NCERT Notes for Class 11 Accountancy Chapter 7 Depreciation provision and Reserve

Class 11 Accountancy Chapter 7 Depreciation provision and Reserve

NCERT Notes for Class 11 Accountancy Chapter 7 Depreciation provision and Reserve, (Accountancy) exam are Students are taught thru NCERT books in some of state board and CBSE Schools.  As the chapter involves an end, there is an exercise provided to assist students prepare for evaluation.  Students need to clear up those exercises very well because the questions with inside the very last asked from those. 

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NCERT Notes for Class 11 Accountancy Chapter 7 Depreciation provision and Reserve

Class 11 Accountancy Chapter 7 Depreciation provision and Reserve

 

Depreciation provision and Reserve

Depreciation

• Depreciation means declaim in the value of fixed asset due to use, passage of time or obsolescence.
• it is treated a s an expense of business.
• Depreciation may be defined as the gradual and permanent diminution in the value of fixed asset due to wear and tear, use or abuse or efflux of time.
• According to Institute of Cost and Management Accounting, London (ICMA) “The depreciation is the diminution in intrinsic value of the asset due to use or lapse of time.’’

Features of depreciation

1. It is declaim in the book value of fixed asset
2. It includes loss of value due to the effluxion of time, usage or obsolescence.
3. It is a continuing process
4. It is an expired cost and hence must be deducted before calculating taxable income.
5. It is a non- cash expense.

Depreciation and other similar terms

Depletion

Decrease in the value of wasting asset due to constant extraction.

Amortisation

Decrease in the value of intangible asset like patent, trademark, copyright, goodwill etc. are called amortisation.

Causes of depreciation

• Wear and tear due to use or passage of time

Decrease in the value of fixed asset because of constant use is called wear and tear

• Expiration of legal rights

Certain categories of asset lose their value after the agreement. E.g. patent, copy right etc.

• Obsolescence

Decrease in the value of asset as a result of change in fashion or technology is called obsolescence.

• Abnormal factors

Abnormal factors such as accident, fire, earthquake, floods etc. may declaim the value of asset.

Need for depreciation

• To ascertain the true result of the business
• To present the true balance sheet
• To retain funds for replacement
• To avoid excess payment of income tax
• To fulfil the legal requirement
• To distribute dividend out of profit only.

Factors affecting depreciation

• Cost of asset

It refers to the purchase price plus all expense of acquiring and installing the asset.

• Estimated useful life.

It means the period for which assets can be effectively utilised

• Scrap value

It is the amount which is expected to be realised on the sale of asset at the end of its useful life. It is also called residual value or salvage value.

• Depreciable cost

Depreciable cost of an asset equal to its cost less net residual value.

Methods of calculating depreciation

straight line method

This is a method in which a fixed amount is deducted from the value of asset year after year on account of depreciation and debited to profit and loss account. It is also called original cost method because depreciation charged every year is a fixed percentage on the original cost of the asset. It is also called fixed instalment method because the amount of depreciation remains constant from year to year over the useful life of the asset. In this method the value of asset become zero or reduced to its scrap value at the end of its effective life.

Formula for calculating depreciation

Depreciation = Original cost of asset – Scrap value / Effective life

Advantages of straight line method

1. it is very simple , easy to understand and apply.
2. Asset can be depreciated up to net scrap value or zero value
3. Every year same amount is charged as depreciation in profit and loss account. This makes comparison of profits for different year easy.
4. This method is suitable for those assets whose useful life can be estimated accurately. Limitations of straight line method
5. This method is based on the faulty assumption of same amount of the utility of an asset in different years.
6. Does not necessary match costs with revenues in different types of long-term assets

 

Written down value method

• This method is also known as diminishing balance method or reducing balance method.
• Under this method a fixed percentage is written off every year on the book value of the asset.
• The amount of depreciation reduces year after year.
• In this method the book value of asset will not become zero after its working life.

Advantages of Written down value method

1. This method is based on more realistic assumption that the benefits from assets go on diminishing with the passage of time. Hence it calls proper allocation of cost because the amount of depreciation is higher in the earlier years when the asset is efficient and the cost of repairs is low. In later years amount of depreciation becomes lower
2. As this method equalizes the total charges of using the asset (i.e., the amount of depreciation plus repair charges) from year to year. This is because depreciation charges decline each year whereas repair charges increase year by year.
3. Income-tax authorities recognize this method.
4. Loss due to obsolescence gets reduced by charging the major part of depreciation in the early years of the life of the asset.
5. This method is suitable for fixed assets which last for long and which require increased repair charges.

Disadvantages of the written down value method

1. Under this method the book value of an asset cannot be reduced to zero.
2. This method is not suitable for an asset having a very short life.
3. The calculation of the rate of the depreciation becomes very difficult.

Difference between Straight line method and written Down Value Method

Straight line method	Written Down Value Method
Charging depreciation on original cost	Charging depreciation on Book value
Annual depreciation is fixed	Declines year after year
Depreciation and repairs unequal year after year. Increases in later years	Almost equal in every year
Not recognised by income tax law	Recognised by income tax law
Suitable for assets in which repair charges are less, the possibility of obsolescence is low	It is suitable for assets which are affected by technological changes and require more repair expense.

Methods of recording depreciation

There are two methods of recording depreciation in the books of accounts:

1. Charging Depreciation to Asset Account
2. Creating Provision for Depreciation Account or Accumulated Depreciation Account.

1-Charging Depreciation to Asset Account

Under this method, depreciation is credited in the respective asset account every year. Here, the asset is shown at its book value (i.e. original cost minus depreciation). Depreciation provided is treated as a business expenses and transferred to P/L account.

Under this method, following journal entries have to be passed:

1.When asset is purchased:

Asset A/c Dr.

To Bank /Cash/Supplier A/c

2. Charging Depreciation

Depreciation A/c Dr.

To Asset A/c

3. When depreciation is transferred to Profit and Loss Account: Profit and Loss A/c Dr.

To Depreciation A/c

4. When asset is sold:

(a)When sale proceeds are received:

Cash / Bank A/c Dr. To Asset A/c

(b) In case of gain on sale of an asset:

Asset A/c Dr. To Profit and Loss A/c

(c) In case of loss on sale of an asset:

Profit and Loss A/c Dr.

To Asset A/c

2-Creating Provision for Depreciation Account or Accumulated Depreciation Account. Under this method, depreciation is not charged to respective assets account. It is credited to a separate account called ‘Provision for Depreciation Account’ or ‘Accumulated Depreciation Account’. Here the asset is shown at original cost in the balance sheet and the amount of accumulated depreciation is shown on the liabilities side of the balance sheet under the head ‘Current Liabilities and Provisions’.

Under this method following journal entries are passed:

• When asset is purchased:

Asset A/c Dr.

To Bank / Cash/Supplier A/c

• When depreciation is charged:

Depreciation A/c Dr.

To Provision for Depreciation A/c or Accumulated Depreciation A/c

• When depreciation is written off:

Profit and Loss A/c Dr.

To Depreciation A/c

• When the accumulated depreciation is transferred to asset account:

Provision for Depreciation A/c Dr.

To Asset A/c

Provisions and Reserves

Provisions:

• Provision means any amount written off or retained by way of providing depreciation or retained by way of providing for any known liability of which the amount cannot be determined.
• Provision is created according to the principle of prudence or conservatism.
• Provision is a charge against profits it means provision has to be made irrespective of business enterprise is earning enough profit or loss.
• Provisions are created by debiting the profit and loss account.

In the balance sheet the amount of provision may be shown either by way of deduction from the concerned asset on the asset side or on the liability as current liabilities.

1. Provision is to be made is respect of a liability, which is certain to be incurred, but its accurate amount is not known.
2. It is charged in the Profit and loss Account on estimate basis. It should be clearly understood that if the amount of a known liability can be determined with reasonable accuracy, it can not a provision.

Examples of Provisions:

• Provision for Depreciation of assets.
• Provision for Repairs and Renewals of assets.
• Provision for Taxation.
• Provision for Discount on Debtors.
• Provision for Bad and doubtful Debts.

Accounting treatment of provision

When business transactions are takes place on credit basis debtor’s account is created and its balance is shown on the asset side of the balance sheet. Debtors may be of three types

1. Good debtors: good debtors are those debtors where collection of debt is certain.
2. Bad debt: bad debts are those debtors from where collection of money is not possible.
3. Doubtful debts: doubtful debts are the amount of money that a business does not expect to collect from its clients. It cannot be written off as bad because non recovery of such amount is not certain.

It is a possible loss on account of non-payment by some debtors. In order to meet this type of losses a provision against sundry debtors is created and is called provision for bad debts or provision for doubtful debts. It is created by debiting the amount of required provision to the profit and loss account and crediting it to the provision for doubtful debt account.

Journal entry is

Profit and loss a/c Dr

To provision for doubtful debt a/c

Reserves

Reserves are the amount set aside out of profits and retained in the business to provide for certain future needs or to meet future contingencies. It is an appropriation of profits and not a charge on the profits. The amount of profit retained is used in the business to meet unforeseen liabilities in future.

Since reserves are neither expenses nor losses, so these are not charged to profit & loss Account rather these are debited to Profit & Loss Appropriation Account which is prepared after Profit and Loss Account. Reserves are created to strengthening the financial positions of the business enterprise. Examples are General Reserve, Dividend Equalization Reserve etc.

If the amount of reserve is invested outside the business then, it is called ‘Reserve Fund’. Creation of reserve does not reduce the net profit but only reduces the divisible profits.

Difference between Provisions and Reserve

Basis	Provision	Reserve
1. Meaning	It is created meet a known liability.	It is created to strengthen the financial position of business enterprise.
2. charge or Appropriation	Provisions are charge against profits.	Reserve is an appropriate of profit.
3. Objective	The object is to provide for known liability but cannot be calculated accurately.	It is created to strengthen the financial position and to meet unforeseen liability.
4. Effect on Profit	It is debited to the Profit & Loss Account. Hence, profit is reduced.	Reserve reduces divisible profits.
5. Creation	Provisions are to be created even if there is insufficient profit only.	Reserve is created out of adequate profits only.
6. Mode of creation	Provision are created by debiting the Profit & loss account.	It is created through Profit & Loss Appropriation Account.
7. Investment	It cannot be invested outside the business. Creation of provision is necessary as per law.	Reserve can be invested outside the business.
8. Necessity	Creation of provision is necessary as per law.	Its creation is not necessary. It is created as a matter of prudence.
9. effect on taxable profit	It reduces taxable profit	It has no effect on taxable profit

Types of Reserve

A reserve is created by retention of profit of the business can be for either a general or a specific reserve.

General Reserve:

If the purpose of creating the reserve is to meet any unforeseen contingency in future, or the purpose of reserve is not specified the reserve is called ‘General Reserve’. These are retained for strengthening the financial position of the enterprise. It is also called free reserve.

Specific Reserve :

Specific reserves are those reserves which are created for a specific purpose and can be utilized only for that purpose. ‘

1. Dividend Equalization Reserve
2. Workmen compensation fund
3. Investment fluctuation fund
4. Debenture redemption reserve

According to the nature of the profit out of which they created reserves are classified as revenue and capital reserve.

Revenue Reserve

A reserve which is created out of the revenue profit is called revenue reserve. Revenue profit is earned in the normal course of the business. Revenue reserve refers to the undistributed revenue profit. It can be distributed as dividend to the shareholders.

 

1. General reserve
2. Dividend Equalization Reserve
3. Workmen compensation fund
4. Investment fluctuation fund
5. Debenture redemption reserve

Capital Reserve:

A reserve which is created out of the capital profit is known as capital reserve. It is not created out of the profit earned in normal course of the business. Capital reserve is created out of the profit earned from some specific transactions of capital nature. Capital reserve is not available for the distribution to the shareholders. The examples of capital profit from which capital reserve is created are as follows:

• Profit on sale of fixed assets
• Profit on sale of investment
• Profit on revaluation of assets and liabilities
• Premium on issue of shares and debentures
• Profit on re-issue of forfeited shares
• Discount on redemption of debentures
• Profit on purchase of an existing business

Secret Reserve :

A reserve which maintained to strengthen the financial position of the business without disclosing it in the book is known as secret reserve. Secret reserve is hidden reserve which is not disclosed by the balance sheet. It is created by showing the figure of net profit less than actual. A secret reserve is created in any of the following ways:

• By depreciating the fixed assets at excessively high rates.
• By undervaluing the current assets.

* By eliminating the assets altogether from the books.

• By over-valuing the liabilities.
• By showing contingent liabilities as real assets.
• By creating excessive amount of reserve for future contingencies.
• By treating capital expenditure as revenue reserve.
• By ignoring accrued income or treating income as liability.

Difference between Revenue Reserve and Capital Reserve

Basis of Difference	Revenue Reserve	Capital Reserve
Source	It is created out of revenue profit, i.e., revenue earned from normal activities of business operations.	It is created out of capital profit, i.e., gain from other than normal activities of business operations, such as sale of fixed assets, etc.
Dividend	It can be used for dividend.	It cannot be used for dividend.
Purpose	It is created for strengthening the financial position of the business.	It is created for the purpose laid down in the Companies Act.