DEPRECIATION,PROVISIONS & RESERVES

1. DEPRECIATION,PROVISIONS & RESERVES DEPRECIATION,PROVISIONS AND RESERVES

3. CONTENTS • 1 CONCEPT OF DEPRECIATION • 2 CAUSES OF DEPRECIATION • 3 NEED OF DEPRECIATION • 4 BASIC FACTORS • 5 METHODS OF DEPRECIATION • 6 PROVISION AND RESERVES DEPRECIATION,PROVISIONS AND RESERVES

4. DEFINITION Depreciation is the permanent decrease in the value of an asset due to use and /or the lapse of the time. CLMA, LONDON DEPRECIATION,PROVISIONS AND RESERVES

5. CAUSES OF DEPRECIATION • Physical depreciation • Economic factors • Time factors • Depletion • Accident

6. NEED FOR CHARGING DEPRECIATION To calculation the profit . True and fair view in balance sheet. Replacement of asset . Saving in income tax. Accurate ascertainment of cost. DEPRECIATION,PROVISIONS AND RESERVES

7. BASIC FACTORS AFFECTING DEPRECIATION Cost of asset . Estimated working life. Salvage/Residual/Scrap value. Legal provisions Additions to assets

8. METHODS OF DEPRECIATION

9. STRAIGHT LINE METHOD Under this method,a fixed asset in written off annually so that,by the time asset is worn out ,its proportion cost of the value in the book is reduced to zero. FORMULA • FIXED ASSET- ESTIMATED SCRAP VALUE ESTIMATED LIFE OF ASSET DEPRECIATION,PROVISIONS AND RESERVES

10. MERITS AND DEMERITS MERITS- 1. Simple . 2. Asset is fully written off . 3. Knowledge of total depreciation charged . 4. Suitable for fixed life assets. DEMERITS- 1. Interest on capital. 2. Reairs and maintenance 3. Income tax DEPRECIATION,PROVISIONS AND RESERVES

11. QUESTION:- A trader bought machinery on 1st jan , 2001 for Rs . 125000 whose useful life has been estimated 5 years . After the expiry of useful life , the scrap will realise Rs 25000. ANNUAL DEPRECIATION 125000-25000 =5000 5

12. MACHINERY ACCOUNT

14. DIMINISHING BALANCE METHOD Depreciation is calculated at a certain percentage each year on the balance of the asset which is brought forward from the previous year. The amount of depreciation charged in each period is not fixed but it goes on decreasing gradually as the beginning balance of the asset in each year will reduce.

15. MERITS & DEMERITS MERITS 1. Fresh calculation of depreciation are not necessary as and when additions are made. 2. this method is recognized by the income tax authorities in India. DEMERITS 1.Its difficult to determine the suitable rate of depreciation. 2. the original cost of the asset is altogether lost sight of in subsequent years and the asset can never be reduced to zero.

16. QUESTION:- A company bought machinery for Rs .400000, including a shaft Rs . 40000. The machinery is subject to dep at 10% by reducing instalment method . In the beginning of the fifth year , the shaft became obsolete and instalment method . In the beginning of the fifth year , the shaft become obsolete and was sold for Rs. 8000.Write up the machinery account for five years .

17. MACHINERY ACCOUNT

20. SUM OF THE DIGITS METHOD • This is a variant of the reducing instalment or diminishing balance method.

21. QUESTION:-Suppose machinery was purchased for Rs. 60000 on 1st jan,2003 and depreciation was charged following the sum of the digits method assuming its useful life to be 3 years. Depreciation for three years will be calculated as under: DEPRECIATION FOR THE FIRST YEAR = 3 Rs.60000 =Rs.30000 3+2+1 SECOND YEAR = 2 Rs.60000=Rs.20000 6 THIRD YEAR = 1 Rs.60000 =Rs.10000 6

22. ANNUITY METHOD Under this ,amount spent on purchase of an asset is regarded as an investment which is assumed to earn interest at a certain rate. The amount to be written off as depreciation is calculated from annuity table , an extract of which is given below :

23. QUESTION:- A firm purchases a 5 yr lease for Rs.40,000 on 1st jan . It decides to write off depreciation on annuity method ,presuming the rate of interest to be 5% per annum . The annuity tables show that a sum of Rs. 9,239 should be written off every year. Show the lease account for five yr .calculation are to be made to the nearest – rupee.

24. LEASE ACCOUNT

26. DEPRECIATION FUND METHOD This method is implies that the amount written off as depreciation should be kept aside and invested in readily saleable securities. The securities accumulate and when the life of asset expires, the securities are sold and with the sale proceeds a new asset is purchased. The rate of interest which is easily calculated from sinking fund tables , an extract of given below :

27. SINKING FUND TABLE

28. QUESTION:- A company purchased a 3 years lease on January 1,2007 for Rs. 25000. It is decided to provide for the replacement of lease at the end of 3 years by setting up a depreciation fund .It is expected that the investments will fetch interest at 5%. Sinking fund table show that to provide the requisite sum at 5% at the end of 3 years an investment of Rs 7932 is required every year. Investment are made to the nearest rupee. On 31st Dec,2009 the investments were sold for Rs. 15250. on 1st January,2010, the same lease was renewed for a further period of 3 years by payment of Rs. 30000.

29. DEPRECIATION FUND ACCOUNT

31. DEPRECIATION FUND INVESTMENT ACCOUNT

32. INSURANCE POLICY METHOD This method is similar to the depreciation fund method but instead of making investment , arrangement are made with an insurance company which will receive premiums annually and pay at the end of the fixed period the required amount . Premiums have to be paid at the beginning of each year.

33. QUESTION:-On 1st jan. 2006,a lease of premises is purchased for four years for Rs.50000 and it is decided to make provision for the replacement of the lease by means of an insurance policy purchased for an annual premium of Rs.12000. show the necessary ledger account for four years assuming that the renewal of the lease costs Rs.50000 on 1-1 2010.

34. LEASE ACCOUNT

35. DEPRECIATION RESERVE ACCOUNT

37. REVALUATION METHOD Under this , the asset is revalued at the end of the accounting year and this value is compared with the value of the asset at the beginning of the year . The difference is treated as depreciation .this method is used in case of bottles, corks, crates or etc

38. QUSETION:- A company manufactures loose tools for its own use .At the end of each year, depreciation is charged on revaluation method. From the following particulars show the loose tools account :Year ended 31-12-2006-loose tools manufactured Rs .5000[revalued on 31-12-2006:Rs.4100]

39. Year ended 31-12-2007-loose tools manufactured :Rs. 2700 [revalued on 31-12-2007:Rs5700]Year ended 31-12-2008-loose tools manufactured :Rs.1000 [revalued on 31-12-2009:Rs.6000] Year ended 31-12-2009-loose tools manufactured :Rs.1500[revalued on 31-12-2009: Rs.5100]

40. LOOSE TOOLS ACCOUNT

42. DEPLETION METHOD This method is mostly used in case of mine, quarries; etc. from which certain quantity of output is expected to be obtained . The value of mine depends only upon quantity of minerals that can be obtained .when the whole quantity is taken ,the mine loses its value .the rate of depreciation is worked out only so much per tonne. It is simply dividing the cost of the mine by the total quantity of the minerals expected to be available.

43. QUESTION:-A mine was acquired at a cost of Rs.20,00,000 on 1st July 2007. It was expected it would yield 2,00,000 tons of minerals in all. The actual output was 2007-10,000 tons ,2008-40,000 tons and 2009-32,000 tons. Write up the mine account for the above years using depletion method of charging depreciation.Rate of depreciation =Rs.10 per ton

44. MINE ACCOUNT

46. MACHINE HOUR RATE METHOD This method is useful in case of machines .The life of machine is fixed in terms of hours . Hourly rate of depreciation is worked out by dividing the cost of the machine by the total number of hours for which the machine is expected to be used .depreciation to be written off in a year will be ascertained by multiplying the hourly rate of depreciation by the number of hours that the machine actually runs in the year.

47. QUESTION:- A machine was acquired on 1st April,2008 at a cost of Rs 90,000, the cost of installation being Rs. 10000. It is expected that its total life will be 20,000 hours. During 2008 it worked for 5,000 hours and during 2009 for 8,000 hours. Write up the machinery account for 2008 & 2009. Machine hour rate= Rs 5 per hour

48. MACHINERY ACCOUNT

49. 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 current year or with retrospective effect .if the change is from current year then there will be no problem but simply to change the method of depreciation .

50. QUESTION:- Plant and machinery account of a company had a debit balance of Rs. 1,47,390 on 1st jan ,2009.The company was incorporated in 2006 and has been following the practice of charging full year, depreciation every year on diminishing balance system @15%. In 2009 it was, however decided to change the method from reducing system to straight line with retrospection effect from 2006 and to give effect of the change while preparing the final accounts for the year ended 31st dec,2009, the rate of depreciation remaining same as before. In 2009, new machineries were purchased at a cost of Rs.50,000. All the other machineries were acquired in 2006. Show Plant and machinery account from 2006 to 2009.