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DEPRECIATION
1.
are
books of accounts?
recorded
in
1. Outline
causes of Depreciation.
1.
What
is
Depreciation?
1. Discuss
depreciations
are
1. Define
and discuss
Depreciation, Depletion
and Amortization.
DEPRECIATION
Causes of Depreciation:
Constant use : The loss in the value, efficiency and utility of
fixed assets due to its constant use is termed as depreciation.
Expiry of time : The effective life of assets goes on decreasing
with the passage of time.
Obsolescence : The old assets will become obsolete due to
new inventions, improved techniques and technological
advancements.
Depletion : Loss of mineral wealth due to constant working of
mines is also depreciation, but specially known as depletion.
Permanent fail in price : Though fluctuations in the market
value of fixed assets is not recorded in the books. Sometimes we
have to account for this loss such as permanent fall in the value
of investments.
Abnormal factors : Depreciation may also be due to the loss
in the value of assets by accidents and damage.
METHODS OF DEPRECIATION
FORMULA
Formula :
The depreciation to be charged under this method can be
worked by using the following formula :
Case Study:
CASE STUDY
A firm purchases a machine at a cost of Rs.510000
on 01.01.2013. The life of the machine is expected
to be 5 years. At the end of 5th year, the firm will be
able to sell the machine for Rs.10000. under
straight line method amount of depreciation can be
worked out as under:-
Here:
Annual Depreciation
Thus Rs.1,00,000 will be charged each year as depreciation of the machine.
MERITS
The merits of straight line method are as under:Simplicity : This method is simple and
calculations are easier to understand.
Consistency : It is a consistent method since
amount of depreciation charged each year is equal.
It is a consistent method since amount of
depreciation charged each year is equal. So we
can easily compare the past performance.
MERITS
The Whole cost can be charged as
depreciation : Under this method, the value
of the asset can be reduced to its estimated
scrap value (if the asset has some residual
value) or nil (if the asset has no residual
value). This is not possible under any other
method.
Reasonable presentation : The balance
sheet shows reasonable and fair values of
the assets.
DE-MERITS
Following are the demerits of straight line method:
Not Iogical: It is well known that the efficiency of an asset
falls and the expense on its repairs and maintenance increases
gradually with the passage of time. However, under this
method the amount of depreciation remains constant. Thus,
the total charges (repairs and maintenance plus depreciation)
to profit and loss account increase in the later years.
Improper presentation : Under this method, the book value
is sometimes reduced to zero, however, it may happen that the
asset is being used in the enterprise. In that case balance
sheet does not show the true and fair view of the enterprise.
Unsuitability : This method becomes unsuitable for certain
assets in which maintenance cost is higher in later years like
plant and machinery, land and building etc.
SUITABILITY
This method is suitable where :
The estimated useful life of an asset can
be easily determined and the assets which
gives almost equal utility in terms of
productivity during the useful life of the
asset like Trademark, Copyright etc.
The maintenance and repair cost, cost of
the assets is almost the same during the
useful life of the asset like furniture etc.
CASE STUDY OF
DIAGRAMMITIC REPRESENTATION OF
10,000
A
B
9,000
8,000
ILLUSTRATION OF
Dr.
Date
Cr
Particulars
J.F
Amount
()
2010
Jan 1
Date
Particulars
To Bank A/c
23,000
Dec 31
By Depreciation
A/c
To Bank A/c
2,000
Dec 31
By Balance c/d
2011
5, 000
20, 000
25,000
2011
To Balance b/d
20,000
Dec 31
By Depreciation
A/c
4,000
By Balance c/d
6,000
20,000
2012
Jan 1
Amount
2010
25,000
Jan 1
J.F
20,000
2012
To Balance b/d
16,000
Dec 31
By Depreciation
A/c
3,200
Amount of
Depreciation
Book Value
Applicability
Total Charge
Suitability
Suitable for assets which give almost This method is suitable for assets which
equal utility in terms of productivity
gives higher utility in the initial years like
during the entire useful life of the
Machinery etc.
assets like Trademarks, Copyright
etc.
PROVISIONS:
Provision means setting aside a part of the profits for
meeting a liability in future, the amount of which is not
known accurately at the time of finalization of financial
statements. Provision is to be made in respect of a liability,
which is certain to be incurred, but its exact amount is not
known. If the exact amount can be known, it becomes a
liability and not provision. Provision for Legal Damages,
Provision for Depreciation, Provision for Taxation,
Provision for doubtful debts, and Provision for Discount
for Debtors are few examples of provisions.
OBJECTIVES:
For ascertainment of true net profit: In practice provision
should be created for those expenses or liabilities for which the
exact amount is unknown or cannot be ascertained accurately. For
example: provision created for doubtful debts, provision for discount
on debtors etc.
For ascertainment of true financial position: The business
must make adequate provisions for all expenses and losses, only
then the Balance sheet will depict the true and fair view of the
financial position of business.
To provide for known losses in the future: For meeting a
liability in future, the amount for which is unknown, steps should
be taken to set, aside a part of profits. For example, provision for
taxation, provision for repairs, provision for bad-debts etc.
For uniform charge on income statements: Provisions are
required to be created for equal distribution of expenses and losses
in all the years so that proper analysis can be made.
IMPORTANT OF PROVISIONS:
The importance of Provisions are as follows:
Funds for replacement of asset: Since fixed assets have limited useful
life, they have to be replaced by new assets when they became obsolete. For
this purpose, Provision for Depreciation, is to be made. When provision for
depreciation is made, the amount of depreciation charged to Profit and Loss
Account is retained in the business and can be used for replacement of the
asset in future years.
Funds for diminution in the value of assets: In the case of
diminution in the value of some assets like investments, adequate provision
in respect of provisions for fluctuation in investments is to be made. For this
purpose Investment Fluctuation Fund is to be made.
Uniform charge of income statements: Provision has to be created for
equal distribution of expenses an losses in all the years so that proper
analysis for deviation in income for any year can be examined.
Incompliance of principle of prudence: As per the convention of
conservatism or prudence, provision must be made for all expected losses so
that the business enterprise can be saved from the burden of heavy losses in
future.
EXAMPLES OF PROVISION
Depending upon the need, size and nature
of the operations of the business, different
types of provisions are maintained by the
business enterprise. Usually, a business
enterprise creates Provision for Legal
Damage, Provision for Depreciation,
Provision for Taxation, Provision for
Doubtful Debts, and Provision for
Discount on Debtors.
RESERVES
Reserve means an appropriation of profits
or other surplus to strengthen the liquid
resources of the business enterprise and
not for meeting any liability, contingency or
any commitment of the business. In other
words, reserve means the amount set aside
out of profit and other surpluses, which are
not earmarked in any way to meet any
particular liability known to exist on the
date of Balance Sheet.
RESERVES - IMPORTANCE
Strengthening the Financial Position: Reserves help in
strengthening the financial position of the enterprise, since it
can be used to meet any unforeseen losses that may arise in
future.
Source of Internal Financing: By creating the reserves,
profits are ploughed back into the business which can be used
as source of finance.
Enhancing the reputation of enterprise: In order to
enhance the reputation or image of the company, regular
dividends must be paid to be shareholders in time. It can be
achieved if the company maintains reserves because in the
years of inadequacy of profits, amount can be withdrawn from
these reserves and paid to the shareholders.
RESERVES - IMPORTANCE
Keeping working
increases the working
enterprise.
DIFFERNECE BETWEEN
PROVISIONS AND RESERVES
BASIS
Appropriation
Or charge
Availability of
Profit
PROVISIONS
Provisions are charge on profits
RESERVES
Reserves are an appropriation on profits
Purpose
Necessity
Accounting
treatment
Sides of balance
sheet
Investment
Distribution
Effect
Creation of provision does not depend Reserves depend upon profit. In the absence of
on profit. They have to be created even adequate profits, reserves cannot be created
if there are inadequate profits or heavy
losses
TYPES OF RESERVES
Broadly, there are two types of reserves:
(1) Revenue Reserves (2) Capital Reserves
REVENUE
RESERVES
REVENUE RESERVES
Revenue reserves are created out of profits
which have been earned in the normal course
and from the day to day activities of the
business concern.
Revenue reserves may further be classified as
(A) General Reserve
(B) Specific Reserve
(C) Secret Reserve
To
Dividend
Equalization Reserve.
Debenture
Redemption Reserve.
Investment
Fluctuation Reserve.
Workmen
Compensation Fund.
By
undervaluing stock,
By making excessive provisions then the required,
By charging capital expenditure to revenue,
By
showing contingent liabilities as actual
liabilities of the enterprise.
Secret reserve is secret in the sense that it is not
known to the outsides. It is suggested that
keeping in view the requirements of the case,
secret reserve should be created within
reasonable limits.
CAPITAL
RESERVES
DIFFERENCE BETWEEN
REVENUE RESERVE
CAPITAL RESERVE
1. Source
2. Period
3. Creation
4. Dividend
5. Object
DIFFERENCE BETWEEN
GENERAL RESERVE
SPECIFIC RESERVE
1. Meaning
2. Purpose
3. Utilization
4. Dividend
DIFFERENCE BETWEEN
RESERVE AND RESERVE
FUND
BASIS
GENERAL RESERVE
1. Meaning
2. Purpose
The
basic
purpose
of The basic purpose is to
keeping reserve is to meet earn regular income
any contingent liability
from securities.
3.
Sale
SPECIFIC RESERVE
investments
not
kept
outside
the loss
on
sale
of
business in any form so the investments in which
question of selling does not the amount of reserve is
arise.
invested outside the
business.