Depreciation, Provisions and Reserves

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Chapter Objectives Understand the concept of depreciation Identify the causes of depreciation Explain the meaning of depreciation accounting Compute depreciation according to different

methods of providing depreciation Explain the role of depreciation policy

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Depreciation Depreciation is defined as the gradual decrease

in the value of an asset. Causes of depreciation are:

Wear and tear Exhaustion Obsolescence Efflux of time Accidents

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Features of Depreciation It is applicable to all fixed assets except some

assets like land and antique. It is a charge against profits and true profit of a

business can only be computed after charging depreciation.

It differs from maintenance expenses, which are incurred for keeping the machines in a workable state.

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Depreciation Accounting Depreciation accounting is concerned with

distributing the cost of a tangible asset over its estimated useful life.

Objectives of depreciation accounting are: To determine true profit of business To provide true financial position of business To provide funds for the purchase of new assets

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Fixation of Depreciation Amount Depreciation amount of a particular asset is

computed and is charged to the profit and loss account.

Depreciation amount in respect to a particular asset depends upon the following factors: Cost of asset Estimated scrap value Estimated useful life

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Methods of Recording Depreciation

To record the depreciation in the books of account, two methods are used: Using Provision for Depreciation account Without using Provision for Depreciation account

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Methods of Recording Depreciation (contd.)

Using Provision for Depreciation account: The Provision for Depreciation account is credited with the

depreciation amount chargeable in a year. The Asset account provides the original cost of asset. The Provision for Depreciation account is transferred to the

Asset account, when the asset is sold. Without using Provision for Depreciation account:

The Depreciation account is debited with the depreciation amount chargeable in a year and the same amount is credited to the Asset account.

The Depreciation account is transferred to the Profit and Loss account.

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Methods of Recording Depreciation (contd.)

In both the methods, when the asset is sold: On profit, the balance of Asset account is

transferred to the Profit and Loss account. On loss, the amount realized on account of sale is

transferred to the Asset account.

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Methods for Providing Depreciation

The methods used for computing depreciation are classified into three categories: Uniform charge methods Declining charge or accelerated depreciation

methods Other methods

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Uniform Charge Methods In these methods a uniform depreciation

amount is charged every year. The various uniform charge methods are:

Fixed installment method: It is also known as Straight Line Method (SLM). It provides a fixed amount of depreciation every year. In this, depreciation is computed by dividing the difference of original cost of asset and estimated scrap value by the estimated life of the asset in years.

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Uniform Charge Methods (contd.) Depletion method: It is also known as productive

output method. In this, depreciation depends upon the actual cost of the asset and actual and estimated quantities of output to be produced using the asset.

Machine hour rate method: It is also known as service hours method. In this, depreciation depends upon the running time of the asset. Depreciation is computed by dividing the difference of asset and scrap value by the life of the asset in hours.

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Declining Charge Depreciation Methods

In these methods, the depreciation amount to be charged decreases with the expected life of the asset.

The various declining charge depreciation methods are: Diminishing balance method: Depreciation is

computed on the book value of the asset. Depreciation rate is obtained using the formula:1 – n ((net residual value/acquisition cost)

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Declining Charge Depreciation Methods (contd.)

Sum of years digits method: It is similar to the diminishing balance method. Depreciation is computed as the product of remaining life of asset divided by the sum of n digits, where n is the estimated life of asset in year, and original cost.

Double declining balance method: It is also similar to the diminishing balance method, but the depreciation rate is double the rate computed using the straight line method.

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Other Methods Group depreciation method: In this, the

homogeneous assets having similar average life are grouped together under a common summary account. The depreciation rate is computed from the expected average life and the scrap values of assets of a group.

Inventory system depreciation: In this, depreciation is computed for the assets whose expected life cannot be determined. Depreciation amount is computed by subtracting the cost of asset at the end of the accounting period from the total cost of the asset available at the beginning and purchased during the accounting period.

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Other Methods (contd.) Annuity method: In this, depreciation is computed by

considering the cost of asset and the interest on the actual cost of the asset that the business would have earned if the amount have been invested in some investment.

Depreciation fund method: In this, the depreciation amount is invested in some securities. This helps in the business to gather funds for the purchase of new assets.

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Other Methods (contd.) Insurance policy method: In this, the business takes

an insurance policy for a particular amount and pays a fixed amount of premium every year. At the end of the duration of insurance policy, the insurance company pays the insured amount, which is used by the business to buy new assets.

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Depreciation Policy Objectives of depreciation policy:

To recover the amount invested in purchasing an asset before the expiry of the economic life of the asset.

To ensure that a uniform rate of return on investment is achieved.

To generate funds for purchasing of new asset after the expiry of an old asset.

To determine correct profit and loss information of the business.

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Depreciation Policy (contd.) Aspects that should be considered while

developing the depreciation policy: An appropriate method for computing depreciation

should be selected depending upon the nature of assets and objectives of the management.

The provisions for depreciation should be periodically reviewed.

The depreciation policy should be evaluated in the context of tax, price level changes and Government regulations.

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Provision Provision is the amount that is set aside from the

profits of the business for providing: Depreciation, renewals and decrease in the value of

assets. An known liability, which cannot be determined.

It is a charge against profits and is created by debiting the Profit and Loss account.

It cannot be distributed as profits. Examples: Provision for bad debts, provision for

repairs and renewals and provision for discount.

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Reserve Reserve is the portion of earnings and receipts

of a business that is kept aside for a specific purpose other than a provision for depreciation.

It is an appropriation of profits that ultimately results to an increase in the funds of the proprietor.

It can be distributed as profits, if required. It is shown on the liability side of the Balance

Sheet under the heading Reserves and Surplus.

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Reserve Funds Reserve funds are the reserves that are kept for

investment outside the business. Types of reserve funds:

Revenue reserves: They are created out of revenue profits of the business.

Capital reserves: They are created out of capital profits of the business.

Secret reserves: They are the reserves that are not shown on the Balance Sheet.

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Summary In this chapter, you have:

Understood the concept of depreciation Identified the causes of depreciation Explained the meaning of depreciation accounting Computed depreciation according to different

methods of providing depreciation Explained the role of depreciation policy