UNIVERSITY QUESTIONS

DEPRECIATION

YEAR – 2013 (UNIVERISTY QUESTIONS)

1. Discuss the factors determining

the amount of depreciation. How

depreciation are recorded in

books of accounts?

YEAR – 2012 (UNIVERISTY QUESTIONS)

Rollex Chemicals Private Ltd. Purchased on 1st April, 2003 a machinery costing Rs. 60, 000. Further purchase of machinery was made on 1st October, 2003 costing Rs. 40, 000 and on 1st july, 2004 costing Rs. 20, 000.

On 1st January, 2005, one third of the machinery purchased on 1st April, 2003 was sold for Rs. 10, 000. Prepare machinery account in the books of company up to 31st December, 2006 assuming 10%. Depreciation P.A. on straight line method. The Calendar year is the accounting year of the company. Your answer must be supported by sufficient working notes.

YEAR – 2011 (UNIVERISTY QUESTIONS)

1. Outline the Concept and

causes of Depreciation.

YEAR – 2010 (UNIVERISTY QUESTIONS)

1. What is Depreciation?

Discuss any two methods of

calculating Depreciation and

bring out their relative merits

and demerits.

YEAR – 2009 (UNIVERISTY QUESTIONS)

1. Discuss the factors determining

the amount of depreciation. How

depreciations are recorded in

books of accounts?

YEAR – 2008 (UNIVERISTY QUESTIONS)

1. Define and discuss

Depreciation, Depletion

and Amortization.

DEPRECIATION

The term Depreciation implies ‘gradual and permanentdecrease in the value of an asset due to use cost.’ It is

non cash expenditure transactions which is allowed expenses for the calculation of profit. Special features of Depreciation: Depreciation is loss in the value of assets.’ Loss should be gradual and constant. Depreciation is the exhaustion of the effective life of

business. Depreciation is the normal feature. Maintenance of assets is not depreciation. It is continuing decrease in the value of assets.

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.

Need for charging Depreciation

For determination of net profit or net loss : Loss in the value of assets is undoubtedly a business expense. It must be recorded and shown at the debit side of the profit and loss account for the correct calculation of net profit or net loss.For showing assets at fair and true value in the balance sheet : If depreciation is not charged, the assets will be shown as value more than its actual value.Provision of funds for replacement of assets: The assets acquired and used in the business will become useless after expiry of its estimated life or even before that, we will have to replace the obsolete assets with another fresh asset.

Need for charging Depreciation

Ascertaining accurate cost of production : Depreciation on factory plant and machinery is factory overhead. It will increase the cost of production and the price of the commodity will be fixed at appropriate price.Distribution of dividend out of profit only : If depreciation is not charged, the profit will be more and the excess dividend will be paid out of capital, which should have been paid out of profit.Legal Obligation : In addition to tax regulations, it is necessary for certain types of business organizations, such as joint stock companies, to charge depreciation before declaring any dividends.

Factors affecting / determining the amount of depreciation

There are some relevant factors must taken into consideration for calculation amount of depreciation to be shown in the financial statement. It is quite impossible to calculate the actual and accurate amount of depreciation. It can always be estimated, though we try our best to be more accurate and correct.

The important factors affecting the amount of depreciation are enumerated below:-

1.Total Cost of assets : Value of assets is determined after adding all expenses of acquiring, installing and constructing the assets. We should take into consideration the total cost of assets for determining the rate and the amount of depreciation.  Case Study : The purchase price of machinery Rs.100000/-, installation charges Rs.10,000/-. In this case, the depreciation will be calculated over Rs.110000/- rather Rs.100000/-. 2.Estimated useful life of assets : The estimated working life of the assets may be measured in terms of years. In case of depreciation the value of assets is allocated over the estimated useful life of the asset. If expected life is more, the rate of depreciation will be lesser and vice versa.

The important factors affecting the amount of depreciation are enumerated below:-

3.Estimated scrap value : It is the residual value, which is expected to be realized even if the asset become obsolete. Suppose, we purchase a machine for Rs.10,000/- whose expected life is ten years, if the scrap value is Rs.1000/-, we will have to arrange Rs.9,000/- i.e. 10,000 – 1,000 in ten years. Every year will bear a depreciation of Rs.900/- i.e. 9,000/10. 4.Chance to obsolescence : If the asset acquired is expected to be obsolete within 5 years, we will have to split its value over 5 years.5.Addition to assets : Depreciation should be charged on the additions to the assets also. If book value of furniture on Jan. 1, 2006 is Rs.10,000/- and additions worth Rs.5000/- are made on July 1, 2006.6.Legal Provisions : The rate and method of depreciation being used must be subject to legal provisions. Companies have to honour the legal provision with regard to depreciation.

METHODS OF DEPRECIATION

Straight line method : Basic Concepts:Under this method, the amount of depreciation remains same over the expected useful life of the assets. That is why this method is called ‘Fixed Installment Method’. This method is also called as “Original Cost Method” because a fixed percentage of the original cost of asset is charged as depreciation during the estimated useful life of the asset.

FORMULA

Formula :The depreciation to be charged under this method can be worked by using the following formula : Amount of Depreciation (D)  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:-

CASE STUDYA 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-MERITSFollowing 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.

DIMINISHING BALANCE METHOD/W.D.V METHOD

Basic ConceptsUnder this method, depreciation is charged as a fixed percentage on the book value of the asset every year. Instead of charging depreciation on the original cost, depreciation is charged on reducing balance of every year.

DIMINISHING BALANCE METHOD MERITS:Equal burden on income statementIn the initial year, the depreciation charges are more and repair expenses are less while in later years, depreciation charges are les and repair expenses are more. Therefore, the total burden on profit and loss account remains approximately the same throughout the life of the asset.Complying with matching principleUnder this method, higher amount of depreciation is charged on the profit and loss account in the initial years when the machine is more efficient giving higher production than the later years when machine becomes older and produces less.Logical approachWritten down value method is more logical method than the straight line method because in the initial years cost of the machine is high so more amount on account of depreciation is to be charged through profit and loss account.

DIMINISHING BALANCE METHOD

MERITS:Approved method by income tax authoritiesThe method is approved by income tax authorities

Suitable for assets having long lifeThis method is suitable for those assets which have long life. It is also suitable for those assets, where additions and extensions are common feature, such as land, building, plant and machinery.

DIMINISHING BALANCE METHOD DEMERITS:Improper presentationUnder this method, the book value of the asset can never be written down to zero. However, it may happen that some assets have zero value after some time. Sometimes, to bring down the book value of the asset to the estimated scrap value some adjustments are to be carried out in the last year.ComplexityUnder this method, the amount of depreciation cannot be determined easily. Lot of figure work is involved in this calculation. It becomes impossible when scrap value of the asset is zero.UnsuitabilityThis method is not suitable for those assets which give a uniform benefit during their entire useful life.

DIMINISHING BALANCE METHOD

DEMERITS:No Funds for replacementThough depreciation is charged every year but the amount charged is retained in the business and used in routine business operations. At the time of replacing assets, firm has to bother for making arrangements of funds, although it has charged depreciation every year.Loss of interestThe amount charged as depreciation is not invested outside the business, so no interest is received. In certain methods, the amount is invested outside the business in securities and interest is received.

DIMINISHING BALANCE METHOD

DEMERITS:Higher rate of DepreciationThe rate of depreciation in this method is higher, because it will require longer period to write off the asset, if the rate is lower and the assets may become useless earlier.

In equal burden on profit and loss accountThe amount of depreciation goes on declining year after year, whereas the asset is used equally by every year.

DIMINISHING BALANCE METHOD

SUITABILITY:This method is useful : Where the cost of maintenance and repairs are high in the later years as compared to the initial years e.g. plant and machinery.Where the additions and repairs are higher in the later years e.g. land and buildings.

CASE STUDY OF DIMINISHING BALANCE METHOD

For example : if a machine has been acquired for `. 1,00,000 and depreciation is charged @ 10% according to written down value method the depreciation to be charged will be made as illustrated below.

1st Year on `. 1,00,000 @ 10% =

2nd Year on `. 90,000 i.e `10,000 - 10, 000= 90,000 x

3rd Year on `. 81,000 i.e `90,000 - ` 9, 000= 81,000 x

4th Year on `. 72,900 i.e `81,000 - ` 8,100= 72,900 x

It is observed that the balance of machine upon which depreciation is calculated goes on reducing/diminishing. The amount of depreciation goes on declining year after year.

DIAGRAMMITIC REPRESENTATION OF DIMINISHING BALANCE METHOD

1 2 3 4

10,000

9,000

8,000

A

B

CD

ILLUSTRATION OF DIMINISHING BALANCE METHOD

(WDV: Sale of assets). Kaushal Traders purchased a second hand machinery on 1st January 2010 for ` 23,000 and spent ` 2,000 on its repairs. It was decided to depreciate the machinery at 20% every year, according to diminishing balance method. Prepare the machinery account from 2010 to 2012 and show profit or loss as it was sold on 31st December 2012 for ` 10, 800. The accounts are closed on December 31 every year

Dr.

Cr

Date Particulars J.F Amount ()

Date Particulars J.F Amount2010 2010Jan 1 To Bank A/c 23,000 Dec 31 By Depreciation

A/c5, 000

To Bank A/c 2,000 Dec 31 By Balance c/d 20, 00025,000 25,000

2011 2011Jan 1 To Balance

b/d20,000 Dec 31 By Depreciation

A/c4,000

By Balance c/d 6,00020,000 20,000

2012 2012Jan 1 To Balance

b/d16,000 Dec 31 By Depreciation

A/c3,200

Dec 31 By Bank a/c 10,800Dec 31 By Profit & Loss 2,000

16,000 16,000

Basis Straight Line Method Written down value methodBasis of Calculation

Depreciation is calculated on original cost of the asset.

Depreciation is calculated on written down value of the asset.

Amount of Depreciation

Amount of depreciation remains same during the useful life of the asset

Amount of depreciation keeps on reducing every year.

Book Value Book-value of the asset can be reduced to zero or to its scrap value

Book value never gets reduced to zero.

Applicability Not applicable for income tax purposes.

Applicable for income tax purposes.

Total Charge In the initial years, total charge (depreciation plus repair) is less but in the later years, total charge increases as repairs increase while depreciation remains the same.

The total charge remains almost the same as in the initial years repairs are less and depreciation is high while in later years, repairs increase and depreciation decreases.

Suitability Suitable for assets which give almost equal utility in terms of productivity during the entire useful life of the assets like Trademarks, Copyright etc.

This method is suitable for assets which gives higher utility in the initial years like Machinery etc.

Difference between Straight Line Method and Written Down Value Method:

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 capital intact: Reserve increases the working capital of the business enterprise.

Facilitating heavy amount when needed: Reserve can be created for some specific purpose which can be used to meet that purpose only. For the redemption of debentures, company has to pay huge amount to debenture holders. When the debentures become due for payment, the company may face a financial difficulty, because a large amount is generally required for redemption of debentures.

DIFFERNECE BETWEEN PROVISIONS AND RESERVES

BASIS PROVISIONS RESERVESAppropriation

Or chargeProvisions are charge on profits Reserves are an appropriation on profits

Availability of Profit

Creation of provision does not depend on profit. They have to be created even if there are inadequate profits or heavy losses

Reserves depend upon profit. In the absence of adequate profits, reserves cannot be created

Purpose They are created to meet known liability

Reserves are created to strengthen the liquid resources of the business enterprise.

Necessity Creation of provision is necessary as per law

Maintenance of reserves is not necessary because they are created as per financial prudence.

Accounting treatment

Provisions are recorded on the debit side of Profit and Loss Account

Reserves are recorded on the debit side of Profit and Loss Appropriation Account

Sides of balance sheet

Provisions may appear on the either side of the balance sheet by way deduction form the concerned asset or separately on the liabilities side

Reserves are always shown on the liabilities side

Investment Provision can never be invested outside business

Reserves can be invested outside business and known as Reserve Fund

Distribution Provision can never be distributed as profit unless actual liability is less than the amount provided for.

Reserves, other than capital reserves, can be distributed as profit

Effect Provision reduces net profit Reserves reduces divisible profits

TYPES OF RESERVES

Broadly, there are two types of reserves:(1) Revenue Reserves (2) Capital Reserves

RESERVES

Revenue Reserve Capital Reserve

General Specific Secret Reserve Reserve Reserve

Terms used for Different Assets

Broadly, there are two types of reserves:(1) Revenue Reserves (2) Capital ReservesThe following are the different terms used for different types of assets:-

Depreciation – This term is used when expired utility of a physical asset is to be recorded. e.g. building, machinery, vehicle.Amortization – This term is used for describing the process of writing down the long term investments in intangibles such as leaseholds, patents, copyright, trade marks, goodwill and heavy organizational costs.Depletion : This term is applied to the process of measuring and recording the exhaustion of natural resources e.g., ore deposits, oil-wells, timber stands, quarries etc.

Terms used for Different Assets

Obsolescence – This term refers to disappearing usefulness resulting from invention, change of style, legislation or other causes having no physical relation to the object affected. It is distinguished from exhaustion, wear and tear and deterioration in that these terms refers to functional loss arising out of a change in physical condition.

Dilapidations – When a property is returned to the landlords after the expiry of lease period then landlord is entitled to demand that it be in as good a condition as when it was leased out. For this leaseholders often set aside a certain amount each year to provide for any dilapidation that may need to be set right when the property is returned. For accounting purposes the expected amount of dilapidations is added to the cost of leased property. The depreciation is provided on the total cost, thus arrived at.

REVENUE RESERVES

REVENUE RESERVESRevenue reserves are created out of profitswhich have been earned in the normal courseand from the day to day activities of thebusiness concern.

Revenue reserves may further be classified as • (A) General Reserve• (B) Specific Reserve • (C) Secret Reserve

(A) GENERAL RESERVES

General reserves is that amount of profits which are set aside to meet some future contingencies and not created for any specific purpose. These are generally retained for strengthening the financial position of the business concern and to provide additional working capital for the business when needed.

OBJECTIVES

To strengthen the financial position of the business concern.

To make available additional working capital all the times.

To meet any liability or contingency, in case of unforeseen circumstances.

To equalize the rate of dividend over the years in case of inadequate profits.

(B). SPECIFIC RESERVE

Specific reserves are created for some specific purposes. These reserves cannot be utilized for any purpose other than the purpose for which they were created. However, if the article of association permits then at the discretion of board of directors, specific reserves may be used for a purpose other than the purpose of its creation.

EXAMPLES OF SPECIFIC RESERVES

Dividend Equalization Reserve.

Debenture Redemption Reserve.

Investment Fluctuation Reserve.

Workmen Compensation Fund.

(C). SECRET RESERVE

Secret reserve is a reserve that do not appear in the balance sheet. It can be created in the years of higher profits and can be merged with the profits during the lean periods.

Secret Reserves can be created as under:-

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.

CAPITALRESERVES

CAPITAL RESERVES

Capital reserves are the reserves created out of capital profits. Following are the examples of some items which may form capital reserves:-

Profit on Sale of Fixed Assets Profit on Revaluation of Fixed Assets Securities Premium received on Issue of Shares or

Debentures Profits on Redemption of Debentures. Profit prior to Incorporation Profit on Reissue of Forfeited Shares, etc. Capital reserves can be utilized for writing off capital losses.

DIFFERENCE BETWEEN REVENUE RESERVE AND CAPITAL

RESERVEBASIS REVENUE RESERVE CAPITAL RESERVE1. Source It is created out of

revenue profits.It is created out of capital profits.

2. Period It cannot arise during the pre-incorporation period

It may arise during the period prior to incorporation.

3. Creation It is created by retaining profit.

It is not created by retaining profit.

4. Dividend

It can be used for payment of dividends without any precondition.

It can be used for payment of dividend only when certain conditions of Companies Act are satisfied.

5. Object It is created to strengthen the financial position, to meet unforeseen contingencies or some other specific purpose.

It is created to meet capital loss or for companies of legal requirements or accounting practices.

DIFFERENCE BETWEEN GENERAL RESERVE & SPECIFIC RESERVE

BASIS GENERAL RESERVE SPECIFIC RESERVE1. Meaning Reserve created not for any

specific and earmarked purpose is known as general reserve.

Reserve created for some specific and earmarked purpose is known as specific reserve.

2. Purpose General reserve is created to meet some future contingencies and for strengthening financial position of a business concern.

Specific reserve is created for some specific purpose.

3. Utilization General reserve is utilized to meet any unknown liability.

Specific reserves can be utilized only for the purpose for which they were created.

4. Dividend In case of need, general reserve can be utilized for paying dividend.

Usually, dividend can not be paid out of the specific reserves.

DIFFERENCE BETWEEN RESERVE AND RESERVE FUND

BASIS GENERAL RESERVE SPECIFIC RESERVE1. Meaning Reserve is the amount set

aside out of profits and other surpluses, securities.

Reserve fund is the amount of reserve which is invested in outside.

2. Purpose The basic purpose of keeping reserve is to meet any contingent liability

The basic purpose is to earn regular income from securities.

3. Sale of investments

As the amount of reserve is not kept outside the business in any form so the question of selling does not arise.

There may be profit or loss on sale of investments in which the amount of reserve is invested outside the business.