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NCERT Class 11 Accountancy Chapter 7 Depreciation, Provisions and Reserves
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Depreciation, Provisions and Reserves
Chapter: 7
| PART – I |
| Short Answers |
1. What is ‘Depreciation’?
Ans: Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value. According to Institute of Cost and Management Accounting, London (ICMA) terminology “The depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time.”
2. State briefly the need for providing depreciation.
Ans: Depreciation needs to be provided because an asset is bound to undergo wear and tear over a period of time. This reduces the working capacity and effectiveness of the asset. Hence, this should reflect the value of the asset, at which it is carried in the books of accounts.Depreciation is necessary to allocate the cost of a tangible asset over its useful life. This ensures that the financial statements reflect a more accurate picture of the company’s financial condition.
3. What are the causes of depreciation?
Ans: Depreciation as the permanent decrease in the value of an asset due to factors like wear and tear, obsolescence, or the passage of time. The document outlines various causes of depreciation including wear and tear, exhaustion, effluxion of time, weather effects, and permanent declines in asset value Depreciation has a significant effect in determining and presenting the financial position and results of operations of an enterprise. Depreciation is charged in each accounting period by reference to the extent of the depreciable amount. It should be noted that the subject matter of depreciation, or its base, are ‘depreciable’ assets which:
(i) “Are expected to be used during more than one accounting period.
(ii) have a limited useful life.
(iii) Tre 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.”
4. Explain basic factors affecting the amount of depreciation.
Ans: The amount of depreciation basically depends upon three factors, i.e. Cost, Useful life and Net realisable value.
5. Distinguish between straight line method and written down value method of calculating depreciation.
Ans: Distinguish between straight line method and written down value method of calculating depreciation:
| Basis of Difference | Straight Line Method | Written Down Value Method |
| (i) Basis of charging depreciation. | Original cost | Book Value (i.e. original cost less depreciation charged till date). |
| (ii) Annual depreciation charge | Fixed (Constant) cost | Declines year after year. |
| (iii) Total charge against profit and loss account in respect of depreciation and repairs. | Unequal year after year. It increases in later years. | Almost equal every year. |
| (iv) Recognition by income tax law. | Not recognised | Recognised |
| (v) Suitability. | It is suitable for assets in which repair charges are less, the possibility of and obsolescence is low scrap value depends upon the time period involved. | It is suitable for assets, which are affected by technological changes and require more repair expenses with passage of time. |
6. “In case of a long term asset, repair and maintenance expenses are expected to rise in later years than in earlier year”. Which method is suitable for charging depreciation if the management does not want to increase burden on profits and loss account on account of depreciation and repair.
Ans: Annuity method of depreciation.
7. What are the effects of depreciation on profit and loss account and balance sheet?
Ans: Depreciation reduces profit on the profit and loss account and reduces the value of fixed assets on the balance sheet.
First, the amount of depreciation will be represented as an expenditure on the debit side of the Profit and Loss Account, and the amount of depreciation will be deducted from the related assets on the assets side of the Balance Sheet.
8. Distinguish between ‘provision’ and ‘reserve’.
Ans: Distinguish between ‘provision’ and ‘reserve’:
| Basis of Difference | Provision | Reserve |
| 1. Basic nature | Charge against profit | Appropriation of profit |
| 2. Purpose | It is created for a known liability or expense pertaining to current accounting period, the amount of which is not certain. | It is made for strengthening the financial position ofthe business.Some reserves are also mandatory under law. |
| 3. Effect on taxable profits. | It reduces taxable profits. | It has no effect on taxable profits. |
| 4. Presentations in Balance sheet | It is shown either (i) by way of deduction from the item on the asset side for which it is created, or (ii) In the liabilities side along with current liabilities. | It is shown on the liabilities. side after capital amount. |
| 6. Use for the payment | It can not be used for dividend distribution. | It can be used for divided distribution. |
9. Give four examples each of ‘provision’ and ‘reserves’.
Ans: Example of provision are:
(i) Provision for depreciation.
(ii) Provision for bad and doubtful debts.
(iii) Provision for taxation.
(iv) Provision for discount on debtors.
Example of reserve are:
(i) General reserve.
(ii) Workmen compensation fund.
(iii) Investment fluctuation fund.
(iv) Capital reserve , and Dividend equalisation reserve.
10. Distinguish between ‘revenue reserve’ and ‘capital reserve’.
Ans: Distinguish between ‘revenue reserve’ and ‘capital reserve’:
| Basis of Difference | Revenue Reserve | Capital Reserve |
| (i)Source of creation | It is created out of revenue profits which arise out of normal operating activities of the business and are otherwise available for dividend distribution. | It is created primarily out ofcapital profit which do not arise out of the normal operating activities of the business and not available for dividend distribution. But revenue profits may also be used for this purpose. |
| (ii) Purpose | It is created to strengthen the financial position, to meet unforeseencontingencies or for some specific purposes. | It is created for compliance of legal requirements or accounting practices. |
| (iii) Usage | A specific revenue reserve can be utilised only for theearmarked purpose while a general reserve can be utilised for any purpose including distribution of dividend. | It can be utilised for specific purposes as provided in the law in force e.g., to write off capita losses or issue of bonus shares. |
11. Give four examples each of ‘revenue reserve’ and ‘capital reserves’.
Ans: Examples of revenue reserves are:
(i) General reserve.
(ii) Workmen compensation fund.
(iii) Investment fluctuation fund.
(iv) Dividend equalisation reserve.
(v) Debenture redemption reserve.
Examples of revenue reserves are:
(i) Premium on issue of shares or debenture.
(ii) Profit on sale of fixed assets.
(iii) Profit on redemption of debentures.
(iv) Profit on revaluation of fixed asset & liabilities.
(v) Profits prior to incorporation.
(vi) Profit on reissue of forfeited shares.
12. Distinguish between ‘general reserve’ and ‘specific reserve’.
Ans: Distinguish between ‘general reserve’ and ‘specific reserve’:
| General reserve | Specific reserve |
| When the purpose for which reserve is created is not specified, it is called General Reserve. It is also termed as free reserve because the management can freely utilise it for any purpose. General reserve strengthens the financial position of the business. | Specific reserve : Specific reserve is the reserve, which is created for some specific purpose and can be utilised only for that purpose. |
13. Explain the concept of ‘secret reserve’.
Ans: Secret reserve is a reserve which does not appear in the balance sheet. It may also help to reduce the disclosed profits and also the tax liability. The secret reserve can be merged with the profits during the lean periods to show improved profits. Management may resort to creation of secret reserve by charging higher depreciation than required. It is termed as ‘Secret Reserve’, as it is not known to outside stakeholders.
Secret reserve can also be created by way of:
(i) Undervaluation of inventories/stock.
(ii) Charging capital expenditure to profit and loss account.
(iii) Making excessive provision for doubtful debts.
(iv) Showing contingent liabilities as actual liabilities.
| Long Answers |
1. Explain the concept of depreciation. What is the need for charging depreciation and what are the causes of depreciation?
Ans: Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value. According to Institute of Cost and Management Accounting, London (ICMA) terminology “The depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time.” Accounting Standard-6 issued by The Institute of Chartered Accountants of India (ICAI) defines depreciation as “a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change. 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 amortisation of assets whose useful life is predetermined”.
The need for providing depreciation in accounting records arises from conceptual, legal, and practical business consideration. These considerations provide depreciation a particular significance as a business expense.
(i) Wear and Tear due to Use or Passage of Time: Wear and tear means deterioration, and the consequent diminution in an assets value, arising from its use in business operations for earning revenue. It reduces the asset’s technical capacities to serve the purpose for, which it has been meant. Another aspect of wear and tear is the physical deterioration. An 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.
(ii) 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 predetermined period. Examples of such assets are patents, copyrights, leases, etc. whose utility to business is extinguished immediately upon the removal of legal backing to them.
(iii) Obsolescence: Obsolescence is another factor leading to depreciation of fixed assets. In ordinary language, obsolescence means the fact of being “out-of-date”. Obsolescence implies to an existing asset becoming out-of-date on account of the availability of better type of asset.
It arises from such factors as: Technological changes; Improvements in production methods; Change in market demand for the product or service output of the asset; Legal or other description.
(iv) Abnormal Factors: Decline in the usefulness of the asset may be caused by abnormal factors such as accidents due to fire, earthquake, floods, etc. Accidental loss is permanent but not continuing or gradual. For example, a car which has been repaired after an accident will not fetch the same price in the market even if it has not been used.
2. Discuss in detail the straight line method and written down value method of depreciation. Distinguish between the two and also give situations where they are useful.
Ans: (i) Straight line method: This is the earliest and one of the widely used methods of providing depreciation. This method is based on the assumption of equal usage of the asset over its entire useful life. It is called straight line for a reason that if the amount of depreciation and corresponding time period is plotted on a graph, it will result in a straight line. 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. According to this method, a fixed and an equal amount is charged as depreciation in every accounting period during the lifetime of an asset.
(ii) 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 predetermined proportion/percentage of the book value of the asset at the beginning of every accounting period, so as to calculate the amount of depreciation. The amount of depreciation reduces year after year.
Straight line and written down value methods are generally used for calculating depreciation amount in practice. Following are the points of differences between these two methods.
| Straight line method | Written down value method | |
| Basis of Charging Depreciation | In straight line method, depreciation is charged on the basis of original cost or (historical cost). | written down value method, the basis of charging depreciation is net book value (i.e., original cost less depreciation till date) of the asset, in the beginning of the year. |
| Annual Charge of Depreciation | The annual amount of depreciation charged every year remains fixed or constant under straight line method | written down value method the annual amount of depreciation is highest in the first year and subsequently declines in later years |
| Recognition by Income Tax Law | Straight line method is not recognised by Income Tax Law | written down value method is recognised by the Income Tax Law |
| Suitability | Straight line method is suitable for assets in which repair charges are low the possibility of obsolescence is low and scrap value depends upon the time period involved, such as freehold land and buildings, patents, trade marks, et | Written down value method is suitable for assets which are affected by technological changes and require more repair expenses with passage of time such as plant and machinery, vehicles, etc |
3. Describe in detail two methods of recording depreciation. Also give the necessary journal entries.
Ans: There are two main methods of calculating depreciation amount:
(i) Straight line method: The Straight Line Method (SLM) of Depreciation reduces the value of an asset consistently till it reaches its scrap value. A fixed amount of depreciation gets deducted from the value of the asset on an annual basis.
(ii) Written down value method: Written-down value is the value of an asset after accounting for depreciation or amortisation. In short, it reflects the present worth of a resource owned by a company from an accounting perspective. This value is included on the company’s balance sheet in its financial statements.
Journal entries for depreciation are given below.
When depreciation is charged to Assets Account
| Depreciation A/c Dr. To Assets A/c Cr.(Depreciation charged to assets account) |
| Profit and Loss A/c Dr. To Depreciation A/c Cr.(Depreciation transferred to profit and loss A/c) |
4. Explain determinants of the amount of depreciation.
Ans: Determinants of the depreciation are as follows:
(i) Cost of the Asset: Cost (also known as original cost or historical cost) of an asset includes invoice price and other costs, which are necessary to put the asset in use or working condition. Besides the purchase price, it includes freight and transportation cost, transit insurance, installation cost, registration cost, commission paid on purchase of asset add items such as software, etc.
(ii) Useful Life: Useful life represents how long is likely to be profitable to the business. It is used to calculate an asset’s depreciation while also helping inform maintenance and purchasing decisions. The longer the asset’s useful life, the lower its depreciation rate will be, but also the longer the company will benefit from it.
(iii) Residual Value: In accounting, residual value is another name for salvage value, the remaining value of an asset after it has been fully depreciated, or after deteriorating beyond further use. The residual value derives its calculation from a base price, calculated after depreciation.
(iv) Depreciation Method: Depreciation is an accounting method that considers an item’s initial cost or value, what it may be worth at the end of its life and how its value changes over time. Instead of writing off an asset that devalues the asset,
(v) Repairs and Maintenance: Costs incurred to maintain or repair an asset may extend its useful life or affect its residual value, thus influencing depreciation.
5. Name and explain different types of reserves in details.
Ans: There are two types of reserves:
(i) General reserve.
(ii) specific reserve.
(i) General reserve: When the purpose for which reserve is created is not specified, it is called General Reserve. It is also termed as free reserve because the management can freely utilise it for any purpose. General reserve strengthens the financial position of the business.
(ii) Specific reserve: Specific reserve is the reserve, which is created for some specific purpose and can be utilised only for that purpose. Examples of specific reserves are given below :
(a) Dividend equalisation reserve: This reserve is created to stabilise or maintain dividend rate. In the year of high profit, amount is transferred to Dividend Equalisation reserve. In the year of low profit, this reserve amount is used to maintain the rate of dividend.
(b) Workmen compensation fund: It is created to provide for claims of the workers due to accident, etc.
(c) Investment fluctuation fund: It is created to make for decline in the value of investment due to market fluctuations.
(d) Debenture redemption reserve: It is created to provide funds for redemption of debentures.
6. What are ‘provisions’. How are they created? Give accounting treatment in case of provision for doubtful Debts.
Ans: There are certain expenses/losses which are related to the current accounting period but amount of which is not known with certainty because they are not yet incurred. It is necessary to make provision for such items for ascertaining true net profit.
An essential step in creating a provision is to estimate the amount of funds to set aside. It must be a reasonable estimate. Companies will often review their past experiences, recent financial statements or industry averages to establish the estimated size of the provision.
The accounting treatment of all types of provisions is almost similar. Therefore, the accounting treatment is explained here taking up the case of provision for doubtful debts.
Doubtful Debts are those debtors who may pay but business firm is not sure about the collection of full amount 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. To consider this possible loss on account of non-payment by some debtors, it is a common practice (and necessary also) to make a suitable provision for doubtful debts at the time of ascertaining true profit or loss. The provision for doubtful debts is usually calculated as a certain percentage of the total amount due from sundry debtors after deducting/ writing- off all known bad debts. Provision for doubtful debts is also called ‘Provision for bad and doubtful debts’. It is created by debiting the amount of required provision to the profit and loss account and crediting it to provision for doubtful debts account.
