk Foods, which was under the process of winding off for Rs. 8,00,000. The company charges depreciation of the @ 10% p.a. on straight line basis. On 1 Jan 1996, it was found that machinery purchased from Gopal Milk Foods was not working effectively. Therefore, the company decided to sell it off for Rs. 4,00,000. On the same date a new machinery cost Rs. 20,00,000 was purchased. Your are required to prepare machinery account, for the year 1995-96 to 1998-99. The books of accounts are closed on 3 March every year. Q. 21 Amrit Raj Data Processing Company whose accounting year is a calendar year. purchased on 1 April 1990, a data processing unit costing Rs. 30,000. On 1 Oct 1990, it made additions to it costing Rs. 20,000 and on 1 July 1991 costing Rs. 10,000. On 1 Jan 1992, a part of data processing unit installed on 1 April 1990 became obsolete and was sold for Rs. 3,000. The asset is depreciated on written down value @ 10% p.a. Prepare the asset account and show the balance as on 1 Jan 1993. Q.22 On 1 Jan 1980, Aroma Fabricators purchased two machines for Rs. 60,000 and 40,000 respectively. On 1 Jan 1981 another machine was purchased for Rs. 1,00,000. On 1 Jan 1982, the machine purchased on 1.1.80 for Rs. 60,000 got out of order and a new machine costing Rs. 1,20,000 was purchased after surrendering the old machine which got out of order and paying cash Rs. 30,000. On 1 Jan 1983 the machine which was purchased on 1 Jan 1981 for Rs. 10,00,00 was destroyed by fire and insurance company paid Rs. 60,000 only. Depreciation is charged @ 10% p.a on written down value basis. Show the machinery account for 1980, 1981, 1982, 1983. Also prepare machinery disposal account and machinery lost by fire account. The books are closed on 31 December eveary year. Q. 23 1.1.2001 Madras Printing House purchased ten machines of Rs. 1,80,000. On 30.6.2002, it acquired another machine at a cost of Rs. 30,000. On 31.3.2003,

DEPRECIATION PROVISION AND RESERVES

one of the machines purchased on 1.1.2001 had become obsolete and was disposed off for Rs. 2,500. Rs. 500 was paid as commission on sale of the machine. It was replaced by a new machine costing Rs. 20,000. Show machinery account from 2001 onwards it– ● ●

Depreciation @ 10% on Straight line method Depreciation @ 10% on Written Down Value method

Q.24 The following information relates to the business of Maharaja Enterprises for the year ended Dec 31, 2001. a. b. c.

d.

A debit balance on the Plant and Machinery account on Jan 1, 2001 Rs.26,840. During the year 2001, three machines standing in the books at Rs.1,286 were sold for Rs.600. On April 1,2001 new machine costing Rs.5,880 were purchased and were installed by the manufacturer’s workman at an expenditure of Rs. 216 (i.e. wages Rs. 174 and materials Rs. 42). It is the practice of the business to write-off 15% depreciation to all additions to the plant during a year and 20% to all old plants. Prepare the Plant and Machinery account as it would appear on Dec 31, 2001.

Q. 25 A Limited Company purchased machinery for Rs. 40,000 on 1 Jan 1987. The machinery was depreciated at 10% p.a. on Straight line basis. On 31 March 1989, the machinery was sold for Rs. 35,000. Give the machinery account in company’s books if the depreciation provision account is maintained. Q. 26 Jinney soaps Ltd. Purchased a truck on 1 April 1998 for Rs. 5,00,000. On 1 July 1999 an other truck was purchased for Rs. 5,50,000. On 1 Oct 2001, the truck purchased on 1 April 1998 met with an accident the claim for Rs. 1,50,000. The company charges depreciation @ 20% on written down value basis and maintain of provision for depreciation account. Prepare turck account, provision for deprecation on truck account, truck disposal account. Q. 27 A firm write off 95% of the cost of machinery acquired over a period of ten years under Straight line method, remaining 5% as estimated scrap value. Full depreciation is written off even if the machinery is in use only for par of a year. On Dec 31, 1997, the original cost of the machinery in use was as follows: ● ● ●

Purchased in 1987 or earlier Purchased in 1989 Purchased in 1993

Rs. 1,20,000 Rs. 40,000 Rs. 30,000

A machine acquired in 1993 at a cost of Rs. 15,000 was sold for Rs. 5,000. On the same date, new machinery was acquired for Rs. 45,000. Prepare the Machinery Account for the year 1998 in books of the firm, the accounts being closed every year on Dec 31.

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Q. 28 Pass the necessary Journal entries and clearly show the working notes separately. Debit Amount Rs. Debtors Bad Debts Discount Allowed Provision for Doubtful Debts Provision for discount on DebtoRs.

Credit Amount Rs.

40,000 2,000 1,000 2,500 900

Additional information It is desired to create a provision for Bad and Doubtful debts at 5% on Debtors and Provision for discount on debtors at 20%. Q. 29 From the following, pass the journal entries, prepare the necessary ledger accounts, also show how these items will appear in Profit and Loss account and Balance Sheet. Extract of Trial Balance as on 31 Dec 2002. Debit Amount Rs. Bad debts Sundry Debtors Bad Debts provision 1.1.2002

1,200 1,02,000 3,650

Additional Information ● ●

Write off further bad debts Rs. 2,000 Provide for doubtful debts at 10% on sundry debtors

ANSWERS 1.

Multiple Choice a. (i) , b. (ii), c. (ii), d. (iii), e. (ii)

2.

Fill in the Blanks (i) (ii) (iii) (iv) (v) (vi)

Diminution, Amount or Value, Equal usage , Dividends, Strengthen , Allocation, Creation

Credit Amount Rs.

DEPRECIATION PROVISION AND RESERVES

3.

True and False (i) (ii) (iii) (iv) (v)

False False True False True

Problems 15. 16. 17. 18. 19. 20. 21. 22. 23.

24. 25.

26. 27. 28. 29.

Depreciation amount Rs. 5,000 Balance of Machinery Account 36,000 Loss on sale Rs.1,50,150 Balance of Machinery Account Rs. 1,41,500 Loss on Sale Rs.10,500 Balance of Machinery Account Rs. 84,500 Balance of Machinery Account Rs. 31,000 Loss on Bus Destroyed Rs. 10,000 Balance of Bus Account Rs. 4,74,000 Loss on Sale Rs. 3,00,000 Balance of Machinery Account Rs. 2,10,000 Loss on Sale Rs. 5,325 Balance on 1 Jan 1993, Rs. 39,330 Balance of Machinery Account Rs. 97,200 Loss by fire Rs. 21,000 SLM- Loss on Sale Rs. 11,950 Balance of Machinery Account Rs. 1,57,400 WDV- Loss on Sale Rs. 12,215 Balance of Machinery Account Rs. 1,62,248 Balance of Machinery Account Rs. 25,626 approx Provision for Depreciation Rs. 9,000 Profit on Sale Rs. 40,000 Balance of Machinery Account Rs. 40,000 Balance of Truck Account Rs. 4,25,0750. Balance of Machinery account Rs. 54,675 approx Provision for doubtful debts Rs. 1,500 Provision on discount on Debtors Rs. 860 Amount Debited to P&L account Rs. 9,550 Net Debtor Shown in Balance Sheet Rs. 90,000

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