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D 7878056472

1. What Is Depreciation ?

Depreciation is a permanent, continuing and gradual shrinkage in the book value of a fixed asset.
Depreciation is charged on the fixed assets only. Current assets are never depreciated rather these are
valued. Depreciation is charged on the book value (as shown in the books after charge of depreciation)
only. It has nothing to do with the market value of the fixed asset. Depreciation is charged on permanent
basis. Once the depreciation is charged it reduces the value of the asset permanently. Depreciation is
charged on continuous basis. Once the depreciation is charged it must be charged on regular basis in the
succeeding period also.

2. Discuss the causes of depreciation ?

Causes of Depreciation

The following are the main causes of depreciation:

(i) Physical Deterioration. It is caused mainly from wear and tear when the asset is in use and from
erosion, rust, rot and decay from being exposed to wind, rain, sun and other elements of nature.

(ii) Economic Factors. These may be said to be those that cause the asset to be put out of use even though
it is in good physical condition. These arise due to obsolescence and inadequacy. Obsolescence means the
process of becoming obsolete or out of date. An old machinery though in good physical condition may be
rendered obsolete by the introduction of a new model which produces more than the old machinery.

(iii) Time factors. There are certain assets with a fixed period of legal life such as lease, patents, and
copyrights. For instance, a lease can be entered into for any period while a patent's legal life is for some
years but on certain grounds this can be extended. Provision for the consumption of these assets is called
amortisation rather than depreciation.

(iv) Depletion. Some assets are of a wasting character perhaps due to the extraction of raw materials from
them. These materials are then either used by the firm to make something else or are sold in their raw
state to other firms. Natural resources such as mines, quarries and oil wells come under this heading. To
provide for the consumption of an asset of a wasting character is called provision for depletion.

(v) Accident. An asset may reduce in value because of meeting of an accident.

3. Discuss the needs for changing depreciation ?

The need for depreciation arises because of following reasons:

(i) To ascertain the true profits. We have seen that depreciation is an expense and becomes an important
element of the cost of production. Though it is not visible like other expenses and never paid to the outside
party yet it is desirable to charge depreciation on fixed assets as these are used for earning purposes; so
their depreciation must be deducted out of the income earned from their use in order to calculate true net
profit or loss.

(ii) To present true financial position. Financial position can be studied from the balance sheet and for the
preparation of the balance sheet fixed assets are required to be shown at their true value. If assets are
shown in the balance sheet without any charge made for their use or depreciation, then their value must
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have been overstated in the balance sheet and will not reflect the true financial position of the business.
So, for the purpose of reflecting true financial position, it is necessary that depreciation must be deducted
from the assets and then at such reduced value these may be shown in the balance sheet.

(iii) To make provision for replacement of assets. If depreciation is not provided, the profits of the concern
will be overstated and can be distributed to the shareholders as dividend. After the end of the working life
of the asset, there will be no provision or funds at the disposal of the concern and has to borrow for
purchasing new assets. Provision for depreciation is a charge to profit and loss account though
depreciation is not paid. The amount of depreciation accumulated during the working life of the asset
provides additional working capital besides providing sum at the end of the working life of the asset for its
replacement.

(iv) To ensure uniform rate of return. It becomes necessary that ideal matching of expired cost against the
revenue and proper measurement of the depreciable asset at each accounting date must be made to
ensure uniform rate of return.

(v) To maintain the capital invested in the cost of asset intact in the business, it is necessary to charge
depreciation. Further it can be re-invested in the profit earning process.

(vi) To ensure maximum tax benefit. Depreciation is an allowable expense for tax purposes. Hence, it
becomes necessary to charge depreciation in order to ensure maximum tax benefit.

[Link] the difference between straight line method and diminishing balance method ?

Distinction Between Straight Line and Diminishing Balance Methods

Sl. Straight Line Sl. Diminishing Balance

No. No.

1. A fixed amount of depreciation is charged. 1. A fixed rate of depreciation is charged.

2. The rate of depreciation is the reciprocal 2. The rate of depreciation is ascertained by
of the life of the asset. applying a formula.
3. The asset may or may not have scrap 3. The asset must have a significant scrap value.
value.
4. The amount of depreciation per year is the 4. The amount of depreciation goes on reducing.
same.
5. In the first year, the depreciation is 5. In the first year, the depreciation is charged
charged on the cost of the asset, less scrap on the cost of the asset.
value, if any.
6. At the end of its life, the book value of the 6. The book value of the asset never reduces to
asset becomes zero. zero.
5. what is reserve . discuss the objectives of reserved?

Meaning

It is that part of the profits of the business, which is not distributed among the owners of the business. It is
created to meet unknown liabilities, contingencies or losses. It is created also to strengthen the financial
prowess of a business.
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It may be created for a specific purpose, e.g. dividend equalisation reserve meant for helping a company to
maintain a regular rate of dividend. It may also be general reserve to meet any unknown loss or liability.

OBJECTIVES OF RESERVE

A reserve is created with any one or more of the following objectives-

1. To meet specific and legal requirements like Capital Redemption Reserve Account created as per Section
80 the Companies Act of India, 1956 or Investment Allowance Reserve created as per the Income Tax Act
of India, 1961.

2. To strengthen the financial base of business.

3. To keep the dividend rate stable or uniform even if annual profits fluctuate like Dividend Equalisation
Reserve.

4. To safeguard against any future loss.

5. To help the development or improvement of functional activities.

6. To replace any fixed asset or to redeem any liability by creating any fund like Sinking Fund. 7. To set
aside non-regular profits like Capital Reserve.

6. what is provisions . discuss the objectives of provisions ?

A provision is an amount written off against or set aside out of profits. It is created to provide for a known
liability whose amount cannot be correctly ascertained. It is also created to provide for depreciation,
renewals or diminution in the values of the assets.

The Companies Act of India, 1956 has defined it as "any amount written off or retained by way of providing
for depreciation, renewals or diminutions in the values, or retained by way of providing for any known
liability of which the amount cannot be determined with substantial accuracy."

OBJECTIVES OF PROVISION

A provision is set aside out of profits with any one or more of the following objectives— 1. To cover any
decrease or diminution in the value of assets like Provision for Depreciation. 2. To provide for any loss or
expense like Provision for Bad Debts, Provision for Renewals etc. 3. To provide for a known liability whose
exact amount cannot be correctly estimated like Provision for Taxation, Provision against any Liability
under dispute, etc.

7. Discuss the difference between reseve and provisions ?

DISTINCTION BETWEEN RESERVES AND PROVISIONS

View Points Reserves Provisions

1. Reason of It is created against unknown It is created to provide for a known liability or
Creation expense or liability that may arise in loss or expense of unknown amount.
future.
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2. Nature of It is an appropriation of profit. For its It is a charge against revenue. For its creation
Creation creation the Profit & Loss the Profit & Loss Account is debited. Whether
Appropriation Account is debited. It there is any profit or a loss need not be
can be created only if there is profit. considered

3. Relationship The amount of Reserve depends Creation of more provisions reduce the
with Profits upon the availability of profits. Its amount of profits. So, the relationship is
relation- ship with profit is direct. opposite or inverse.

4. Essentiality It is usually created as a measure of A provision is created essentially as per

security. Unless any reserve is to be accounting principles.
created statutorily, like Capital Re-
demption Reserve, a reserve need
not be created mandatorily.

5. Disclosure in A Reserve is shown on the liability A provision is usually deducted from an Asset
Financial side of the Balance Sheet. Under the in the Balance Sheet.
Statements Companies' Act it is shown under the
head 'Reserve & Surplus'.

6. Extension of Until it is fully utilised, a Reserve A provision in excess of amount required is

Utilisation remains intact. If it is any specific treated as a Reserve.
reserve, and its purpose is over, it is
closed by transfer to Profit/Loss
Account or Asset Account. If the
actual amount requird is less than
the amount reserved, the Reserve
remains unchanged.
7. Divisibility If current profits are inadequate, A provision cannot be utilised for dividend
past reserve can be utilised for payment in the normal course.
payment of dividends. In that case,
as per Sec- tion 205A (3) of the
Companies Act, the declaration of
dividend should bemade as per rules
and permission of the Central
Government.
8. Investment of The reserved amount may be The amount of a provision is not
the amount in- invested outside in securities. invested outside.
volved

8. discuss the different methods of calculations of depreciation ?

1. Straight Line/Equal Instalment Method

This is the most popular method because of its simplicity and consistency. It requires allocation of an equal amount
to each period. A fixed amount of the original cost is charged as depreciation every year. Thus, the asset is written
down in value each year by the same amount. This amount is such that the book value of the asset may be reduced
to zero or its residual value, as the case may be, at the end of its life Since this method assumes that the cost of the
asset expires at a steady (straight line) function of time, the acquisition cost less salvage value is divided by the
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estimated economic life. The rate of depreciation is the reciprocal of the estimated useful life. If the useful life of an
asset is 10 years, the depreciation rate will be 1/10 or 10%. This may be put in the shape of a formula as under:

Cost of the Asset-Residual Value

Annual Depreciation =

Estimated Economic Life

Advantages

1. It is simple to calculate and easy to understand.

2. It can reduce the book value of the asset to zero.
3. The valuation of the asset each year in the Balance Sheet is reasonably fair.

Disadvantages

1. This method ignores the fact that the service yielding ability of the assets fall while the repairs and
maintenance costs increase with the passage of time. Though each year's charge for depreciation is
the same, the charge for repairs and renewals goes on increasing as the asset becomes older.
Therefore, the charge to the Profit and Loss Account increases over the years.
2. If an additional asset is acquired, the amount to be charged as depreciation needs to be
recalculated.

Diminishing Balance Method

Where the straight line method assumes that the net cost of an asset should be allocated to successive
periods in uniform amounts, the diminishing balance method assumes that the rate of allocation should be
constant through time. Under this method, instead of a fixed amount, a fixed rate on the reduced balance
of the asset is charged as depreciation every year, Since a constant percentage rate is being applied to the
written down value, the amount of depreciation charged every year decreases over the life of the asset.
Though the percentage at which depreciation is charged remains fixed, the amount of depreciation goes
on diminishing year after year.

Advantages

1. As the decreasing charge for depreciation cancels out the increasing charges for repairs over the
years, it gives a fair charge for depreciation.
2. No recalculation is necessary when additional assets are purchased.
3. This method is applicable for income tax purposes.
4. The impact of obsolescence can be reduced if a significant part of the cost is written off in early life.

Disadvantages

1. This method lacks simplicity-the ascertainment of the percentage to be applied.

2. This method cannot be applied for assets with a very short life.
3. The asset is never fully depreciated.
4. The cost should be spread over evenly throughout the economic life of an asset or should be spread
according to use. This method follows neither principle.
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Sinking Fund Method or Depreciation Fund Method

A Sinking Fund is a fund created by the regular investment of a fixed amount to accumulate the amount of
money required to replace an asset at a set date in the future. This method is based on concept of present
values. The previous two methods made no attempt to generate fund for replacement of asset at the end
of its useful life. The sinking fund method not only takes depreciation into account but also makes
provision for replacement of the asset. Under this method, a fund is created by debiting Depreciation
Account and crediting Sinking Fund Account.

Insurance Policy Method

This is similar to the sinking fund method but, instead of investing the money in securities, the amount is
used in paying premium on a policy taken out with an insurance company. The policy should mature
immediately after the expiry of the useful life of the asset. The money that is received from the insurance
company is used to replace the asset. Though the interest received is lower than could be obtained by
investing in securities, the risk of loss on realisation of securities is avoided. To be more conservative, some
accountants are of the opinion that the policy account should be adjusted, at the year end, at its surrender
value so as to maintain the policy in the Balance Sheet at its net realisable value. Others argue that there is
no need to write down the policy to its surrender value, because the policy is for a fixed sum and there is
no intention of surrendering it.