Chapter 7 - Depreciation, Provisions And Reserves

Depreciation, Provisions and Reserves

 

Depreciation

• Now you are aware that fixed assets are the assets which are used in business for more than one accounting year.
• Fixed assets (technically referred to as “depreciable assets”) tend to reduce their value once they are put to use. In general, the term “Depreciation” means decline in the value of a fixed assets due to use, passage of time or obsolescence.
• In other words, if a business enterprise procures a machine and uses it in production process then the value of machine declines with its usage. Even if the machine is not used in production process, we can not expect it to realise the same sales price due to the passage of time or arrival of a new model (obsolescence).
• It implies that fixed assets are subject to decline in value and this decline is technically referred to asdepreciation.
• As an accounting term, depreciation is that part of the cost of a fixed asset which has expired on account of its usage and/or lapse of time. Hence, depreciation is an expired cost or expense, charged against the revenue of a given accounting period.

 

Meaning of Depreciation

• Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.
• According to Institute of Cost and Management Accounting, London (ICMA) terminology “ The depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time.”
• Accounting Standard-6 issued by The Institute of Chartered Accountants of India (ICAI) defines depreciation as “a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change.
• Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is pre-determined”.

 

Features of Depreciation

Above mentioned discussion on depreciation highlights the following features of depreciation:

 

1. It is decline in the book value of fixed assets.
2. It includes loss of value due to effluxion of time, usage or obsolescence. For example, a business firm buys a machine for Rs. 1,00,000 on April 01, 2012. In the year 2014, a new version of the machine arrives in the market. As a result, the machine bought by the business firm becomes outdated. The resultant decline in the value of old machine is caused by obsolescence.
3. It is a continuing process.
4. It is an expired cost and hence must be deducted before calculating taxable profits. For example, if profit before depreciation and tax is Rs. 50,000, and depreciation is Rs. 10,000; profit before tax will be:

 

(Rs.)

 

Profit before depreciation & tax                                                                                      50,000

 

(-) Depreciation                                                                                                                (10,000)

 

Profit before tax                                                                                                                 40,000

 

5. It is a non-cash expense. It does not involve any cash outflow. It is the process of writing-off the capital expenditure already incurred.

 

Depreciation and other Similar Terms

There are some terms like ‘depletion’ and ‘amortisation’, which are also used in connection with depreciation. This has been due to the similar treatment given to them in accounting on the basis of similarity of their outcome, as they represent the expiry of the usefulness of different assets.

 

Depletion

• The term depletion is used in the context of extraction of natural resources like mines, quarries, etc. that reduces the availability of the quantity of the material or asset.
• For example, if a business enterprise is into mining business and purchases a coal mine for Rs. 10,00,000. Then the value of coal mine declines with the extraction of coal out of the mine. This decline in the value of mine is termed as depletion.
• The main difference between depletion and depreciation is that the former is concerned with the exhaution of economic resources, but the latter relates to the usage of an asset.
• In spite of this, the result is erosion in the volume of natural resources and expiry of the service potential. Therefore, depletion and depreciation are given similar accounting treatment.

 

Amortisation

• Amortisation refers to writing-off the cost of intangible assets like patents, copyright, trade marks, franchises, goodwill which have utility for a specified period of time.
• The procedure for amortisation or periodic write-off of a portion of the cost of intangible assets is the same as that for the depreciation of fixed assets. For example, if a business firm buys a patent for Rs. 10,00,000 and estimates that its useful life will be 10 years then the business firm must write-off Rs. 10,00,000 over 10 years. The amount so written- off is technically referred to asamortisation.

 

Causes of Depreciation

These have been very clearly spelt out as part of the definition of depreciation in the Accounting Standard 6 and are being elaborated here.

 

Wear and Tear due to Use or Passage of Time

Wear and tear means deterioration, and the consequent diminution in an assets value, arising from its use in business operations for earning revenue. It reduces the asset’s technical capacities to serve the purpose for, which it has been meant.

 

Another aspect of wear and tear is the physical deterioration. An asset deteriorates simply with the passage of time, even though they are not being put to any use. This happens especially when the assets are exposed to the rigours of nature like weather, winds, rains, etc.

 

Expiration of Legal Rights

Certain categories of assets lose their value after the agreement governing their use in business comes to an end after the expiry of pre-determined period. Examples of such assets are patents, copyrights, leases, etc. whose utility to business is extinguished immediately upon the removal of legal backing to them.

 

Obsolescence

Obsolescence is another factor leading to depreciation of fixed assets. In ordinary language, obsolescence means the fact of being “out-of-date”. Obsolescence implies to an existing asset becoming out-of-date on account of the availability of better type of asset. It arises from such factors as:

 

• Technological changes;
• Improvements in production methods;
• Change in market demand for the product or service output of the asset;
• Legal or other description.

 

Abnormal Factors

Decline in the usefulness of the asset may be caused by abnormal factors such as accidents due to fire, earthquake, floods, etc. Accidental loss is permanent but not continuing or gradual. For example, a car which has been repaired after an accident will not fetch the same price in the market even if it has not been used.

 

Need for Depreciation

The need for providing depreciation in accounting records arises from conceptual, legal, and practical business consideration. These considerations provide depreciation a particular significance as a business expense.

 

Matching of Costs and Revenue

The rationale of the acquisition of fixed assets in business operations is that these are used in the earning of revenue.

 

Every asset is bound to undergo some wear and tear, and hence lose value, once it is put to use in business. Therefore, depreciation is as much the cost as any other expense incurred in the normal course of business like salary, carriage, postage and stationary, etc.

 

It is a charge against the revenue of the corresponding period and must be deducted before arriving at net profit according to ‘Generally Accepted Accounting Principles’.

 

Consideration of Tax

Depreciation is a deductible cost for tax purposes. However, tax rules for the calculation of depreciation amount need not necessarily be similar to current business practices,

 

True and Fair Financial Position

If depreciation on assets is not provided for, then the assets will be over valued and the balance sheet will not depict the correct financial position of the business. Also, this is not permitted either by established accounting practices or by specific provisions of law.

 

Compliance with Law

Apart from tax regulations, there are certain specific legislations that indirectly compel some business organisations like corporate enterprises to provide depreciation on fixed assets.

 

Factors Affecting the Amount of Depreciation

The determination of depreciation depends on three parameters, viz. cost, estimated useful life and probable salvage value.

 

Cost of Asset

Cost (also known as original cost or historical cost) of an asset includes invoice price and other costs, which are necessary to put the asset in use or working condition.

 

Besides the purchase price, it includes freight and transportation cost, transit insurance, installation cost, registration cost, commission paid on purchase of asset add items such as software, etc.

 

In case of purchase of a second hand asset it includes initial repair cost to put the asset in workable condition. According to Accounting Standand-6 of ICAI, cost of a fixed asset is “the total cost spent in connection with its acquisition, installation and commissioning as well as for addition or improvement of the depreciable asset”.

 

For example, a photocopy machine is purchased for Rs. 50,000 and Rs. 5,000 is spent on its transportation and installation. In this case the original cost of the machine is Rs. 55,000 (i.e. Rs. 50,000 + Rs.5,000 ) which will be written-off as depreciation over the useful life of the machine.

 

Estimated Net Residual Value

Net Residual value (also known as scrap value or salvage value for accounting purpose) is the estimated net realisable value (or sale value) of the asset at the end of its useful life.

 

The net residual value is calculated after deducting the expenses necessary for the disposal of the asset. For example, a machine is purchased for Rs. 50,000 and is expected to have a useful life of 10 years.

 

At the end of 10th year it is expected to have a sale value of Rs. 6,000 but expenses related to its disposal are estimated at Rs. 1,000. Then its net residual value shall be Rs. 5,000 (i.e. Rs. 6,000 – Rs. 1,000).

 

Depreciable Cost

Depreciable cost of an asset is equal to its cost less net residual value. Hence, in the above example, the depreciable cost of machine is Rs. 45,000 (i.e., Rs. 50,000 – Rs. 5,000.)

 

It is the depreciable cost, which is distributed and charged as depreciation expense over the estimated useful life of the asset. In the above example, Rs. 45,000 shall be charged as depreciation over a period of 10 years.

 

It is important to mention here that total amount of depreciation charged over the useful life of the asset must be equal to the depreciable cost. If total amount of depreciation charged is less than the depreciable cost then the capital expenditure is under recovered. It violates the principle of proper matching of revenue and expense.

 

Estimated Useful Life

Useful life of an asset is the estimated economic or commercial life of the asset. Physical life is not important for this purpose because an asset may still exist physically but may not be capable of commercially viable production.

 

For example, a machine is purchased and it is estimated that it can be used in production process for 5 years. After 5 years the machine may still be in good physical condition but can’t be used for production profitably, i.e., if it is still used the cost of production may be very high.

 

Therefore, the useful life of the machine is considered as 5 years irrespective of its physical life. Estimation of useful life of an asset is difficult as it depends upon several factors such as usage level of asset, maintenance of the asset, technological changes, market changes, etc. As per Accounting Standard – 6 useful life of an asset is normally the “period over which it is expected to be used by the enterprise”.

 

Normally, useful life is shorter than the physical life. The useful life of an asset is expressed in number of years but it can also be expressed in other units, e.g., number of units of output (as in case of mines) or number of working hours. Useful life depends upon the following factors :

 

• Pre-determined by legal or contractual limits, e.g. in case of leasehold asset, the useful life is the period of lease.
• The number of shifts for which asset is to be used.
• Repair and maintenance policy of the business organisation.
• Technological obsolescence.
• Innovation/improvement in production method.
• Legal or other restrictions.

 

Methods of Calculating Depreciation Amount

The depreciation amount to be charged for during an accounting year depends upon depreciable amount and the method of allocation. For this, two methods are mandated by law and enforced by professional accounting practice in India.

 

These methods are straight line method and written down value method. Besides these two main methods there are other methods such as – annuity method, depreciation fund method, insurance policy method, sum of years digit method, double declining method, etc. which may be used for determining the amount of depreciation.

 

The selection of an appropriate method depends upon the following :

• Type of the asset;
• Nature of the use of such asset;
• Circumstances prevailing in the business;

 

As per Accounting Standard-6, the selected depreciation method should be applied consistently from period to period. Change in depreciation method may be allowed only under specific circumstances.

 

Straight Line Method

• This is the earliest and one of the widely used methods of providing depreciation. This method is based on the assumption of equal usage of the asset over its entire useful life.
• It is called straight line for a reason that if the amount of depreciation and corresponding time period is plotted on a graph, it will result in a straight line.
• It is also called fixed installment method because the amount of depreciation remains constant from year to year over the useful life of the asset. According to this method, a fixed and an equal amount is charged as depreciation in every accounting period during the lifetime of an asset.
• The amount annually charged as depreciation is such that it reduces the original cost of the asset to its scrap value, at the end of its useful life. This method is also known as fixed percentage on original cost method because same percentage of the original cost (infact depreciable cost) is written off as depreciation from year to year.

 

The depreciation amount to be provided under this method is computed by using the following formula:

 

Depriciation = total cost of the asset – net realizable value/ Life of the asset

 

Advantages of Straight Line Method

Straight Line method has certain advantages which are stated below:

 

• It is very simple, easy to understand and apply. Simplicity makes it a popular method in practice;
• Asset can be depreciated upto the net scrap value or zero value. Therefore, this method makes it possible to distribute full depreciable cost over useful life of the asset;
• Every year, same amount is charged as depreciation in profit and loss account. This makes comparison of profits for different years easy;
• This method is suitable for those assets whose useful life can be estimated accurately and where the use of the asset is consistent from year to year such as leasehold buildings.

 

Limitations of Straight Line Method

Although straight line method is simple and easy to apply it suffers from certain limitations which are given below.

 

• This method is based on the faulty assumption of same amount of the utility of an asset in different accounting years;
• With the passage of time, work efficiency of the asset decreases and repair and maintenance expense increases. Hence, under this method, the total amount charged against profit on account of depreciation and repair taken together, will not be uniform throughout the life of the asset, rather it will keep on increasing from year to year.

                      

Written Down Value Method

Under this method, depreciation is charged on the book value of the asset. Since book value keeps on reducing by the annual charge of depreciation, it is also known as ‘reducing balance method’.

 

This method involves the application of a pre-determined proportion/percentage of the book value of the asset at the beginning of every accounting period, so as to calculate the amount of depreciation. The amount of depreciation reduces year after year.

 

 

For example, the original cost of the asset is Rs. 2,00,000 and depreciation is charged @ 10% p.a. at written down value, then the amount of depreciation will be computed as follows:

 

(i) Depreciation (I year) = 200000*10/100 = 20000

(ii) Written down value = Rs. 2,00,000 – 20,000 = Rs.1,80,000

(at the end of the I year)

(iii) Depreciation (II year) = 180000*10/100 = 18000

(iv) Written down value = Rs. 1,80,000 – Rs.18,000 = 1,62,000

(at the end of the II year)

(v) Depreciation (III year) = 162000*10/100 = 16200

(vi) Written down value = Rs. 1,62,000 – Rs. 16,200 = Rs. 1,45,800

(at the end of III year)

 

As evident from the example, the amount of depreciation goes on reducing year after year. For this reason, it is also known ‘reducing installment’ or ‘diminishing value’ method.

 

This method is based upon the assumption that the benefit accruing to business from assets keeps on diminishing as the asset becomes old. This is due to the reason that a pre-determined percentage is applied to a gradually shrinking balance on the asset account every year. Thus, large amount is recovered depreciation charge in the earlier years than in later years.

 

Advantages of Written Down Value Method

Written down value method has the following advantages:

 

• This method is based on a more realistic assumption that the benefits from asset go on diminishing (reducing) with the passage of time. Hence, it calls for proper allocation of cost because higher depreciation is charged in earlier years when asset’s utility is higher as compared to later years when it becomes less effective.
• It results into almost equal burden of depreciation and repair expenses taken together every year on profit and loss account;
• Income Tax Act accept this method for tax purposes;
• As a large portion of cost is written-off in earlier years, loss due to obsolescence gets reduced;
• This method is suitable for fixed assets which last for long and which require increased repair and maintenance expenses with passage of time. It can also be used where obsolescence rate is high.

 

Limitations of Written Down Value Method

Although this method is based upon a more realistic assumption it suffers from the following limitations.

• As depreciation is calculated at fixed percentage of written down value, depreciable cost of the asset cannot be fully written-off. The value of the asset can never be zero;
• It is difficult to ascertain a suitable rate of depreciation.

 

Straight Line Method and Written Down Method: A Comparative Analysis

Straight line and written down value methods are generally used for calculating depreciation amount in practice. Following are the points of differences between these two methods.

 

Basis of Charging Depreciation

In straight line method, depreciation is charged on the basis of original cost or (historical cost). Whereas in written down value method, the basis of charging depreciation is net book value (i.e., original cost less depreciation till date) of the asset, in the beginning of the year.

 

Annual Charge of Depreciation

The annual amount of depreciation charged every year remains fixed or constant under straight line method. Whereas in written down value method the annual amount of depreciation is highest in the first year and subsequently declines in later years. The reason for this difference, is the difference in the basis of charging depreciation under both methods. Under straight line method depreciation is calculated on original cost while under written down value method it is calculated on written down value.

 

Total Charge Against Profit and Loss Account on Account of Depreciation and Repair Expenses

It is a well-accepted phenomenon that repair and maintenance expenses increase in later years of the useful life of the asset. Hence, total charge against profit and loss account in respect of depreciation and repair expenses increases in later years under straight line method. This happens because annual depreciation charge remains fixed while repair expenses increase. On the other hand, under written down value method, depreciation charge declines in later years, therefore total of depreciation and repair charge remains similar or equal year after year.

 

Recognition by Income Tax Law

Straight line method is not recognised by Income Tax Law while written down value method is recognised by the Income Tax Law.

 

Suitability

Straight line method is suitable for assets in which repair charges are low the possibility of obsolescence is low and scrap value depends upon the time period involved, such as freehold land and buildings, patents, trade marks, etc. Written down value method is suitable for assets which are affected by technological changes and require more repair expenses with passage of time such as plant and machinery, vehicles, etc.

 

Basis of Difference­	Straight Line Method	Written Down Value Method­
1.  Basis of charging depreciation	Original cost­	Book Value (i.e. original cost less depreciation charged till date)
2. Annual depreciation charge	Fixed (Constant) year	Declines year after year
3.Total charge against profit and loss account in respect of depreciation and repairs	Unequal year after year. It increases in later years.	Almost equal every year.
4. Recognition by income tax law	Not recognised	Recognised
5. Suitablity	It is suitable for assets in which repair charges are  less, the possibility of  and obsolescence is low  scrap value depends upon the time period involved.	It is suitable for assets,which are affected by technological changes and require more repair expenses with passage of time.

 

Methods of Recording Depreciation

In the books of account, there are two types of arrangements for recording depreciation on fixed assets:

• Charging depreciation to asset account or
• Creating Provision for depreciation/Accumulated depreciation account.

 

Charging Depreciation to Asset account

According to this arrangement, depreciation is deducted from the depreciable cost of the asset ( credited to the asset account) and charged (or debited) to profit and loss account. Journal entries under this recording method are as follows:

 

1. For recording purchase of asset (only in the year of purchase)

Asset A/c Dr. (with the cost of asset including installation, freight, etc.)

To Bank/Vendor A/c

 

2. Following two entries are recorded at the end of every year

(a) For deducting depreciation amount from the cost of the asset.

 

Depreciation A/c Dr. (with the amount of depreciation)

To Asset A/c

 

(b) For charging depreciation to profit and loss account.

 

Profit & Loss A/c Dr. (with the amount of depreciation)

To Depreciation A/c

 

3. Balance Sheet Treatment

 

When this method is used, the fixed asset appears at its net book value (i.e. cost less depreciation charged till date) on the asset side of the balance sheet and not at its original cost (also known as historical cost).

 

Creating Provision for Depreciation Account/Accumulated Depreciation Account

This method is designed to accumulate the depreciation provided on an asset in a separate account generally called ‘Provision for Depreciation’ or ‘Accumulated Depreciation’ account.

 

By such accumulation of depreciation the asset account need not be disturbed in any way and it continues to be shown at its original cost over the successive years of its useful life. There are some basic characteristic of this method of recording depreciation. These are given below:

 

• Asset account continues to appear at its original cost year after year over its entire life;
• Depreciation is accumulated on a separate account instead of being adjusted in the

asset account at the end of each accounting period.

 

The following journal entries are recorded under this method:

 

1. For recording purchase of asset (only in the year of purchase)

Asset A/c Dr. (with the cost of asset including installation, expenses etc.)

To Bank/Vendor A/c (cash/credit purchase)

 

2. Following two journal entries are recorded at the end of each year:

(a) For crediting depreciation amount to provision for depreciation account

 

Depreciation A/c Dr. (with the amount of depreciation)

To Provision for depreciation A/c

 

(b) For charging depreciation to profit and loss account

Profit & Loss A/c Dr. (with the amount of depreciation)

To Depreciation A/c

 

3. Balance sheet treatment

 

In the balance sheet, the fixed asset continues to appear at its original cost on the asset side. The depreciation charged till that date appears in the provision for depreciation account, which is shown either on the “liabilities side” of the balance sheet or by way of deduction from the original cost of the asset concerned on the asset side of the balance sheet.

 

Illustration

M/s Singhania and Bros. purchased a plant for Rs. 5,00,000 on April, 01 2014, and spent Rs. 50,000 for its installation. The salvage value of the plant after its useful life of 10 years is estimated to be Rs. 10,000. Record journal entries for the year 2014-15 and draw up Plant Account and Depreciation Account for first three years given that the depreciation is charged using straight line method if :

(i) The books of account close on March 31 every year; and

(ii) The firm charges depreciation to the asset account.

 

Solution

Books of Singhania and Bros. Journal

 

Date	Particulars	L.F.	Debit Amount Rs.	Credit Amount Rs.
2014 Apr. 01	Plant A/c Dr.  To Bank A/c  (Purchased plant for Rs. 5,00,000)		5,00,000	5,00,000
Apr. 01	Plant A/c Dr.  To Bank A/c 50,000 (Expenses incurred on installation)		50,000	50,000
2015 Mar. 31	Depreciation A/c Dr.  To Plant A/c (Depreciation charged on asset)		54,000	54,000
Mar. 31	Profit and Loss A/c Dr.  To Depreciation A/c  (Depreciation debited to profit and loss account)		54,000	54,000

 

Plant Account

 

Date	Particulars	J.F.	Amount  Rs.	Date	Particulars	J.F.	Amount  Rs.
2014 Apr. 01	Bank Bank   (Installation expenses)		5,00,000 50,000 5,50,000	2015 Mar.31	Depreciation Balance c/d		54,000 4,96,000 5,50,000
2015 Apr. 01	Balance b/d		4,96,000 4,96,000	2016 Mar.31	Depreciation  Balance c/d		54,000 4,42,000 4,96,000
2016 Apr. 01	Balance b/d		4,42,000 4,42,000	2017 Mar.31	Depreciation  Balance c/d		54,000 3,88,000 4,42,000
2017 Apr. 01	Balance b/d		3,88,000

 

Depreciation Account

Dr.                                                                                                                                                            

Date	Particulars	J.F.	Amount  Rs.	Date	Particulars	J.F.	Amount  Rs.
2014 Apr. 01	Plant		54,000	2015 Mar.31	Profit and Loss		54,000
2015 Apr. 01	Plant		54,000	2016 Mar.31	Profit and Loss		54,000
2016 Apr. 01	Plant		54,000	2017 Mar.31	Profit and Loss		54,000

 

Illustration

M/s Mehra and Sons acquired a machine for Rs. 1,80,000 on October 01, 2014, and spent Rs 20,000 for its installation. The firm writes-off depreciation at the rate of 10% on original cost every year. Record necessary journal entries for the year 2014 and draw up Machine Account and Depreciation Account for first three years given that:

(i) The book of accounts closes on March 31 every year; and

(ii) The firm charges depreciation to asset account.

 

Solution

Books of Mehra and Sons

Journal

 

Date	Particulars	L.F.	Debit Amount Rs.	Credit Amount Rs.
2014 oct. 01	Machine A/c Dr. To Bank A/c (Purchased machine for Rs.1,80,000)		1,80,000	1,80,000
Apr. 01	Machine A/c Dr. To Bank A/c (Expenses incurred on installation)		20,000	20,000
2015 Mar. 31	Depreciation A/c Dr.  To Machine A/c (Depreciation charged on machine)		10,000	10,000
Mar. 31	Profit and Loss A/c Dr.  To Depreciation A/c (Depreciation debited to profit and loss account)		10,000	10,000
2016 Mar. 31	Depreciation A/c Dr.  To Machine A/c (Depreciation charged on machine)		20,000	20,000
Mar. 31	Profit and Loss A/c Dr.  To Depreciation A/c (Depreciation debited to profit and loss account)		20,000	20,000
2017 Mar. 31	Depreciation A/c Dr.  To Machine A/c (Depreciation charged on machine)		20,000	20,000
Mar. 31	Profit and Loss A/c Dr.  To Depreciation A/c (Depreciation debited to profit and loss account)		20,000	20,000

 

Books of M/s Mehra and Sons

Machine Account

 

Date	Particulars	J.F.	Amount  Rs.	Date	Particulars	J.F.	Amount  Rs.
2014 Oct. 01  Oct. 01	Bank Bank (Installation expenses)		1,80,000 20,000 2,00,000	2015 Mar.31 Mar.31	Depreciation (for 6 months) Balance c/d		10,000 1,90,000 2,00,000
2015 Apr. 01	Balance b/d		1,90,000 1,90,000	2016 Mar.31	Depreciation Balance c/d		20,000 1,70,000 1,90,000
2016 Apr. 01	Balance b/d		1,70,000 1,70,000	2017 Mar.31	Depreciation Balance c/d		20,000 1,50,000 1,70,000

 

Depreciation Account

Date	Particulars	J.F.	Amount  Rs.	Date	Particulars	J.F.	Amount  Rs.
2015 Mar. 31	Machine		10,000 10,000	2015 Mar.31	Profit & Loss		10,000 10,000
2016 Mar. 31	Machine		20,000 20,000	2016 Mar.31	Profit & Loss		20,000 20,000
2017 Mar. 31	Machine		20,000 20,000	2017 Mar.31	Profit & Loss		20,000 20,000

 

Illustration

M/s. Dalmia Textile Mills purchased machinery on April 01, 2014 for Rs. 2,00,000 on credit from M/s Ahuja and sons and spent Rs. 10,000 for its installation. Depreciation is provided @10% p.a. on written down value basis. Prepare Machinery Account for the first three years. Books are closed on March 31, every year.

 

Solution

Books of Dalmia Textiles mills

Machinery Account

 

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2014 Apr.01	Bank Bank		2,00,000 10,000 2,10,000	2015 Mar.31	Depreciation Balance c/d		21,0001 1,89,000 2,10,000
2015 Apr.01	Balance b/d		1,89,000 1,89,000	2016 Mar.31	Depreciation Balance c/d		18,9002 1,70,100 1,89,000
2016 Apr.01	Balance b/d		1,70,100 1,70,100	2017 Mar.31	Depreciation Balance c/d		17,0,0103 1,53,090 1,70,100
2017	Balance b/d		1,53,090

 

Working Notes

1. Calculation of the amount of depreciation (Rs.)

 

Original cost on 01.04.2014                                                                            2,10,000 (i.e. 2,00,000 + 10,000)

 

Less: Depreciation for 2014-15                                                                             (21,000)

 

WDV on 01.04.2015                                                                                             1,89,000

 

Less: Depreciation for 2015-16                                                                            (18,900)

 

WDV on 01.04.2016                                                                                             1,70,100

 

Less: Depreciation for 2016-17                                                                            (17,010)

 

WDV on 01.04.2017                                                                                             1,53,090

 

Disposal of Asset

Disposal of asset can take place either (a) at the end of its useful life or (b) during its useful life (due to obsolescence or any other abnormal factor).

 

If it is sold at the end of its useful life, the amount realised on account of the sale of asset as scrap should be credited to the asset account and the balance is transferred to profit and loss account. In this regard the following journal entries are recorded.

 

1. For sale of asset as scrap

Bank A/c Dr.

To Asset A/c

 

2. For transfer of balance in asset account

 

(a) In case of profit

Asset A/c Dr.

To Profit and Loss A/c

 

(b) In case of loss

Profit and Loss A/c Dr.

To Asset A/c

 

In case, however, the provision for depreciation account has been in use for recording the depreciation, then before passing the above entries transfer the balance of the provision for depreciation account to the asset account by recording the following journal entry:

 

Provision for depreciation A/c Dr.

To Asset A/c

 

Illustration

R.S. Limited purchased a vehicle for Rs. 4, 00,000. After
4 years its salvage value is estimated at Rs. 40,000. To find out the amount of depreciation to be charged every year based on straight line basis, and show as to how the vehicle account would appear for four years assuming it is sold for Rs. 50,000 at the end when

(a) depreciation is charged to asset account; and

(b) provision for depreciation account is maintained.

Consider the following entries in the book of account of R.S. Limited

 

(a) When depreciation is charged to assets account

 

Books of R.S. Limited

Vehicle Account

 

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
I Year	Bank Bank		4,00,000 4,00,000	End Of The Year	Depreciation Balance c/d		90,000 3,10,000 4,00,000
II Year	Balance b/d		3,10,000 3,10,000	End Of The Year	Depreciation Balance c/d		90,000 2,20,100 3,10,000
III Year	Balance b/d		2,20,000 2,20,000	End Of The Year	Depreciation Balance c/d		90,000 1,30,000 2,20,000
IV Year	Balance b/d		1,30,000 10,000 1,40,000		Depreciation Bank		99,000 50,000 1,40,000

 

(b) When Provision for depreciation account is maintained.

 

Books of R.S. Limited

Vehicle Account

 

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
I Year	Bank Bank		4,00,000 4,00,000	End Of The Year	Depreciation Balance c/d		90,000 3,10,000 4,00,000
II Year	Balance b/d		3,10,000 3,10,000	End Of The Year	Depreciation Balance c/d		90,000 2,20,100 3,10,000
III Year	Balance b/d		2,20,000 2,20,000	End Of The Year	Depreciation Balance c/d		90,000 1,30,000 2,20,000
IV Year	Balance b/d Profit and loss		1,30,000 10,000 1,40,000		Depreciation Bank		99,000 50,000 1,40,000

 

Provision for Depreciation

 

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
I Year	Balance b/d		9,00,000 9,00,000	End Of The Year	Depreciation		90,000 9,00,000
II Year	Balance b/d		1,80,000 1,80,000	End Of The Year	Balance c/d Depreciation		90,000 90,000 1,80,000
III Year	Balance b/d		2,70,000 2,70,000	End Of The Year	Balance c/d Depreciation		1,80,000 90,000 2,70,000
IV Year	Machinery		3,60,000 3,60,000	End Of The Year	Balance c/d Provison for Depreciation		2,70,000 90,000 3,60,000

 

Use of Asset Disposal Account

• Asset disposal account is designed to provide a complete and clear view of all the transactions involved in the sale of an asset under one account head. The concerned variables are the original cost of the asset, depreciation accumulated on the asset upto date, sale price of the asset, value of the parts of the asset retained for use, if any and the resultant profit or loss on disposal. The balance of this amount is transferred to the profit and loss account.
• This method is generally used when a part of the asset is sold and provision for depreciation account exists.
• Under this method, a new account titled Asset Disposal Account is opened. The original cost of the asset being sold is debited to the asset disposal account and accumulated depreciation amount appearing in provision for depreciation account relating to that asset till the date of disposal is credited to the asset disposal account.
• The net amount realised from the sale of the asset is also credited to this account. The balance of asset disposal account shows profit or loss which is transferred to profit and loss account.

 

The advantage of this method is that it gives a full picture of all the transactions related to asset disposal at one place.

 

The journal entries required for the preparation of asset disposal account is as follows:

1. Asset Disposal A/c Dr.

To Asset A/c

 

2. Provision for Depreciation A/c Dr.

To Asset Disposal A/c

 

3. Bank A/c Dr. (with the net sales proceeds)

To Asset Disposal A/c

 

Asset Disposal Account may ultimately show a debit or credit balance. The debit balance on the account indicate loss on disposal and would be dealt with as follows:

 

Profit and Loss A/c Dr. (with the amount of loss on sale)

To Asset Disposal A/c

 

The credit balance of the account, profit on disposal and would be closed by the following journal entry:

 

Asset Disposal A/c Dr. (with the amount of profit on sale)

To Profit and Loss A/c

 

Illustration

On January 01 2014, Khosla Transport Co. purchased five trucks for Rs. 20,000 each. Depreciation has been provided at the rate of 10% p.a. using straight line method and accumulated in provision for depreciation acount. On January 01, 2015, one truck was sold for Rs. 15,000. On July 01, 2016, another truck (purchased for Rs. 20,000 on Jan 01, 2014) was sold for Rs. 18,000. A new truck costing Rs. 30,000 was purchased on October 01, 2016. You are required to prepare trucks account, Provision for depreciation account and Truck disposal account for the years ended on December 2014, 2015 and 2016 assuming that the firm closes its accounts in December every year.

 

Solution

Book of Khosla Transport Co.

 

Trucks Account

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2014 Jan.01	Bank (Purchase of truck)		1,00,000 1,00,000	2014 Dec.31	Balance c/d		1,00,000 1,00,000
2015 Jan.01	Balance b/d		1,00,000 1,00,000	2015 Jan.01 Dec.31	Truck disposal Balance c/d		20,000 80,000 1,00,000
2016 Jan.01 Oct.01	Balance b/d Bank (Purchase of new truck) ­		80,000 30,000 1,10,000	2016 Jul.01 Dec.31	Truck disposal Balance c/d		20,000 90,000 1,10,000

 

Truck Disposal Account

 

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2015 Jan.01	Machinery		20,000 20,000	2015 Jan.01 Jan.01 Jan.01	Provision for  Depreciatio Bank (Sale)­ Profit & Loss ­(Loss on sale)		2,000 15,000 3,0004 20,000
2016 Jul.01 Jul.01	Machinery Profit & Loss (Profit on sale)		20,000 3000 23,000	2016 Jul.01 Jul.01	Provision for Depreciation(Rs. 2,000 + 2,000 +1,000)­ Bank (Sale)­ ­		5,000 18,000 23,000

 

Provision for Depreciation Account

 

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2014 Dec.31	Balance c/d		10,000 10,000	2014 Mar.31	Depreciation		10,0001 10,000
2015 Jan.01 Dec.31	Truck Disposal Balance c/d		2,000 16,000 18,000	2015 Jan.01 Dec.31	Balance b/d Depreciation		10,000 8,0002 18,000
2016 Jan.01 Dec.31	Truck Disposal Balance c/d		5,000 18,750 23,750	2016 Jan.01 Dec.31	Balance b/d Depreciation (Rs. 6000+1000+750)		16,000 7,7503 23,750

 

Illustration

On April 01, 2014, following balances appeared in the books of M/s Kanishka Traders: Furniture account Rs. 50,000, Provision for depreciation on furniture Rs. 22,000. On October 01, 2014 a part of furniture purchased for Rupees 20,000 in April 01, 2010 was sold for Rs. 5,000. On the same date a new furniture costing Rs. 25,000 was purchased. The depreciation was provided @ 10% p.a. on original cost of the asset and no depreciation was charged on the asset in the year of sale. Prepare furniture account and provision for depreciation account for the year ending March 31, 2015.

 

Solution

Books of Kanishka Traders

Furniture Account

                                                                                                                                                                           

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2014 Apr.01 Oct.10	Balance b/d Bank		50,000 25,000 75,000	2014 Oct.01 Apr.01	Bank Provision for depreciation Profit and Loss (Loss on sale) Balance c/d­		5,000 8,000 7,0001 55,000 75,000

 

Provision for Depreciation on Furniture Account

 

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2014 Oct.01 2015 Oct.31	Furniture (Accumulated depreciation on furniture­ sold)­ Balance c/d­		8,000 18,250 26,200	2014 Apr.01 2015 Mar.31	Balance b/d Depreciation (Rs. 3,000 +­1,250)		22,000 4,250 26,250

 

Illustration

Solve illustration 07, if the firm maintains furniture disposal account prepared along with furniture account and provision for depreciation on furniture account.

 

Books of Anil Traders

Furniture Account

                 

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2014 Oct.01 Oct.01	Balance b/d   Bank­		50,000 25,000 75,000	2014 Apr.01 2015 Mar.31	Furniture Disposal Balance c/d		20,000 55,000 75,000

 

 

 

Provision for Depreciation on Furniture Account

 

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2014 Oct.01 Oct.01	Furniture Disposal   Balance c/d­		8,000 18,250 26,250	2014 Apr.01 2015 Mar.31	Balance b/d Depreciation		22,000 5,250 26,250

 

Furniture Disposal Account

                             

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2014 Oct.01	Furniture		20,000 20,000	2014 Oct.01	Provision for­ Depreciation Bank ­ Profit & Loss ­ (Loss on sale)­ ­		8,000 5,000 7,000 20,000

 

Illustration

On Jan 01, 2010 Jain & Sons purchased a second hand plant costing Rs. 2,00,000 and spent Rs. 10,000 on its overhauling. It also spent Rs. 5,000 on transportation and installation of the plant. It was decided to provide for depreciation @ of 20% on written down value. The plant was destroyed by fire on July 31, 2013 and an insurance claim of Rs. 50,000 was admitted by the insurance company. Prepare plant account, accumulated depreciation account and plant disposal account assuming that the company closes its books on December 31, every year.

 

Solution

Books of Jain & Sons.

Plant Account

                   

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2010 Jan.01	Bank		2,15,000 2,15,000	2010 Dec.31	Balance c/d		2,15,000 2,15,000
2011  Jan.01	Balance b/d		2,15,000 2,15,000	2011 Dec.31	Balance c/d		2,15,000 2,15,000
2012  Jan.01	Balance b/d		2,15,000 2,15,000	2012 Dec.31	Balance c/d		2,15,000 2,15,000
2013 Jan.01	Balance b/d		2,15,000 2,15,000	2013 Dec.31	Plant disposal		2,15,000 2,15,000

 

Accumulated Depreciation Account

           

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2010 Dec.31	Balance c/d		43,000 43,000	2010 Dec.31	Depreciation		43,0001 43,000
2011  Jan.01	Balance c/d		77,400 77,400	2011 Jan.01	Balance b/d Depreciation		43,000 34,4002 77,400
2012  Dec.31	Balance c/d		1,04,920 1,04,920	2012 Jan.01 Dec.31	Balance b/d Depreciation		77,400 27,5203 1,04,920
2013 Jul.31	Plant disposal		1,17,763 1,17,763	2013 Jan.01 Dec.31	Balance b/d Depreciation		1,04,920 12,8434 1,17,763

 

Plant Disposal Account

                       

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2013 Jul.31	Plant		2,15,000	2013 Jul.31	Accumulated depreciation Insurance Co. Profit & Loss (Loss on sale)­ ­ ­		1,17,763 50,000 47,2375 2,15,000

 

Effect of any Addition or Extension to the Existing Asset

An existing asset may require some additions or extensions for being suitable for operations. Such additions/extensions may or may not become an integral part of the asset.

 

The amount incurred on such additions/extensions is capitalised and written off as depreciation over the life of the asset. It is important to mention here that the amount so incurred is in addition to usual repair and maintenance expenses. AS-6 (Revised) mentions that

 

• Any addition or extension, which becomes an integral part of the existing asset should be depreciated over the useful life of that asset;
• The depreciation on such addition or extension may also be provided at the rate applied to the existing asset;
• Where an addition or extension retains a separate identity and is capable of being used after the existing asset is disposed off, depreciation, should be provided independently on the basis of its own useful life.

 

Illustration

M/s Digital Studio bought a machine for Rs. 8,00,000 on April 01, 2012. Depreciation was provided on straight-line basis at the rate of 20% on original cost. On April 01,2014
a substantial modification was made in the machine to make it more efficient at a cost of Rs. 80,000. This amount is to be depreciated @ 20% on straight line basis. Routine maintenance expenses during the year 2013-14 were Rs. 2,000.

Draw up the Machine account, Provision for depreciation account and charge to profit and loss account in respect of the accounting year ended on March 31,2015.

 

Solution

Books of Digital Studio

Machine Account

               

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2012 Jul.31	Balance b/d Bank		800,000 80,000 8,80,000	2013 Mar.31	Balance c/d		8,80,000 8,80,000

 

Provision for Depreciation Account

                   

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2013 Mar.31	Balance b/d Bank		4,96,000 4,96,000	2013 April.01 2014 Mar.31	Balance b/d  Depreciation		3,20,0001 1,76,0002 4,96,000

 

Working Notes

1. Cost of modification is capitalised but routine repair expenses are treated as revenue expenditure.
2. Calculation of balance of provision for depreciation account on 01.04.2014.

Original Cost on 01.04.2012 = Rs. 8,00,000

Depreciation for the years 2012-13 and 2013-14 = Rs 3,20,0001

(@ 20% of Rs. 8,00,000 )

3. Depreciation for the year 2014-15 is calculated as under:

20% of 8,00,000 = Rs. 1,60,000

20% of Rs. 80,000 = Rs. 16,000

Total Depreciation for 2014-15 = Rs. 1,76,0002

 

4. Amount to be charged to profit and loss account

Depreciation­ Rs. 1,76,000­

Repair and maintenance Rs. 2,000­

 

Illustration

M/s Nishit printing press bought a printing machine for Rs. 6, 80,000 on April 01, 2012. Depreciation was provided on straight line basis at the rate of 20% on original cost. On April 01, 2014 a modification was made in the machine to increase its technical reliability for Rs 70,000. On the same date, an important component of the machine was replaced for Rs. 20,000 due to excessive wear and tear. Routine maintenance expenses during the year are Rs. 5,000

Prepare machinery account, provision for depreciation account. Show the working notes accordingly for the year ending March 31, 2015.

 

Machinery Account

                     

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2014 Apr.01	Balance b/d Bank Bank		6,80,000 70,000 20,000 7,70,000	2015 Mar.01	Balance b/d		7,70,000 7,70,000

 

Provision for Depreciation Account

                     

Date	Particulars	J.F.	Amount Rs.	Date	Particulars	J.F.	Amount Rs.
2015 Mar.01	Balance c/d		4,38,000 4,38,000	2014 Apr.01 2015 Mar.31	Balance b/d  Depreciation		2,72,000 1,66,000 4,38,000

 

Provisions

There are certain expenses/losses which are related to the current accounting period but amount of which is not known with certainty because they are not yet incurred. It is necessary to make provision for such items for ascertaining true net profit.

 

For example, a trader who sells on credit basis knows that some of the debtors of the current period would default and would not pay or would pay only partially. It is necessary to take into account such an expected loss while calculating true and fair profit/loss according to the principle of Prudence or Conservatism.

 

Therefore, the trader creates a Provision for Doubtful Debts to take care of expected loss at the time of realisation from debtors. In a similar way, Provision for repairs and renewals may also be created to provide for expected repair and renewal of the fixed assets. 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.

 

 

It must be noted that the amount of provision for expense and loss is a charge against the revenue of the current period. Creation of provision ensures proper matching of revenue and expenses and hence the calculation of true profits. Provisions are created by debiting the profit and loss account. In the balance sheet, the amount of provision may be shown either:

 

• By way of deduction from the concerned asset on the assets side. For example, provision for doubtful debts is shown as deduction from the amount of sundry debtors and provision for depreciation as a deduction from the concerned fixed assets;

 

• On the liabilities side of the balance sheet alongwith current liabilities, for example provision for taxes and provision for repairs and renewals.

 

Accounting Treatment for Provisions

The accounting treatment of all types of provisions is almost similar. Therefore, the

accounting treatment is explained here taking up the case of provision for doubtful debts.

 

As already stated that when business transaction takes place on credit basis, debtors account is created and its balance is shown on the asset-side of the balance sheet.

 

These debtors may be of three types:

• Good Debtors are those from where collection of debt is certain.
• Bad Debts are those debtors from where collection of money is not possible and the amount of credit given is a certain loss.
• Doubtful Debts are those debtors who may pay but business firm is not sure about the collection of full amount from them. In fact, as a matter of business experience, some percentage of such debtors are not likely to pay, hence treated as doubtful debts. To consider this possible loss on account of non-payment by some debtors, it is a common practice (and necessary also) to make a suitable provision for doubtful debts at the time of ascertaining true profit or loss.

 

The provision for doubtful debts is usually calculated as a certain percentage of the total amount due from sundry debtors after deducting/writing-off all known bad debts. Provision for doubtful debts is also called ‘Provision for bad and doubtful debts’. It is created by debiting the amount of required provision to the profit and loss account and crediting it to provision for doubtful debts account.

 

For creating a provision for doubtful debts the following journal entry is recorded:

 

Profit and Loss A/c Dr. (with the amount of provision)

To Provision for doubtful debts A/c

This is explained with the help of the following example

 

Observe an extract of the trial balance from the books of Trehan Traders on March 31, 2014 is given below:

 

Date	Account title	L.F.	Debit Amount  Rs.	Credit Amount  Rs.
	Sunday Debtors		68,000

 

Additional Information

• Bad debts proved bad but not recorded amounted to Rs. 8,000
• Provision is to be maintained at 10% of debtors.

In order to create the provision for doubtful debts, the following journal entries will be recorded:

 

Journal

Date	Particulars	L.F.	Amount  Rs.	Amount  Rs.
2014 Mar.31	Bad debts A/c Dr. To Sundry debtors A/c (Bad debts written off)		8,000	8,000
Mar.31	Profit & Loss A/c Dr. To Bad debts A/c (Bad debts debited to profit and loss account)		8,000	8,000
Mar.31	Profit and Loss A/c Dr. To Provision for doubtful debts a/c (For creating provision for doubtful debts)		6,0001	8,000

 

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.

 

 

 

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.

 

However, retention of profits in the form of reserves reduces the amount of profits available for distribution among the owners of the business. It is shown under the head Reserves and Surpluses on the liabilities side of the balance sheet after capital.

 

Examples of reserves are:

• General reserve;
• Workmen compensation fund;
• Investment fluctuation fund;
• Capital reserve;
• Dividend equalisation reserve;
• Reserve for redemption of debenture.

 

Difference between Reserve and Provision

The points of difference between reserve and provision are explained below:

1. Basic nature:A provision is a charge against profit whereas reserve is an appropriation of profit. Hence, net profit cannot be calculated unless all provisions have been debited to profit and loss account, while a reserve is created after the calculation of net profit.

 

2. Purpose:Provision is made for a known liability or expense pertaining to current accounting period, the amount of which is not certain. On the other hand reserve is created for strengthening the financial position of the business. Some reserves are also mandatory under the law.

 

3. Presentation in balance sheet:Provision is shown either (i) by way of deduction from the item on the asset side for which it is created, or (ii) on the liabilities side along with current liabilities. On the other hand, reserve is shown on the liabilities side after capital.

 

4. Effect on taxable profits:Provision is deducted before calculating taxable profits. Hence, it reduces taxable profits. A reserve is created from profit after tax and therefore it has no effect on taxable profit.

 

5. Element of compulsion:Creation of provision is necessary to ascertain true and fair profit or loss in compliance with ‘Prudence’ or ‘Conservatism’ concept. It has to be made even if there are no profits. Whereas creation of a reserve is generally at the discretion of the management. However, in certain cases law has stipulated for the creation of specific reserves such as Debenture Redemption Reserve. Reserve cannot be created unless there are profits.

 

6. Use for the payment of dividend:Provision cannot be used for distribution as dividends while general reserve can be used for dividend distribution.

 

Basis of Difference­	Provision	Reserve­
1. Basic nature	Charge against profit.	Appropriation of profit­.
2. Purpose	It is created for a known liability or expense pertaining to current accounting period, the amount of which is not certain.	It is made for strengthening the financial position of the business.Some reserves are also mandatory under law.
3. Effect on taxable profit	It reduces taxable profits.	It has no effect on taxable profits. profit.
4. Presentations in Balance sheet	It is shown either (i) by way of deduction from the item on the asset side for which it is created, or (ii) In the liabilities side along with current liabilities.	It is shown on the liabilities. side after capital amount.
5. Element of compulsion	Creation of provision is necessary to ascertain true and fair profit or loss in compliance ‘Prudence’ or  ‘Conservatism’ concept. It must be made even  if there are no profits.	Generally, creation of a Reserve is at the discretion of the management. Reserve cannot be created unless there are profits. However, in certain cases law has stipulated for the creation of specific reserves such as ‘Debenture’ ‘Redemption’ reserve.
6. Use for the payment of dividend	It can not be used for dividend distribution.	It can be used for divided distribution.

 

Types of Reserves

A reserve is created by retention of profit of the business can be for either a general or a specific purpose.

 

1. General reserve :When the purpose for which reserve is created is not specified, it is calledGeneral Reserve . It is also termed as free reserve because the management can freely utilise it for any purpose. General reserve strengthens the financial position of the business.

 

2. Specific reserve :Specific reserve is the reserve, which is created for some specific purpose and can be utilised only for that purpose. Examples of specific reserves are given below :

(i) Dividend equalisation reserve: This reserve is created to stabilise or maintain dividend rate. In the year of high profit, amount is transferred to Dividend Equalisation reserve. In the year of low profit, this reserve amount is used to maintain the rate of dividend.

(ii) Workmen compensation fund: It is created to provide for claims of the workers due to accident, etc.

(iii) Investment fluctuation fund: It is created to make for decline in the value of investment due to market fluctuations.

(iv) Debenture redemption reserve: It is created to provide funds for redemption of debentures.

 

Reserves are also classified as revenue and capital reserves according to the nature of the profit out of which they are created.

 

(a) Revenue reserves : Revenue reserves are created from revenue profits which arise out of the normal operating activities of the business and are otherwise freely available for distribution as dividend. Examples of revenue reserves are:

• General reserve;
• Workmen compensation fund;
• Investment fluctuation fund;
• Dividend equalisation reserve;
• Debenture redemption reserve;

 

(b) Capital reserves: Capital reserves are created out of capital profits which do not arise from the normal operating activities. Such reserves are not available for distribution as dividend. These reserves can be used for writing off capital losses or issue of bonus shares in case of a company. Examples of capital profits, which are treated as capital reserves, whether transferred as such or not, are :

• Premium on issue of shares or debenture.
• Profit on sale of fixed assets.
• Profit on redemption of debentures.
• Profit on revaluation of fixed asset & liabilities.
• Profits prior to incorporation.
• Profit on reissue of forfeited shares

 

Difference between Revenue and Capital Reserve

Revenue reserves and capital reserves are differentiated on the following grounds:

1. Source of creation :Revenue reserve is created out of revenue profits, which arise out of the normal operating activities of the business and are otherwise available for dividend distribution. On the other hand capital reserve is created primarily out of capital profit, which do not arise from the normal operating activities of the business and are not available for distribution as dividend. But revenue profits may also be used for creation of capital reserves.
2. Purpose :Revenue reserve is created to strengthen the financial position, to meet unforeseen contingencies or for some specific purposes. Whereas capital reserve is created for compliance of legal requirements or accounting practices.
3. Usage :A specific revenue reserve can be utilised only for the earmarked purpose while a general reserve can be utilised for any purpose including distribution of dividend. Whereas a capital reserve can be utilised for specific purposes as provided in the law in force, e.g. to write off capital losses or issue of bonus shares.

 

Basis of Difference­	Revenue Reserve	Capital Reserve
1. Source of creation	It is created out of revenue profits which arise out of normal operating activities of the business and are otherwise available for dividend distribution.­	It is created primarily out of capital profit which do not arise out of the normal operating activities of the business and not available for dividend distribution. But revenue profits may also be used for this purpose.
2. Purpose	It is created to strengthen the financial position, to meet unforeseen contingencies or for some specific purposes.	It is created for compliance of legal requirements or accounting practices.
3. Usage	A specific revenue reserve can be utilised only for the earmarked purpose while a general reserve can be utilised for any purpose including distribution of dividend.	It can be utilised for specific purposes as provided in the law in force e.g. to write off capital losses or issue of bonus shares.

 

Importance of Reserves

A business firm may consider it proper to set up some mechanism to protect itself from the consequences of unknown expenses and losses, it may be required to bear in future.

It may also regard it as more appropriate in certain cases to reduce the amount that can be drawn by the proprietors as profit in order to conserve business resource to meet certain significant demands in future.

 

An example of such a demand is the much needed expansion in the scale of business operations. This is presented as the justification for reserves in business activities and in accounting. The amount so set aside may be meant for the purpose of :

• Meeting a future contingency
• Strengthening the general financial position of the business;
• Redeeming a long-term liability like debentures, etc.

 

Secret Reserve

Secret reserve is a reserve which does not appear in the balance sheet. It may also help to reduce the disclosed profits and also the tax liability . The secret reserve can be merged with the profits during the lean periods to show improved profits.

 

Management may resort to creation of secret reserve by charging higher depreciation than required. It is termed as ‘Secret Reserve’, as it is not known to outside stakeholders. Secret reserve can also be created by way of :

• Undervaluation of inventories/stock
• Charging capital expenditure to profit and loss account
• Making excessive provision for doubtful debts
• Showing contingent liabilities as actual liabilities

 

Creation of secret reserves within reasonable limits is justifiable on grounds of expediency, prudence and preventing competition from other firms.