# NCERT Solutions for Class 11 Accountancy Chapter 7 Depreciation, Provisions and Reserves

Detailed, Step-by-Step NCERT Solutions for 11 Accountancy Chapter 7 Depreciation, Provisions and Reserves Questions and Answers were solved by Expert Teachers as per NCERT (CBSE) Book guidelines covering each topic in chapter to ensure complete preparation.

## Depreciation, Provisions and Reserves NCERT Solutions for Class 11 Accountancy Chapter 7

### Depreciation, Provisions and Reserves Questions and Answers Class 11 Accountancy Chapter 7

1. You are looking at the profit and loss account of three business enterprises. You find the term depletion in first case and amortisation in third case. State the type of business of two enterprises are into.
2. A pharmaceutical manufacturer has just developed and registered a patent for a rare medicine. Which term will appear in its profit and loss account regarding the cost of patent written-off.
1. Fixed assets, exhaustion of natural resources, specific contracted business.
2. Amortisation.

State whether the following statements are True or False.
1. Depreciation is a non-cash expense.
2. ‘ Depreciation is also charged on current assets.
3. Depreciation is decline in the market value of tangible fixed assets.
4. The main cause of depreciation is wear and tear caused by its usage.
5. Depreciation must be charged so as to ascertain true profit or loss of the business.
6. Depletion term is used in case of intangible assets.
7. Depreciation provides fund for replacement.
8. When market value of an asset is higher than book value, depreciation is not charged.
9. Depreciation is charged to reduce the value of asset to its market value.
10. If adequate maintenance expenditure is incurred, depreciation need not be charged.
1. True
2. False
3. False
4. True
5. True
6. False
7. False
8. False
9. False
10. True

There are two dentists Dr. Aggarwal and Dr. Mehta in your locality who are competitors. Both of them have recently bought an equipment for treatment of patients. Dr. Aggarwal has decided to write-off an equal amount of depreciation every year while Dr. Mehta wants to write-off a larger amount in earlier years. They do not know anything about the methods of depreciation. Can you inform them more about the methods of depreciation they are applying even without knowing anything about accounting in formal. Who is more wise in your opinion? Give reasons in support of your answer.
Written down value method is more appropriate because this method is suitable for those assets which are affected by technological changes. Moreover, this method is recognised by income tax department.

Basaria Confectioner bought a cold storage plant on July 01,2003 for Rs. 1,00,000. Compare the amount of depreciation charged for first three years using :
1. Rate of depreciation @ 10% on original cost basis;
2. Rate of depreciation @ on written down value basis;
3. Also, plot the computed amount of depreciation on a graph.
………………..
………………..
………………..

I. State with reasons whether the following statements are True or False:
(i) Making excessive provision for doubtful debts builds up the secret reserve in the business.
(ii) Capital reserves are normally created out of free or distributable profits.
(iii) Dividend equalisation reserve is an example of general . reserve.
(iv) General reserve can be used only for some specific purposes.
(v) ‘Provision’is a charge against profit.
(vi) Reserves are created to meet future expenses or losses the amount of which is not certain.
(vii) Creation of reserve reduces taxable profits of the business.
(i) True
(ii) False
(iii) False
(iv) False
(v) True
(vi) False
(vii) False

II. Fill in the correct words :
(i) Depreciation is decline in the value of …………..
(ii) Installation, freight and transport expenses are a part of …………..
(iii) Provision is a ………….. against profit.
(iv) Reserve created for maintaining a stable.rate of dividend is ………….. termed as
(i) Assets
(ii) Acquisition cost
(iii) Charge
(iv) Dividend Equilisation Fund

Question 1.
What is Depreciation?
Depreciation :
Meaning – Depreciation means a fall in the value of an asset. The net result of an asset’s depreciation is that sooner or later the asset will become useless. Every fixed asset is liable to lose its value, once it begins to be used. It would be proper to consider some important definitions of depreciation.

These are :
“The permanent and continuing diminution in the quality, quantity or value of an asset.” – Pickles “Depreciation may be defined as a measure of the exhaustion of the effective life of an asset from any cause during a given period.” – Spicer and Pegler

“Depreciation is the diminution in the intrinsic value of the asset due to use and or lapse of time.” – Institute of Cost and Management Account (ICMA), London Having considered the above definitions, now depreciation can be defined as a part of the cost of fixed asset which has expired on account of its usage and/or the lapse of time, hi other words, it is reduction in the value of a fixed asset.

Here, it is important to note that depreciation is charged on all fixed assets except land/Usually the value of land appreciates over a period. The reason is that unlike other fixed assets like machinery, furniture it does not have finite economic life.

Accounting Concept of Depreciation – Accounting concept of depreciation means to distribute the cost of fixed assets over its estimated life in a reasonable manner. According to this concept, in an accounting period, diminution in the value of assets can be charged to that accounting period. Annual depreciation in the value of assets is like an expense which is due to use of assets in business functions and thus, is a charge optional but compulsory.

If we do not deduct any expense from the income of an accounting period, the ascertained profit will be wrong and will not disclose correct result of the business. As depreciation is also an expense which refers to cost of use of fixed assets, it must be deducted from the incomes of that accounting period. Therefore, there should be a regular provision of annual depreciation.

Question 2.
State briefly the need for providing depreciation.
Need for providing depreciation may be explained as follows :
(i) To ascertain the profit or loss properly : The first objective is to ascertain the correct profit or loss. If depreciation is ignored the cost that is occurring (though not being paid for in cash) in respect .of fixed assets will be ignored. The loss will suddenly loom large when the asset becomes useless or valueless.

Looking at it from another point of view, when goods are produced it involves use of fixed assets – the reduction in their value should be treated like another cost for production of the goods. Depreciation should, therefore, be debited to the Profit and Loss Account before profit is ascertained.

(ii) To show a true and fair view of the financial position : Depreciation, if not charged, would result in assets being stated as a higher value. As a result of this, the Position Statement (Balance Sheet) would not present a true and fair view of the financial position.

(iii) To show the asset at its proper value : The third objective is to show the fixed assets in the Balance Sheet at their proper value. To continue show them at cost, when their value has fallen because of wear and tear will be improper it will tantamount to painting a financial picture better than it is. If depreciation is not allowed, the Balance Sheet would fail to show the true financial position. Therefore, depreciation must be accounted for in order to present the assets at their proper value.

(iv) To retain, out of profits, funds for replacment : The fourth objective of depreciation is to retain, out of profits, funds of replacement of assets. The amounts debited in the Profit and Loss Accounts are retained in the business (no payment is made like other expenses).

These are available for replacement of the asset when its life is over. Funds would not be collected for this purpose without accounting for depreciation. One can see that depreciation has an important role to play in ascertaining the profit and portraying the correct financial position and ensuring continuity of business.

Question 3.
What are the causes of depreciation ?
Causes of Depreciation – The main causes of depreciation are:
(1) Wear and Tear : Wear and tear is an important cause of depreciation in the case of tangible assets. It is mainly due to use of the assets.

(2) Efflux of Time : Some, assets have a definite life period like a lease; on the expiry of the life the asset will cease to exist. Other assets, like plant and machinery, may not have a definite life; in their case the life is estimated.

(3) Obsolescense ; If a better machine comes in the market, the old machines may have to be scrapped even though they are capable of being used. It is a reduction in usefulness of the asset.

(4) Accidents : Accidental loss may be permanent but is not continuing and gradual. Of the above, only the first two factors are considered as relevant to depreciation. Factors (3) and (4) are considered only when they occur; they do not happen to all assets. It should be noted that when we talk of depreciation, we think only of fixed assets.

Only in a few cases do assets depreciate. Land may go up in value. But usually the value of assets diminishes continuously. This is so even if an asset is not used, mere passage of time is sufficient to reduce the value of the asset.  One unfortunate thing about depreciation is that it is not visible like other expenses till the very end.

In case of other, expenditure is obvious and, hence, everybody provides for such expenses while calculating loss or profit. It is not so with depreciation. Many people do not deduct depreciation from the gross earning to ascertain their net profit simply because there is no payment for it. This is fallacious. Let us make it clear by an example. Suppose ;

(1) A starts a small manufacturing business and buys machinery worth Rs. 20,000;
(2) He does not realise that this machinery is depreciating and, therefore, uses up all ‘profits’ which his business gives;
(3) By the end of ten years, he has earned a net income of Rs. 30,000, without considering depreciation; and
(4) The machinery bought by A is useless at the end of 10th year. It is clear that A’s net income is not Rs. 30,000 but only Rs. 10,000, because out of Rs. 30,000, he must deduct the loss of machinery worth Rs. 20,000. Would it not have been better if he had deducted every year a due proportion of his expenditure on the machinery before ascertaining his profit.

Further, if A has already used up Rs. 30,000, which according to his mistaken idea are his profits for the 10 years, he cannot continue to run his business for his machinery is no longer serviceable unless he raises funds, say, as a loan. If he had provided proper depreciation he would have retained sufficient funds to buy new machinery when the old one became useless. Provision of depreciation, therefore, is necessary first for ascertaining the true profit, and secondly, for retaining funds in the business so that the asset can be replaced (when its life is over) by a new one.

Question 4.
Explain basic factors affecting the amount of depreciation.
Basic factors affecting amount of depreciation – For calculating the amount of depreciation, the most important factors are the following:
(i) Original (Historical) cost of asset – Cost will include all expenses incurred like freight and erection charges up to the point the asset is ready for use.

(ii) The estimated residual or scrap value at its life – Residual value is an estimated sale value of the asset at the end of its economic life to the firm. Suppose, a machine is purchased at a cost of Rs. 50,000. It is expected that it will be used for 15 years at the end of which period it will have a scrap value of Rs. 5,000. We must provide a total ‘depreciation’ of Rs. 45,000 in 15 years.

(iii) Estimated effective or commercial life or the legal life whichever is shorter – Physical life is not important, an asset may still exist physically but may not be capable of producing goods at a reasonable cost.

If, for instance, an asset can work for twenty years but is likely to lose its commercial value within ten years, life for the purpose of accounting should be considered as only ten years. Depreciation therefore, should be provided each year so that the book value of the asset is reduced to its estimated scrap value at the end of its useful life.

Question 5.
Distinguish between Straight Line Method and Written Down Value Method (Fixed Instalment Method and Diminishing Balance Method) of calculating depreciation.
Difference between Straight Line Method and Written Down Value Method (Fixed Instalment Method and Diminishing Balance Method) :

 Basis of Difference Fixed Instalment Method Diminishing Balance Method 1.  Depreciation Depreciation is calcula­ted on original cost of a fixed asset. Depreciation is calcula­ted on the diminishing balance or written down value of the fixed asset. 2.  Amount of depreci­ation The amount of depreci­ation remains the same for all years. The amount of depreci­ation goes on reducing year after year. 3. Zero balance At the expiry of the working life of the asset, account reduces to zero. The balance in the asset account will not reduce to zero. 4.  Cost of depreciation and repair The combined cost on account of depreciation and repairs is higher in the later years. The combined cost on account of depreciation and repairs remains, more or less, equal throughout the period. 5.Suitability This method is more suitable for asset which get depreciated on account of expiry of working life of the asset. This method’s is suitable for such assets which require more and more repairs in the later years of their working life.

Question 6.
In case of a long term asset, repair and maintenance expenses are expected to rise in later years than in earlier years. 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.
Straight line method is suitable for assets in which repair charges are less, the possibility of obsolescence is less and scrap value depends upon the time period involved. Written down value method is suitable for assets, which are affected by technological changes and require more repair expenses with the passage of time such as plant
and machinery, motor vehicle etc. In this problem, written down value method is suitable for charging depreciation.

Question 7.
What are the effects of depreciation on profit and loss account and balance sheet?
Under straight line method, same amount is charged as depreciation in profit and loss account which makes comparison of profits for different years easy, with the passage of time, work efficiency of asset decrease and repair and maintenance expenses increase.

The total amount charged against profit on account of depreciation will not be uniform throughout the life of the asset, adversely affect the profit and loss account and balance sheet. Written down value method results the equal burden on profit and loss account every year. This method is suitable for fixed assets which lasts for long period, not adversely affects the position of Balance
Sheet.

Question 8.
Distinguish between ‘Provision’ and ‘Reserve’.
Difference between Provision and Reserve’:

Question 9.
Give four examples each of ‘Provision’ and ‘Reserve’.
Provisions – There are certain expenses or losses which are related to current accounting period but amount of which is not known with certainty because they are not yet recovered. It is necessary to make provision for such losses or expenses. Examples of provisions are :
(i) Provision for Depreciation
(ii) Provision for Bad & Doubtful Debts
(iii) Provision for Taxation
(iv) Provision for Repairs and Renewals

Reserves – When a part of profits will be set aside and retained in the business to provide certain future needs like growth and expansion or to meet future contingencies and known as Reserves.
Examples of reserves are:
(i) Workman Compensation Fund
(ii) General Reserve
(iii) Investment Fluctuation Fund
(iv) Capital Reserve
(v) Dividend Equalization Reserve
(vi) Debenture Redemption Reserve

Question 10.
Distinguish between ‘Revenue Reserve and ‘Capital Reserve’.

 Basis Revenue Reserve Capital Reserve 1. Source It is created out of business profits. It is created out of capital profits. 2. Dividend It can be used for distribu­tion of dividends without any precondition. It can be used for distribu­tion of dividends only if the company satisfies cer­tain conditions prescribed by the Companies Act. 3.Purpose It is created for strengthen­ing the financial position, and meeting the unforeseen contingencies pr some specific purpose. It is created for meeting capital losses or to be used for purposes specified by Companies Act.

Question 11.
Give four examples each of ‘Revenue Reserve’ and ‘Capital Reserve’.
Revenue Reserves and Capital Reserves :
Revenue Reserves are created out of revenue profits which are available for distribution as dividend. Examples of revenue reserves are :
(i) General Reserves,
(ii) Dividend Equalisation Reserve,
(iii) Debenture Redemption Reserve, and
(iv) Investment Fluctuation Reserve, etc.

Capital Reserves are created out of capital profits and are normally not available for distribution as cash dividend. Examples of capital reserves are :
(i) Profit prior to incorporation,
(ii) Premium on issue of shares or debentures,
(iii) Profits on redemption of debentures,
(iv) Profit on forfeiture of shares,
(v) Profit on sale of fixed assets,
(vi) Capital redemption reserve, and
(vii) Profit on revaluation of fixed assets and liabilities.
It is to be noted that al 1 capital profits should, therefore, be regarded as Capital Reserve.

Question 12.
Distinguish between ‘General Reserve’ and ‘Specific Reserve’.
General reserve is the amount that is set aside out of profits which is not created for any specific purpose. It is available for any future contingency or expansion of the business. Such reserve strengthens the financial position of the business. It is to be noted that General Reserve and Contingency Reserve generally mean the same thing.
Specific reserve is that reserve which is created for specific purpose and can be utilised only for that purpose.

For example, Dividend Equalisation Reserve is a specific reserve because it is created to maintain steady rate of dividend. Thus, this reserve will be utilised to keep the dividend up in the year in which the profits are insufficient. Debenture Redemption Fund, Capital Redemption Reserve, Development Rebate Reserve etc., are other examples of specific reserve.

Question 13.
Explain the concept of ‘Secret Reserve’.
Secret Reserve – Secret Reserve is a reserve which does not appear in the balance sheet. It may also help to reduce the disclosed profits as also the tax liability. The secret reserve can be merged with profits during the lean period to show improved profits. Secret Reserve is not known to outside state It may be created from the following :
(i) Under valuation of inventories.
(ii) Charging capital expenditure to profit and loss account.
(iii) Showing contingent liabilities as actual liabilities.
(iv) Making excessive provision for bad and doubtful debts.
It is maintained to prevent competition from other firms within reasonable limits.

Question 1.
Explain the concept of depreciation. What is the need for changing depreciation and what are the causes of depreciation?
Meaning – In every business there are certain assets of a fixed nature that are needed for the conduct of business operations. Some examples of such assets are building, plant and machinery, motor vehicles, furniture, office equipments, etc.

These assets have a definite span of life after the expiry of which the assets will lose their usefulness for the business operations. Fall in the value and utility of such assets due to their constant use and expiry of time is termed as depreciation. In other words, the process of allocation of the cost of a fixed asset over its useful life is known as depreciation.

Definitions – Some of the well-known definitions of depreciation are. given below :
(1) “Depreciation is the gradual and permanent decrease in the value of an asset from any cause.” R. N. Carter
(2) “Depreciation may be defined as the permanent and continuing diminution in the quality, quantity or the value
of an asset.” – William Pickles
(3) “Depreciation is the measure of the exhaustion of the effective life of an asset from any cause during a given period.” – Spicer & Peglar
(4) “It is a matter of common knowledge that all fixed assets such as plant, machinery, building, furniture etc. gradually diminishing value as they get older and become worn out by constant use in the business.” – J.R. Batliboi

Need, Importance or Objects of providing Depreciation :
(1) For ascertaining the true profit or loss – The true profit of a business can be ascertained only when all costs incurred for the purpose of earning revenues have been debited to the Profit-and Loss Account. As the assets are used in earning revenues, the depreciation in the value of an asset is as much an expense as any other, such as wages, salary, rent etc.

(2) For showing the ‘true and fair view’ of the financial position If the depreciation is not charged, the assets will be shown in the Balance Sheet at an amount which is in excess of their true values. As Such, the Balance Sheet will not present ‘the true and fair view’ of the financial position of a business.

(3) To ascertain the accurate cost of production – A depreciation is also an item of expense, the correct cost of production cannot be calculated unless it is also taken into account. Sale price chargeable from customers is determined on the basis of cost of production and hence if the depreciation is not included in cost of production, the sale price will be fixed at lower rates and this in turn will lead to reduced profits.

(4) To provide funds for replacement of assets – Depreciation though debited to Profit & Loss Account, is not paid in cash like other expenses. Hence, the amount of depreciation is retained in the business and is used for the replacement of fixed assets after the expiry of their estimated span of life.

(5) To prevent the distribution of profits out of capital – If the depreciation is not charged, the profit shown by the Profit and Loss Account will be in excess of the actual profits. Such an excess profit may be wholly withdrawn by the proprietor or may be distributed among the shareholders as dividend. Hence, the amount of dividend distributed will also include the amount of depreciation which is actually a part of capital.

(6) For avoiding over payment of Income Tax – If depreciation is not debited to Profit and Loss Account, the net profit shown by it will be in excess of actual profits. Hence, we will also have to pay more income tax.

(7) Other objectives – If the depreciation is not charged, the net profit shown by Profit & Loss Account will exceed the actual profits and as a result:
(i) Employees may demand an increase in wages and bonus
(ii) It may also result in extravagance
(iii) It may lead to increase in competition in that type of business.

Causes of Depreciation – Main causes of depreciation are as follows :
(1) By Constant Use – Due to the constant use of fixed assets in business operations wear and tear arise in them which results in the reduction of their values.

(2) By Expiry of Time – The value of majority of assets decreases with the passage of time even if they are not being put to use in the business. Natural forces such as rain, winds, weather etc. contribute to the deterioration of their values.

(3) By Expiry of Legal Rights – There are certain assets which have a definite span of life such as Lease. For example, if a lease has been obtained for 20 years for Rs. 5,00,000, it will lose 1 /20th, i.e. 25,000 of its value each year whether utilised or not, so that at the end of 20th year its value is reduced to zero.

(4) By Obsolescence – Quite often, due to new inventions and improved techniques the old assets become obsolete and may have to be discarded even if they can be put to use physically.

(5) By Accident – Sometimes a machine may be destroyed due to fire etc. or a vehicle may be damaged due to accident.

(6) By Depletion – Depletion is the decrease in the value of wasting assets such as mines, oil-wells etc. due to their constant working.

(7) By Permanent Fall in Market Price – Though, the fluctuations in the market value of fixed assets are not recorded because such assets are not meant for resale but for use in the business, sometimes the fall in the value of certain fixed assets is treated as depreciation such as permanent fall in the value of investments.

Question 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.
Straight Line Method This method is also termed as ‘Original Cost Method’ because under this method depreciation is charged at a fixed percentage on the original cost of the asset. The amount of depreciation remains equal from year to year and as such the method is also known as ‘Equal Instalment Method’ or ‘Fixed

Instalment Method’. Under this method, the amount of depreciation is calculated by deducting the scrap value from the original cost of the asset and then by dividing the remaining balance by the number of years of its estimated life.

The depreciation so calculated and charged annually will reduce the originial cost of the asset to zero, or its scrap value, as the case may be, at the end of its estimated life. Under this method, the amount of depreciation is calculated by the following formula:

Yearly Depreciation:
$$\frac{\text { OriginalCost of the Asset-Estimated Scrap Value }}{\text { Estimated Life of the Asset }}$$

For example, if the original cost of the asset is Rs. 1,00,000 and its scrap value is likely to be Rs. 15,000 after its estimated life of 10 years, the depreciation written off will be
$$\frac{1,00,000-15,000}{10}=\text { Rs. } 8,500 \text { every year}$$

Merits :
(1) Simplicity – Calculation of depreciation under this method is very simple and as such the method is widely popular,
(2) Equality of Depreciation Burden – Under this method, equal amount of depreciation is debited to the Profit and Loss Amount of each year. Hence, the burden of depreciation on each year’s net profit is equal.
(3) Assets can be completely written off – Under this method, the book value of an asset can be reduced to zero, which is not possible under some other methods.
(4) Knowledge of Original Cost and Upto-date depreciation

Under this method, the original cost of the asset is shown in the Balance Sheet and the upto-date depreciation is shown as a direct deduction from it. As such the information of Original Cost of the asset and its upto-date depreciation is available at any time. Various assets also maintain their separate identity under this method.

Demerits :
(1) Difficulty in computation – When there are different machines having different life-spans* the computation of depreciation becomes complicated because the depreciation on each machine will have to be calculated separately.

(2) Unequal charge against income — Repair charges go on increasing year by year as the asset becomes older but as the equal depreciation is charged under this method each year, the total burden charged to Profit and Loss Account in respect of depreciation and repairs put together will not be equal each year. The total burden will be lighter in earlier years and heavier during the later years.

(3) Undue pressure in later years – It is a well-known fact that the efficiency and usefulness of a machine is more in the earlier years in comparison to later years. As such, more depreciation should be charged in earlier years in comparison to the later years, whereas, depreciation remains constant from year to year under this method.

(4) Omission of interest factor – This method does not take into ’ consideration the loss of interest on the amount invested in the asset. The amount.would have earned interest, had it been invested outside the business.

(5) Unrealistic to write-off the value of asset to zero – Sometimes, even after the value of an asset is reduced to zero in the books, it continues to be used in the business in actual practice.

(6) Difficulty in the determination of scrap value – It is quite difficult to assess the true scrap value of the asset after a long period, say 10 to 20 years from the date of its installation. Suitability – This method is suitable for those assets which do not require much expenses on repairs and renewals and which have a comparatively shorter life and less cost such as furniture, patents etc.

Accounting Treatment : Following entries are passed in this method :

Written Down Value Method – Under this method, as the value of asset goes on diminishing year after year, the amount of depreciation charged every year also goes on declining. For example, if a machine is purchased for Rs. 20,000 and depreciation is to be charged at 10% p.a. according to ‘Written Down Value Method’, the depreciation will be charged as under :

It will be observed from the above calculations that each year’s depreciation is calculated on the book value of the asset at the beginning of that year, rather than on the original cost. As the value of the asset and also the depreciation charged on it goes on reducing year after year, the method is also known as ‘Reducing Instalment Method’ or ‘Diminishing Balance Method’.

Merits :
(1) Easy calculation — It is easy to calculate the depreciation under this method, even if some new assets are purchased year after year. Different assets are grouped for the purpose of providing depreciation.

(2) Equal charge against income – In this method, the total burden on Profit & Loss Account in respect of depreciation and repairs put together remains almost equal year after year. This is so because in the initial years depreciation is more in comparison to repair charges whereas, in the later years, as the asset gets older, the amount of depreciation goes on decreasing while the expenses on repairs go on increasing, thus keeping the combined charge of depreciation and repairs almost uniform.

(3) No undue pressure in later years – The efficiency,and usefulness of a machine is more in the earlier years than in later years. Hence, the depreciation in first few years should be more in comparison to the later years. This is ensured by adopting the diminishing balance method.

(4) Balance of asset is never written off to zero – This method ensures that the asset is never reduced to zero so that some depreciation, however small, is debited to Profit & Loss Account so long as the asset remains in use.

(5) Approved method by Income Tax Authorities – This method of providing depreciation is permissible under Income Tax regulations.

Demerits :
(1) Asset cannot be completely written off – Under this method, the value of an asset, even if it becomes obsolete and useless, cannot be reduced to zero and some balance, however small, would continue on Asset Account.

(2) Omission of Interest Factors – As with the original cost method, this method also does not take into consideration the loss of interest on the amount.

(3) Difficulty in determining the rate of depreciation – Under this method, the rate of providing depreciation cannot be easily decided. The rate is generally kept higher because it takes a very long time to write an asset down to its scrap value. If the rate of depreciation is kept lower, the asset may become obsolete earlier.

(4) Knowledge of original cost and upto-date depreciation not possible – Under this method, the original cost of various assets is not shown in the Balance Sheet. Sometimes, the assets are grouped in such a way that it becomes difficult to know their specific, identity. The residue balance of some assets may continue in the Balance Sheet even after they have been actually scrapped.

Suitability – This method is very suitable in case of assets having a comparatively long life and which require considerable repairs in the later years when they become older, such as building, plant etc.

Distinction between the two methods :

Question 3.
Describe in detail two methods of recording depreciation. Also give the necessary journal entries.
Methods of Recording Depreciation – There are two methods of recording depreciation in the books :
(1) First Method – By Charging to Asset Account – In this case ‘Provision for Depreciation Account’ is not maintained and the depreciation is directly credited to the ‘Asset A/c’. Hence the Asset A/c appears in the ledger at a written down value.

(2) Second Method – By Creating Provision for Depreciation Account – In such a case, the depreciation is credited to ‘Provision for Depreciation A/c’ instead of ‘Asset A/c’ and hence the Asset A/c always appears in the ledger at its original cost. The balance .on the credit side of ‘Provision for Depreciation A/c’ shows the total amount of depreciation accumulated to date. However, when the asset is sold or discarded, the total accumulated depreciation for that asset is transferred to the credit side of the Asset A/c with the help of the following entry :

Provision for Depreciation A/c — Dr.
To Asset A/c

After making the above entry, the balance in the provision for depreciation account will indicate the accumulated depreciation on the assets in service or unsold assets.
First Method :
Entries for charging depreciation to asset account – In this method depreciation is deducted from the depreciable cost of the asset and charges to profit and loss account. Journal Entries are as follows :

(i) For recording purchase of Asset –
Asset A/c — Dr.
To Bank/Vendor A/c

(ii) For deducting depreciation amount –
Depreciation A/c — Dr.
To Asset A/c

(iii) For charging depreciation expenses to Profit and Loss Account –
Profit & Loss A/c –Dr.
To Depreciation A/c
Fixed asset in this method appears at net book value i.e., cost less depreciation.

Second Method :
Journal Entries for creating Provision for Depreciation Account – In this method, a separate, account namely provision for depreciation or accumulated depreciation account is created. Asset account continues to appear at its original cost year after year over its entire life.
Journal Entries

(i) For recording purchase of Asset
Asset A/c — Dr.
To Bank/Vendor A/c

(ii) For creating depreciation amount to provision for depreciation account –
Depreciation A/c — Dr.
To Provision for Depreciation A/c

(iii) For charging depreciation to Profit and Loss Account
Profit & Loss A/c — Dr.
To Depreciation A/c
In the balance sheet, the fixed asset continues to appear at its original cost.

Question 4.
Explain the determinants or factors of the amount of depreciation.
Factors determining the amount of depreciation – It is impossible to calculate the actual and true amount of depreciation. It can only be estimated by keeping the following factors into considerations :

(1) Total cost1 of the asset – The cost of a fixed asset is determined . after adding all expenses incurred for bringing the asset to usable condition, such as freight, transit insurance and installation costs etc.

(2) Estimated useful life of asset-Useful life of an asset is estimated in terms of number of years, it can be effectively used for business operations. For example, if a machine can work for 25 years but is likely to become obsolete in 15 years on account of availability of a better type of machine due to improved technology, its useful life will be considered as only 15 years.

(3) Estimated scrap value – It is the estimated sale value of the asset at the end of its useful life. It is also known as residual value or break-up value. For example, a machine is purchased for Rs. 60,000 and Rs. 4,000 are spent on its freight and Rs. 1,000 for installation. It is estimated that its serviceable life will be 10 years at the end of which period it will have a scrap value of Rs. 8,000. Depreciation in this case will be calculated on Rs. 57,000
(i.e., Rs. 60,000 + Rs. 4,000 + Rs. 1,000 – Rs. 8,000). Depreciation charged on this machine will be $$\frac{57,000}{10}$$ = Rs. 5,700 every year.

(4) Depreciable cost – Depreciable cost of an asset is equal to its cost tess net residual value of the asset. Suppose in the above problem, the total cost of asset including installation expenses and freight is Rs. 20,000. The depreciable cost will be calculated as Rs. 14,300 (i.e., Rs. 20,000 – Rs. 5,700).
Depreciabe cost is distributed and charged as expense over the estimated useful life of the asset.

Question 5.
Name and explain different types of reserves in detail.
Reserves – Reserves mean amounts set aside out of profits and other surplus to meet future uncertainties. In other words, a reserve is meant for meeting any unknown liability or loss in the future.

According to William Pickles, “Reserves mean the amounts set aside out of profits and other surpluses, which are not earmarked in any way to meet any particular liability, known to exist on the date of the Balance Sheet.”

Types of Reserves

Revenue Reserves – These reserves, come into existence out of profits which have been earned in the course of day-to-day business operations. Therefore, the revenue reserves represent undistributed profits and as such are available for the distribution of dividends. Kohler has defined revenue reserves as, “that portion, or any detail thereof, the net worth or total equity of an enterprise representing retained earnings available for withdrawal by proprietors.”

Revenue reserves may be of the following of two types –

(A) General Reserve – Usually, the businessmen do not withdraw the entire profits from the business but retain a part of it in the business to meet unforeseen future uncertainities. Profits so retained in the business for ‘a rainy day’ are known as ‘General Reserve’. Similarly, companies also do not distribute the entire profits as dividends but keep aside a part of it in the form of General Reserve. Such reserves are also termed as Contingency Reserves or Free Reserves because these are not created for any specific puipose and can be freely used for any purpose.

Objectives : General Reserves may be created or utilized for any of the following purposes –
(1) For meeting unforeseen losses.
(2) For the strengthening of financial position of business.
(3) For expansion of business through internal resources or ploughing back of profits.
(4) For equalization of dividends over year, in case of Companies.
It is not compulsory and binding upon the business enterprises to maintain general reserves. Such reserves may be created in the year in which the profits are sufficient and the management thinks it advisable to do so. General Reserves are shown on the liabilities side of the Balance Sheet under the head ‘Owner’s Equity’.

(B) Specific Reserves – Such a reserve is created for a speicfic purpose and can be utilised only for that purpose. Examples of specific reserves are :
(1) Dividend Equalisation Reserve – Such a reserve is created to maintain steady rate of dividend. In the years in which the profits are sufficient, a part of the profit is transferred to such reserve and it is utilised to keep the dividend up in the year in which the profits are insufficient.

(2) Reserve for Replacement of Asset – Such a reserve is created to provide finances for the replacement of an asset at the end of its serviceable life. The amount of annual depreciation charged on assets is only capable of providing the original cost of the asset but the replacement of the asset will require a large sum of money due to the inflationary trend of prices. As such, a ‘reserve for replacement of asset’ is created to provide for the extra amount required for the purchase of the new asset.

For example, if an asset was purchased 10 years ago at a cost of Rs. 10 Lac and if the depreciation has been provided @ 10% on the original cost, it will proide only a sum of Rs. 10 Lac. But, suppose the current price of the asset is Rs. 40 Lac, an additional sum of Rs. 30 Lac will be required for purchasing a new asset. Therefore, the reserve is created for providing this additional sum.

‘Reserve for Replacement of Asset’ is created by annually transferring a certain amount from Profit & Loss Appropriate A/c. Following entry is passed for this purpose :
Profit & Loss Appropriate A/c — Dr.

To Asset Replacement Reserve A/c (Amount transferred out of divisible profits)
The amount of replacement reserve is either kept and utilized in the business itself or is invested in outside securities bearing interest at a pre-determined rate. When this reserve is invested in outside securities it is known as ‘reserve fund’.

Such a reserve is created out of divisible profits. In other words, instead of declaring higher dividends the amount is transferred to replacement reserve. If such a reserve had not been created, the profit would have been distributed as dividend and the amount would have gone outside the business. The amount thus saved is accumulated from year to year and is utilized for the specific purpose of replacement of the asset.

Capital Reserves – In addition to the normal profits, capital profits are also earned in the business from many sources. The reserves created out of such capital profits are known as Capital Reserves. Such reserves generally, are not available for distribution as cash dividend among the shareholders of a company.

Profits received from the following sources are termed as capital profits :
(1) Profits on the sale of fixed assets.
(2) Profits on the revaluation of fixed assets and liabilities.
(4) Profit on the purchase of a running business.
(5) Profit prior to the incorporation of a company.
(6) Profit from the reissue of forfeited shares.
(7) Profit on redemption of debentures.

All the capital profits mentioned above should be treated as Capital Reserves.
Capital reserves are used to write off capital losses and for the issue of fully paid bonus shares. Usually, the capital reserves are not available for distribution as dividends. Some capital reserves can however be utilized to distribute dividends subject to fulfilment of the following conditions :
(1) Articles of the company must not prohibit such dividend.
(2) Capital profits must have been realised in cash.
(3) Such profit remains after a fair revaluation of assets and liabilities.
All the same, it would be a prudent policy on the part of the management not to distribute such profits. They should be kept in the business to strengthen its financial position.

Question 6.
What are Provisions? How are they created? Give amounting treatment in case of provision for Doubtful Debts.
Provisions – According to the Companies Act the term Provision refers to any of the following amounts :
(a) The amount written off or retained by way of providing for depreciation renewals or diminution in value of assets; or

(b) The amount retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy. It should be clearly understood that if the amount of a known liability can be determined with reasonable accuracy, it must be classified as an outright liability and not a provision. Also if any excess provision is made knowingly or intentionally, the amount in excess of the actual need will be treated as reserve.

Examples of Provisions – Provisions are created for the fulfilment of various objectives :
(1) Provision for Depreciation, Repairs and Renewals of assets.
(2) Provision for Taxation.
(3) Provision for Bad and Doubtful Debts.
(4) provision for Discount on Debtors.
(5) Provision for Fluctuations in the value of Investments.

Characteristics or Features of Provision –
(1) Provision is made to meet a known liability.

(2) The liability is known but the amount of such liability cannot be determined with reasonable accuracy. For example, it is almost certain that some debts will prove irrecoverable but the exact amount of bad debts cannot be predicted with certainty.

(3) Provision is a charge against profits and as such reduces the profits of the year in which it is created. The loss when actually occurs will be written off against such provision and thus the profit of the year in which such loss occurs will not be affected.

Purpose or Importance of Provisions :
(1) To ascertain the true net profit of the business – In order to ascertain the true profit of a business it is necessary that all expenses pertaining to that year, whether paid or outstanding, must be debited to Profit and Loss account and a provision should also be made for expenses or liabilities the amount of which cannot be estimated with reasonable accuracy. For example, the provision should be made for doubtful debts, because the amount of such bad debts cannot be estimated very accurately.

(2) To ascertain the true financial position of the business – The Balance Sheet will depict the true and fair view of the financial position of the business only if adequate provision is made for all the anticipated losses and expenses.

(3) To provide for known losses in the future – Funds will be required’to meet the losses and liabilities that are likely to occur in the near future. As such, provisions are made to provide funds for meeting. Those losses such as provision for taxation, provision for repairs, provision for damages likely to arise from a pending suit and such others.

(4) For the equitable distribution of expenses – For example, if a machine is estimated to run for 10 years and the total amount of repairs expected to be incurred during its entire life span is Rs. 20,000, a ‘provision for repairs A/c’ will be created by debiting Rs. 2,000 to each year’s Profit and Loss account. Actual expenses of repairs incurred each year will be debited to this account. Hence, it will put equal burden on the Profit and Loss account of each year in respect of expenses of repairs which will be very fight in the earlier years but definitely heavy in the later years.

Accounting for Provisions – Provision may be created for the following:
(1) Provision for Doubtful Debts
(2) Provision for Discount

Provision for Doubtful Debts – When an amount become irrecoverable from a debtor, the amount is debited to Bad-Debts A/c and credited to the personal account of the debtor. But this is not sufficient. At the end of the year, the list of the debtors may still contain some debts which are doubtful of recovery.

But the actual amount of the bad-debts relating to the current year would only be known in the next accounting year. As such, in order to ascertain the true profit of the current year a provision called Provision for Doubtful Debts is created out of current year’s profits to provide for the possible bad- debts which would be known in the next year.

As the exact amount of possible bad-debts in the next year cannot be ascertained with reasonable accuracy, a provision for doubtful debts is made at a fixed percentage on debtors. Such percentage is fixed on the basis of past experience.

Accounting Treatment – Provision for Doubtful Debts, on the one hand, is shown on the debit side of P & L A/c and on the other hand, is also shown as a deduction from debtors on the assets side of the.Balance Sheet. ‘

In this question the amount of old provision exceeds the total of bad-debts and new provision. Hence, the difference will be written on . the credit side of Profit & Loss Account.

Numerical Questions

Question 1.
On April 01, 2000 M/s Bajrang Marbles purchased a Machine Rs. 2,80,000 and spent Rs. 10,000 on its carriage and Rs. 10,000 on its installation. It is estimated that its working life is 10 years and after 10 years its scrap value will be Rs. 20,000.
(a) Prepare Machine account and Depreciation account for the first four years by providing depreciation on Straight Line Method. Accounts are closed, on 31st March every year.
(b) Prepare Machine account, Depreciation account and Provision for Depreciation account (or Accumulated Depreciation account) for the first four years by providing depreciation using Straight Line Method. Accounts are closed on March 31 every year.
part-a

part – b

Question 2.
On July 01, 2000, Ashok Ltd. purchased a machine for Rs. 1,08,000 and spent Rs. 12,000 on its installation. At the time of purchase it was estimated that the effective commercial life of the machine will be 12 years and after 12 years its salvage value will be Rs. 12,000. Prepare Machine Account and Depreciation Account in the books of Ashok Ltd. for first three years, if depreciation is written of according to Straight Line Method. The account are closed on 31st December every year.

Question 3.
Reliance Ltd. purchased a second hand machine for Rs. 56,000 on October 1,2001 and spent Rs. 28,000 on its overhaul and installation before putting it to operation. It is expected that the machine can be sold for Rs. 6,000 at the end of its useful life of 15 years. Moreover an estimated cost of Rs. 1,000 is expected to be incurred to recover the salvage value of Rs. 6,000. Prepare Machine Account and Provision for depreciation account for the first three years charging depreciation by Fixed Installment Method. Accounts are closed on December 31, every year.

Question 4.
Berlia Ltd. purchased a second hand machine for Rs. 56,000 on July 01, 2001 and spent Rs. 24,000 on its repair and installation and Rs. 5,000 for its carriage. On September 01,2002. It purchased another machine forRs. 2,50,000 and spent Rs. 10,000 on its installation.
(a) Depreciation is provided on machinery @ 10% p.a. on original cost method annually on December 31. Prepare Machinery Account and Depreciation Account from the years 2001 to 2004.
(b) Prepare Machinery Account and Depreciation Account from the years 2001 to 2004 if depreciation is provided on machinery @ 10% p.a. on written down value annually on December 31.

part – b

Question 5.
Ganga Ltd. purchased a machinery on January 01,2001 for Rs. 5,50,000 and spent Rs. 50,000 on its installation. On September 01,2001 it purchased another machine forRs. 3,70,000. On May 01, 2002 it purchased another machine for Rs. 8,40,000 (including installation expenses). Depreciation was provided on machinery @ 10% p.a. on Original Cost Method annually on 31st December. Prepare :
(a) Machinery account and depreciation account for the year 2001, 2002, 2003 and 2004.
(b) If depreciation is accumulated in provision for depreciation account then prepare Machine Account and Provision for Depreciation Account for the years 2001, 2002, 2003 and 2004.
Part (a)

Part (b)

Question 6.
Azad Ltd. purchased furniture on October 01, 2002 for Rs. 4,50,000. On March 01, 2003 it purchased another furniture for Rs. 3,00,000. On July 01, 2004 it sold off the first furniture purchased in 2002 for Rs. 2,25,000. Depreciation is provided at 15% p.a. Prepare Furniture Account and Accumulated Depreciation Account for the years ended on March 31, 2003, March 31, 2004, and March 31, 2005. Also give the above two accounts if furniture Disposal Account is opened.

Question 7.
M/s. Lokesh Fabrics purchased a Textile Machine on April 01,2001 for Rs. 1,00,000. On July 01,2002 another machine costing Rs. 2,50,000 was purchased. The machine purchased on April 01, 2001 was sold for Rs. 25,000 on October 01, 2005. The company charges depreciation @ 15% p.a. on straight line method. Prepare Machinery Account and Machinery Disposal Account for the year ended March 31, 2006.

Question 8.
The following balances appear in the books of Crystal Ltd. on Jan. 01, 2005 :
Machinery Account on — 15,00,000
Provision for Depreciation Account — 5,50,000
On April 01, 2005 a machinery which was purchased on Jan. 01, 2002 for Rs. 2,00,000 was sold for Rs. 75,000. A new machine was purchased on July 01, 2005 for Rs. 6,00,000. Depreciation is provided on machinery at 20% p.a. on Straight Line Method and books are closed on December 31 every year. Prepare the Machinery Account and Provision for Depreciation Account for the year ending December 31, 2005.

Question 9.
M/s. Excel Computers has a debit balance of Rs. 50,000 (original cost Rs. 1,20,000) in computers account on April 01,2000. On July, 01, 2000 it purchased another computer costing Rs. 2,50,000. One more computer was purchased on January 01, 2001 for Rs. 30,000. On April 01, 2004 the computer which has [ purchased on July 01, 2000 became obsolete and was sold for Rs. 20,000. A new version of the IBM computer was purchased on August 01, 2004 for Rs. 80,000. Show Computers Account in the I books of Excel Computers for the years ended on March 31,2001, 2002,2003,2004 and 2005 computer is depreciated @ 10% p.a. on straight line method basis.

Question 10.
Carriage Transport Company purchased 5 trucks at the cost of Rs. 2,00,000 each on April 01,2001. The company writes off depreciation @ 20% p.a. on original cost and closes its books on December 31 evey year. On October 01,2003, one of the trucks is involved in an accident and is completely destroyed. Insurance company has agreed to pay Rs. 70,000 in full settlement of the claim. On the same date the company purchased a second hand truck for Rs. 1,00,000 and spent Rs. 20,000 on its overhauling. Prepare Truck Account and Provision for Depreciation Account for the three years ended on 31st December, 2003. Also give Truck Account if Truck Disposal Account is prepared.

Question 11.
Saraswati Ltd. purchased a machinery costing Rs. 10,00,000 on January’ 01,2001. A new machinery’ was purchased on 1 May, 2002 for Rs. 15,00,000 and another on July 01, 2004 for Rs. 12,00,000. A part of the machinery which originally cost Rs. 2,00,000 in 2001 was sold for Rs. 75,000 on October 31, 2004. Show the Machinery Account, Provision for Depreciation Account and Machinery Disposal Account for 2001 to 2005 if depreciation is provided at 10% p.a. on original cost and account are closed on December 31 every year.

Question 12.
On July 01, 2001 Ashwani purchased a machine for Rs. 2,00,000 on credit. Installation expenses Rs. 25,000 are paid by cheque. The estimated life is 5 years and its scrap value after 5 years will be Rs. 20,000. Depreciation is to be charged on straight line basis. Show the journal entry for the year 2001 and prepare necessary ledger accounts for first three years.12. On July 01, 2001 Ashwani purchased a machine for Rs. 2,00,000 on credit. Installation expenses Rs. 25,000 are paid by cheque. The estimated life is 5 years and its scrap value after 5 years will be Rs. 20,000. Depreciation is to be charged on straight line basis. Show the journal entry for the year 2001 and prepare necessary ledger accounts for first three years.

Question 13.
On October 01, 2000 a truck was purchased for Rs. 8,00,000 by Laxmi Transport Ltd. Depreciation was provided at 15% p.a. on the diminishing balance basis on this truck. On December 31, 2003 this truck was sold for Rs. 5,00,000. Accounts are closed on 31st March every. Prepare Truck Account for the four years.

Question 14.
Kapil Ltd. purchased a machinery’ on July 01,2001 for Rs. 3,50,000. It purchased two additional machines, on April 01, 2002 costing Rs. 1,50,000 and on October 01, 2002 costing Rs. 1,00,000. Depreciation is provided @ 10% p.a. on straight line basis. On January 01,2003, first machinery become useless due to technical changes. This machinery was sold for Rs. 1,00,000. Prepare Machinery Account for four years on the basis of calendar year.14. Kapil Ltd. purchased a machinery’ on July 01,2001 for Rs. 3,50,000. It purchased two additional machines, on April 01, 2002 costing Rs. 1,50,000 and on October 01, 2002 costing Rs. 1,00,000. Depreciation is provided @ 10% p.a. on straight line basis. On January 01,2003, first machinery become useless due to technical changes. This machinery was sold for Rs. 1,00,000. Prepare Machinery Account for four years on the basis of calendar year.

Question 15.
On January 01,2001, Satkar Transport Ltd. purchased 3 buses for Rs. 10,00,000 each. On July 01, 2003, one bus was involved in an accident and was completely destroyed and Rs. 7,00,000 were received from the Insurance Company in full settlement. Depreciation is written off @ 15% p.a. on diminishing balance method. Prepare Bus Account from 2001 to 2004. Books are closed on December 31 every year.

Question 16.
On October 01, 2001 Juneja Transport Company purchased two trucks for Rs. 10,00,000 each. On July 01, 2003, one truck was involved in an accident and was completely destroyed and Rs. 6,00,000 were received from the Insurance Company in full settlement. On December 31,2003 another truck was involved in an accident and destroyed partially, which was not insured. It was sold off for Rs. 1,50,000. On January 31, 2004 company purchased a fresh truck forRs. 12,00,000. Depreciation is to be provided at 10% p.a. on the written down value every year. The books are closed every’ year on March 31. Give the Truck Account from 2001 to 2004.

Question 17.
A Noida based construction company owns 5 cranes and the value of this asset in its books on April 01, 2001 is Rs. 40,00,000. On October 01, 2001 it sold one of its cranes whose value was Rs. 5,00,000 on April 01, 2001 at a 10% profit. On the same day it purchased two cranes for Rs. 4,50,000 each. Prepare Cranes Account. It closes the books on December 31 and provides for depreciation on 10% written down value.

Question 18.
Shri Krishan Manufacturing Company purchased 10 machines atRs. 75,000 each on July 01,2000. On October 01,2002, one of the machines got destroyed by fire and an insurance claim of Rs. 45,000 was admitted by the company. On the same date another machine is purchased by company for Rs. 1,25,000. The company writes off 15% p.a. depreciation on written down value basis. The company maintains the calendar year as its financial year. Prepare the machinery account from 2000 to 2003.

Question 19.
On January 01, 2000 a Limited Company purchased machinery for Rs. 20,00,000. Depreciation is provided 15% p.a. on Diminishing Balance Method. On March 01, 2002 one fourth of machinery’ was damaged by fire and Rs. 40,000 were received from the Insurance Company in full settlement. On September 01, 2002 another machinery was purchased by the company for Rs. 15,00,000. Write up the Machinery Account from 2000 to 2003. Books are closed on December 31 every year.

Question 20.
A plant was purchased on 1st July, 2000 at a cost of Rs. 3,00,000 and Rs. 50,000 were spent on its installation. The depreciation is written off at 15% p.a. on the straight line method. The plant was sold for Rs. 1,50,000 on October 01,2002 and on the same date a new plant was installed at the cost of Rs. 4,00,000 including purchasing value. The accounts are closed on December 31 every year. Show the Machinery Account and Provision for Depreciation Account for 3 years.

Question 21.
An extract of Trial Balance from the books of Tahiliani and Sons Enterprises on December 31, 2005 is given below :