21/04/23 DEPRECIATION,PROVISIONS AND RESERVES 1

1 CONCEPT OF DEPRECIATION 2 CAUSES OF DEPRECIATION 3 NEED OF DEPRECIATION 4 BASIC FACTORS 5 METHODS OF DEPRECIATION6 PROVISION AND RESERVES

21/04/23 DEPRECIATION,PROVISIONS AND RESERVES 3

DEFINITIONDepreciation is the permanent decrease in the value of an asset due to use and /or the lapse of the time.

CLMA, LONDON

21/04/23 4DEPRECIATION,PROVISIONS AND RESERVES

CAUSES OF DEPRECIATIONPhysical depreciation Economic factors Time factors Depletion Accident

21/04/23 DEPRECIATION,PROVISIONS AND RESERVES 6

NEED FOR CHARGING DEPRECIATION

To calculation the profit .True and fair view in balance sheet. Replacement of asset .Saving in income tax.Accurate ascertainment of cost.

BASIC FACTORS AFFECTING DEPRECIATION

Cost of asset .Estimated working life.Salvage/Residual/Scrap value.Legal provisions Additions to assets

METHODS OF DEPRECIATION

CHANGEMACHINE HOUR RATE

DEPLETION

REVALUATION

INSURANCE POLICYDEPRECIATION FUND

ANNUITY

SUM OF THE DIGITS

DIMINISHING BALANCE

FIXED INSTALMENT

STRAIGHT LINE METHODUnder this method,a fixed asset in written off

annually so that,by the time asset is worn out ,its proportion cost of the value in the book is reduced to zero.

FORMULA FIXED ASSET- ESTIMATED SCRAP

VALUE ESTIMATED LIFE OF ASSET

21/04/23 DEPRECIATION,PROVISIONS AND RESERVES 9

MERITS AND DEMERITS

21/04/23 DEPRECIATION,PROVISIONS AND RESERVES 10

MERITS- 1. Simple . 2. Asset is fully written off . 3. Knowledge of total depreciation charged . 4. Suitable for fixed life assets. DEMERITS- 1. Interest on capital. 2. Reairs and maintenance 3. Income tax

QUESTION:- A trader bought machinery on 1st jan , 2001 for Rs . 125000 whose useful life has been estimated 5 years . After the expiry of

useful life , the scrap will realise Rs 25000. ANNUAL DEPRECIATION

125000-25000 =5000

5

MACHINERY ACCOUNTDATE

PARTICULARS

AMT DATE

PARTICULARS

AMT

2001 Jan 1

To bank a\c 125000

2001 Dec 31

By depreciation a\c

20000

Dec 31

By bal c\d 105000

125000

125000

2002Jan 1

To bal b\d 105000

2002Dec 31

By depreciation a\c

20000

Dec 31

By bal c\d 85000

105000

105000

2003Jan 1

To bal b\d 85000

2003Dec 31

By depreciation a\c

20000

Dec 31

By bal c\d 65000

85000

85000

2004 Jan 1

To bal b\d 65000

2004Dec 31

By depreciation a\c

20000

By bal c\d 45000

65000

65000

2005Jan 1

To bal b\d 45000

2005Dec 31

By depreciation a\c

20000

Dec 31

By bal c\d 25000

45000

45000

DIMINISHING BALANCE METHODDepreciation is calculated at a certain

percentage each year on the balance of the asset which is brought forward from the previous year. The amount of depreciation charged in each period is not fixed but it goes on decreasing gradually as the beginning balance of the asset in each year will reduce.

MERITS & DEMERITSMERITS

1. Fresh calculation of depreciation are not necessary as and when additions are made. 2. this method is recognized by the income tax authorities in India.

DEMERITS 1.Its difficult to determine the suitable rate of depreciation. 2. the original cost of the asset is altogether lost sight of in subsequent years and the asset can never be reduced to zero.

QUESTION:- A company bought machinery for Rs .400000, including a shaft Rs . 40000. The machinery is subject to dep at 10% by reducing instalment method . In the beginning of the fifth year , the shaft became obsolete and instalment method . In the beginning of the fifth year , the shaft become obsolete and was sold for Rs. 8000.Write up the

machinery account for five years .

MACHINERY ACCOUNTDATE

PARTICULARS

AMT DATE PARTICULARS

AMT

1ST Yr

To bank a\c 400000

1ST Yr.

By depreciation a\c

40000

By bal c\d 360000

400000

400000

2ND

YrTo bal b\d 36000

02ND

YrBy depreciation a\c @10% ON 360000

36000

By bal c\d 324000

360000

360000

3RD Yr.

To bal b\d

324000

3rd Yr.

By depreciation@10%ON Rs.324000

32400

By bal c\d 291600

324000

324000

4TH Yr.

To bal b\d

291600

4TH Yr.

By depreciation@10%ON Rs.291600

29160

By bal c\d 262440

291600

291600

5th Yr.

To bal b\d

262440

5TH Yr.

By bank a\c 8000

By profit & loss [Loss on sale of shaft]

18244

By depreciation@10%ON Rs 236196

23620

By bal c\d 212576

262440

262440

SUM OF THE DIGITS METHOD

This is a variant of the reducing instalment or diminishing balance method.

QUESTION:-Suppose machinery was purchased for Rs. 60000 on 1st jan,2003 and depreciation was charged following the sum of the digits method assuming its useful life to be 3 years. Depreciation for three years will be calculated as under:

DEPRECIATION FOR THE FIRST YEAR = 3 Rs.60000 =Rs.30000

3+2+1 SECOND YEAR = 2 Rs.60000=Rs.20000

6 THIRD YEAR = 1 Rs.60000 =Rs.10000

6

ANNUITY METHOD Under this ,amount spent on purchase of an

asset is regarded as an investment which is assumed to earn interest at a certain rate. The amount to be written off as depreciation is calculated from annuity table , an extract of which is given below :

Years 3% 3 1% 2

4% 4 1% 2

5%

3 0.353530

0.359634

0.360349

0.363773

0.367209

4 0.269027

0.272251

0.275490

0.278744

0.282012

5 0.218355

0.221481

0.224627

0.227792

0.230975

QUESTION:- A firm purchases a 5 yr lease for Rs.40,000 on 1st jan . It decides to write off depreciation on annuity method ,presuming the rate of interest to be 5% per annum . The annuity tables show that a sum of Rs. 9,239 should be written off every year. Show the lease account for five yr .calculation are to be made to the nearest – rupee.

DATE PARTICULARS

AMT DATE PARTICULARS

AMT

1st yrJan 1

To cash 40000 1st yr Dec 31

By depreciation a\c

9239

Dec 31

To interest 2000 Dec 31

By bal c\d 32761

42000 42000

2nd yr Jan 1

To bal b\d 32761 2nd yr Dec 31

By depreciation a\c

9239

Dec 31

To interest 1638 Dec 31

By bal c\d 25160

34399 34399

LEASE ACCOUNT

3rd yr Jan 1

To bal b\d 25160

3rd yr Dec 31

By depreciation a\c

9239

Dec 31

To interest 1258 Dec 31

By bal c\d 17179

26418

26418

4th yr Jan 1

To bal b\d 17179

4th yr Dec 31

By depreciation a\c

9239

Dec 31

To interest 859 Dec 31

By bal c\d 8799

18038

18038

5th yr Jan 1

To bal b\d 8799 5th yr Dec 31

By depreciation a\c

9239

Dec 31

To interest 440

9239 9239

DEPRECIATION FUND METHODThis method is implies that the amount

written off as depreciation should be kept aside and invested in readily saleable securities. The securities accumulate and when the life of asset expires, the securities are sold and with the sale proceeds a new asset is purchased. The rate of interest which is easily calculated from sinking fund tables , an extract of given below :

years 3% 3 1% 2

4% 4 1% 2

5%

3 0.323540

0.321934

0.320349

0.318773

0.317208

4 0.239027

0.237251

0.235490

0.233741

0.232012

5 0.188350

0.186481

0.184627

0.182792

0.180975

SINKING FUND TABLE

QUESTION:- A company purchased a 3 years lease on January 1,2007 for Rs. 25000. It is decided to provide for the replacement of lease at the end of 3 years by setting up a depreciation fund .It is expected that the investments will fetch interest at 5%. Sinking fund table show that to provide the requisite sum at 5% at the end of 3 years an investment of Rs 7932 is required every year. Investment are made to the nearest rupee. On 31st Dec,2009 the investments were sold for Rs. 15250. on 1st January,2010, the same lease was renewed for a further

period of 3 years by payment of Rs. 30000.

DEPRECIATION FUND ACCOUNT2007 Jan 1

To bal c\d 7932

2007 Dec 31

By depreciation a\c

7932

2008Dec 31

To bal c\d 16261

2008 Jan 1

By bal b\d 7932

Dec 31

By bank 397

Dec 31

By depreciation a\c

7932

16261

16261

2009 Dec 31

To depreciation Fund investment a\c

1011

2009 Jan 1

By bal b\d 16261

Dec 31

To lease a\c 25000

Dec 31

By bank [interest] 813

Dec 31

By depreciation a\c

7932

Dec 31

By profit & loss a\c

1005

26011

26011

DEPRECIATION FUND INVESTMENT ACCOUNT

2007 Dec 31

To bank 7932 2007 Dec 31

By bal c\d 7932

2008 jan 1

To bal b\d 7932 2008 Dec 31

By bal c\d 16261

Dec 31

To bank 8329

16261

16261

2009 jan 1

To bal b\d 16261

2009 Dec 31

By bank 15250

Dec 31

By depreciation fund a\c [loss transferred]

1011

16261

16261

INSURANCE POLICY METHODThis method is similar to the

depreciation fund method but instead of making investment , arrangement are made with an insurance company which will receive premiums annually and pay at the end of the fixed period the required amount . Premiums have to be paid at the beginning of each year.

QUESTION:-On 1st jan. 2006,a lease of premises is purchased for four years for Rs.50000 and it is decided to make provision for the replacement of the lease by means of an insurance policy purchased for an annual premium of Rs.12000. show the necessary ledger account for four years assuming that the renewal of the lease costs Rs.50000 on 1-1 2010.

LEASE ACCOUNT 2006 Jan 1

To bank a\c 50000

2006 dec31

By bal c\d 50000

2007 jan 1

To bal b\d 50000

2007dec31

By bal c\d 50000

2008 jan 1

To bal b\d 50000

2008dec31

By bal c\d 50000

2009 jan 1

To bal b\d 50000

2009dec31

By bal c\d 50000

DEPRECIATION RESERVE ACCOUNT

2006 Dec 31

To bal c\d 12000

2006 Dec 31

By profit and loss a\c

12000

2007 Dec 31

To bal c\d 24000

2007 Jan 1

By bal b\d 12000

Dec 31

By profit and loss a\c

12000

24000

24000

2008 Dec 31

To bal c\d 36000

2008 Jan 1

By bal b\d 24000

Dec 31

By profit and loss a\c

12000

36000

36000

2009 Dec 31

To lease a\c 50000

2009 jan 1

By bal b\d 36000

Dec 31

By profit and loss a\c

12000

Dec 31

By depreciation insurance policy a\c [profit on the realisation of policy]

2000

50000

50000

REVALUATION METHOD Under this , the asset is revalued at the end of the accounting year and this value is compared with the value of the asset at the beginning of the year . The difference is treated as depreciation .this method is used in case of bottles, corks, crates or etc

QUSETION:- A company manufactures loose tools for its own use .At the end of each year, depreciation is charged on revaluation method. From the following particulars show the loose tools account :Year ended 31-12-2006-loose tools manufactured Rs .5000[revalued on 31-12-2006:Rs.4100]

Year ended 31-12-2007-loose tools manufactured :Rs. 2700 [revalued on 31-12-2007:Rs5700]Year ended 31-12-2008-loose tools manufactured :Rs.1000 [revalued on 31-12-2009:Rs.6000] Year ended 31-12-2009-loose tools manufactured :Rs.1500[revalued on 31-12-2009: Rs.5100]

LOOSE TOOLS ACCOUNT 2006 TO COST OF

PRODUCTION A\C

5000

2006

BY DEP A\C [Bal .fig.]

900

BY BAL C\D 4100

5000

5000

2007 TO BAL B\D 4100

2007

BY DEP A\C [Bal .fig.]

1100

TO COST OF PRODUCTION A\C

2700

BY BAL C\D 5700

6800 6800

2008 To bal b\d 5700 2008 By depreciation a\c

700

To cost of production a\c

1000 By bal c\d 6000

6700 6700

950

250

1200

DEPLETION METHODThis method is mostly used in case of mine,

quarries; etc. from which certain quantity of output is expected to be obtained . The value of mine depends only upon quantity of minerals that can be obtained .when the whole quantity is taken ,the mine loses its value .the rate of depreciation is worked out only so much per tonne. It is simply dividing the cost of the mine by the total quantity of the minerals expected to be available.

QUESTION:-A mine was acquired at a cost of Rs.20,00,000 on 1st July 2007. It was expected it would yield 2,00,000 tons of minerals in all. The actual output was 2007-10,000 tons ,2008-40,000 tons and 2009-32,000 tons. Write up the mine account for the above years using depletion method of

charging depreciation. Rate of depreciation =Rs.10 per ton

MINE ACCOUNT 2007 July 1

To bank a\c 2000000

2007 Dec 31

By depreciation a\c

100000

Dec31

By bal c\d 1900000

2000000

2000000

2008 Jan 1

To bal b\d 1900000

2008 Dec31

By depreciation a\c

400000

Dec31

By bal c\d 15000000

1900000

1900000

2009 Jan 1

To bal b\d 1500000

2009 Dec 31

By depreciation a\c

320000

Dec 31

By bal c\d 1180000

1500000

1500000

2010 Jan 1

To bal b\d 1180000

MACHINE HOUR RATE METHODThis method is useful in case of

machines .The life of machine is fixed in terms of hours . Hourly rate of depreciation is worked out by dividing the cost of the machine by the total number of hours for which the machine is expected to be used .depreciation to be written off in a year will be ascertained by multiplying the hourly rate of depreciation by the number of hours that the machine actually runs in the year.

QUESTION:- A machine was acquired on 1st April,2008 at a cost of Rs 90,000, the cost of installation being Rs. 10000. It is expected that its total life will be 20,000 hours. During 2008 it worked for 5,000 hours and during 2009 for 8,000 hours. Write up the machinery account for 2008 & 2009. Machine hour rate= Rs 5 per hour

MACHINERY ACCOUNT 2007Ap 1

To bank a\c [cost and installation charges]

100000

Dec 31

By depreciation a\c

25000

Dec31

By bal c\d 75000

100000

100000

2009 Jan 1

To bal b\d 75000 2009Dec31

By depreciation a\c

40000

Dec31

By bal c\d 35000

75000 75000

2010 Jan 1

To bal b\d 35000

CHANGE OF METHODSometimes the method is changed either

from straight line method to diminishing balance method or from diminishing balance method to straight line method with effect from the current year or with retrospective effect .if the change is from current year then there will be no problem but simply to change the method of depreciation .

QUESTION:- Plant and machinery account of a company had a debit balance of Rs. 1,47,390 on 1st jan ,2009.The company was incorporated in 2006 and has been following the practice of charging full year, depreciation every year on diminishing balance system @15%. In 2009 it was, however decided to change the method from reducing system to straight line with retrospection effect from 2006 and to give effect of the change while preparing the final accounts for the year ended 31st dec,2009, the rate of depreciation remaining same as before. In 2009, new machineries were purchased at a cost of Rs.50,000. All the other machineries were acquired in 2006.

Show Plant and machinery account from 2006 to 2009.

PLANT AND MACHINERY ACCOUNT

2006 Jan 1

TO BANK A\C

240000

2006 Dec31

BY DEP A\C [15% on Rs 240000]

36000

Dec31

BY BALC\D 204000

240000

240000

2007 Jan 1

TO BAL B\D 204000

2007 Dec31

BY DEP A\C [15% on Rs204000

30600

Dec31

BY BAL C\D 173400

204000

204000

2008 Jan 1

To bal b\d 173400

2008 Dec 31

By depreciation a\c [15% on Rs173400

26010

Dec 31

By bal c\d 147390

173400

173400

2009 Jan 1

To bal b\d 147390

2009 Dec 31

By profit and loss a\c [additional dep] 2

15390

Jan 1

To bank a\c [Additions]

50000 Dec31

By depreciation a\c [15%on 240000+50000]

43500

Dec 31

By bal c\d 138500

197390

197390

PROVISIONS AND RESERVESMEANING OF PROVISIONS

The term “provision” means any amount written off or retained by way of providing depreciation ,renewals or diminution in the value of assets or retained by way of providing for any know liability the amount of which may not be determined with substantial accuracy

Question:- A firm desires to debit its profit and loss account with a uniform figure every year in respect of repairs and renewals. It expects that considering the life of the asset in question Rs.10,000 will be the average amount to spent per year. Actual repairs are Rs.1,000 in the first year, Rs.2,300 in the second year and Rs.3,700 in the third year. Show the provision for repairs and renewals account.

FOR REPAIRS AND RENEWALS ACCOUNTYEAR 1

To bank [Repairs] 1000 YEAR 1

By profit and loss a\c

10000

To bal c\d 9000

10000 10000

2 To bank [Repairs] 2300 2 By bal b\d 9000

To bal c\d 16700 By profit and loss a\c

10000

19000 19000

3 To bank [Repairs] 3700 3 By bal b\d 16700

To bal c\d

23000

By profit and loss a\c

10000

26700

26700

MEANING OF RESERVE

Any sum which is appropriated out of profit and loss

appropriation account and is not meant to cover up

liability,contingency,commitment,or reduction in the value of an

asset is a reserve.

QUESTION:- Show the distinction between sinking fund to repay a liability and sinking fund to replace a wasting asset by the operation of ledger account at the end of five years in the following cases: 1. sinking fund to replace leasehold property valued Rs. 900000 at the end of five years . 2. sinking fund to repay Rs. 900000 debentures at the end of five years .

To old lease a\c [transfer]

900000 By bal b\d 900000

1. Sinking fund [to replace an asset at the end of five years]

OLD LEASE ACCOUNT

To bal b\d 900000 By sinking fund a\c [transfer]

900000

To bank a\c 900000

NEW LEASE ACCOUNT

2. Sinking fund [to repay a liability at the end of five years]To reserve fund [transfer]

900000 By bal b\d 900000

DEBENTURES ACCOUNT

To bank a\c 900000 By bal b\d 900000