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Depreciation | Provisions | Meaning, Types and Difference | Financial Accounting Notes | B.Com 1st Sem | CBCS Pattern

  Financial Accounting Notes
Measurement of Business Income
Depreciation and Provisions
B.Com 1st Sem CBCS Pattern

Part C: Depreciation and Provisions 

Table of Contents

1. Meaning and Features of Depreciation

2. Objectives and Causes of charging depreciation

3. Factors affecting amount of depreciation

4. Methods of Charging depreciation

5. Assets Disposal Account

6. Change in the method of Charging Depreciation

7. Meaning and Difference of Provisions and Reserves

 Depreciation

Depreciation: The word depreciation is derived from a Latin word “Depretium” where “De” means decline and “pretium” means price. Thus, the word “Depretium” stands for decline in the value of assets. It stands for gradual and continuous decline. In simple words, Depreciation may be defined as permanent decrease in the value of assets due to Use and /or the lapse of the time.

According to Carter, “Depreciation may be defined as the permanent and gradual decrease in the Value of assets from any cause.’’

Depletion: Depletion implies removal of available resources e.g. Coal from Coal mine, Oil out of Oil well.

Amortisation: The process of writing off intangible assets such as goodwill, patents, and trademarks etc. is called amortisation.

Dilapidation: The term Dilapidation reduces to damage done to a building or other property during tendency.

Obsolescence: When an asset becomes out dated due to new or improved technology or invention, this is called Obsolescence.

Characteristics or Features of Depreciation

a)      Depreciation may be physical and Functional.

b)      It is a non cash expenses.

c)       It is a charge against Profit.

d)      Depreciation is charged in respect of fixed assets only.

Objectives or causes for providing depreciation              

a)      To find out correct cost of goods manufactured.

b)      To find out correct profit for the year.

c)       To provide for replacement of assets.

d)      To find out correct financial position.

e)      To reduce tax burden.

Causes of Depreciation

The causes of decline on the book value of fixed assets may be divided into two categories:

1)      Physical: Physical causes may be as follows

a)      Wear and tear

b)      Destruction

2)      Functional: Functional causes may be as follows

a)      Obsolescence

b)      Inadequacy

c)       Effluxion of time

d)      Depletion

e)      Exhaustion

Factors on which the calculation of depreciation depends:

For determining the amount of depreciation on fixed assets, following factors should be considered:

a)    Cost of asset: Original cost of asset including expenses incurred at the time of purchase is the amount on which the amount of depreciation is calculated.

b)   Estimated working life of the assets: Working life of any asset is to be taken into consideration while calculating the amount of depreciation. In case of SLM method, the amount of depreciation is calculated by dividing the cost of assets less scrap value by estimated working life of the assets.

c)    Scarp value: Estimated salvage/residual/ scarp value which is estimated to be realised when asset is sold is to be deducted from the cost of asset to find out the amount of depreciation.

d)   Provision for repairs: Provision for repairs and renewals required to keep the asset in good condition is also taken into consideration while calculating the amount of depreciation.

e)   Addition and subtraction: Any addition to the asset or sale of part of asset during the life of the asset is also taken into consideration while calculating the amount of depreciation.

f)     Obsolescence: In present technological world, change in technology can cause huge depreciation in the value of asset. So obsolescence is also a key factor while calculating the amount of depreciation.

Methods of  Charging Depreciation

Methods of Depreciation classified under the following groups:

(1)Uniform charge methods: (a) fixed installment method. (b) Depletion method (c) Machine hour rate method

(2)Declining charged method: (a) Diminishing balance method (b) Sum of years Digit method. (c)Double Declining method

(3)Others method: (a)Group Depreciation method (b)Annuity method (c)Inventory system of Depreciation (d)Insurance policy method

But out of the methods mentioned above, two methods are more popular – Straight line method and Written down value method.

Straight Line method or Fixed installments method: This method of charging depreciation is each to understand and simple to calculate. Under this method depreciation is charged on original cost of the assets on uniform basis every year. The value of the assets can be reduced to ‘O’ under this method.

Merits:

(1) It is simplest to understand and easy to apply.

(2)The value of the assets can be reduce to zero under this method.

Demerits:

(1) Under this method, same amount of Depreciation is charged from year to year, irrespective of use of the assets.

(2)With the passage of time efficiency of assets decreases but the amount of Depreciation remains the same.

Diminishing Balance method: Under this method a fixed rate of depreciation is charged each year on the diminishing value of the assets till the amount is reduced to scrap value. This method involves more calculation as compared to SLM and value of assets cannot be reduced to zero under this method.

Merits:

(1) The amount of depreciation decreases continuously with the decrease in the life of assets.

(2) High amount of Depreciation is provided in earlier year thus reducing the impact of Obsolescence

Demerits:

(1) The book value of assets can never be zero.

(2)The determination of a suitable rate of Depreciation is also difficult.

Difference between fixed installment and reducing installment method are given below:

(1)The rate and amount of depreciation remains the same each year under fixed installment method. The rate remains the same, but amount of Depreciation reduces each year under reducing balance method.

(2)Depreciation is calculated on original cost under fixed installment method. Depreciation is charged on the diminishing value of assets under reducing Balance Method.

(3)The book value of assets reduces to zero under straight line method. The book value of assets can never be zero under reducing balance method.

Asset Disposal Account

When, a part of machinery is disposed off or discarded, it is better to open a machinery disposal account. The book value less depreciation of the discarded portion should be debited to this account and credited to the asset account. But if the asset is maintained at original cost and a separate provision for depreciation account is maintained, then machinery disposal account should be debited with the cost of the discarded portion of the asset and credited with depreciation provision applicable to this asset. The amount realized or the estimated realizable value is credited to the machinery disposal account and the balance of this account will show profit or loss and is transferred to Profit and Loss Account. Following entries are passed in such a case on sale of an asset:

a)      Assets Disposal A/c

To Assets A/c                   [With original cost of asset]

b)      Bank A/c

To Asset Disposal A/c        [With amount realized from the sale of asset]

c)       Provision for Depreciation A/c

To Asset Disposal A/c                                                   [With accumulated depreciation on the asset sold]

d)      Profit & Loss A/c

 To Asset Disposal A/c                                                          [For transfer of loss on sale of asset]

Note. Reverse entry in case there is profit.

Change of Method

Sometimes 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 particular year or with retrospective effect. If the change is from particular year, then there will be no problem but simply to change the method of depreciation. But if the change is to be effective with retrospective effect, then calculations are required to be made.

Step in recording a change in the Method of Depreciation with retrospective effect:

Step 1: Calculate the total depreciation already provided on the existing assets from the back date under the existing method.

Step 2: Calculate the total depreciation on the existing asset from the back date under the new method and rate till date.

Step 3: Calculate the difference between the total depreciation under existing method (as per Step 1) and under the new method (Step 2).

Step 4: Adjust the short depreciation (excess of Step 2 over Step 1) by debiting Profit & Loss Accounting and Crediting the Asset Account /Provision for Depreciation Account.

Or

Adjust the excess depreciation (Excess of Step 1 over Step 2) by debiting Asset Account/Provision for Depreciation Account and Crediting Profit & Loss Account)

Step 5: Charge depreciation from the current accounting year and onwards by adopting new method.

Provisions and Reserves

Provisions: The term ‘provision’ means an amount, which is: written off, or retained, by way of providing for depreciation, renewals, diminution in the value of assets; or retained by way of providing for any unknown future liability of which the amount cannot be determined with reasonable accuracy.

Examples of provisions are: Provision for depreciation; Provision for bad and doubtful debts; Provision for taxation; Provision for discount on debtors; and Provision for repairs and renewals.

Reserves: A part of the profit may be set aside and retained in the business to provide for certain future needs like growth and expansion or to meet future contingencies such as workmen compensation are called reserves. Unlike provisions, reserves are the appropriations of profit to strengthen the financial position of the business. Reserve is not a charge against profit as it is not meant to cover any known liability or expected loss in future.

Examples of reserves are: General reserve; Workmen compensation fund; Investment fluctuation fund; Capital reserve; Dividend equalization reserve; Reserve for redemption of debenture.

Difference between Provisions and Reserves:

a)      Provision is a charge on profits and reduces the amount of net profits. Whereas Reserves is an appropriation of profits and reflects undistributed profits.

b)      Provision is to be made even if there are no profits. On the other hand, Reserve is created only when there are profits.

c)       Provision creation is compulsory. But Reserves creation is at the discretion of Management.

d)      Dividend cannot be paid out of provisions. But dividend can be paid out of reserves.

e)      Provisions are utilised for specific purpose for which it has been created. But, reserves can be utilised for any purpose.

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