Title Chapter 7 Depreciation, Provisions And Reserves.pdf ✅

ACCOUNTANCY Chapter 7: Depreciation, Provisions And Reserves
(1) 07 DEPRECIATION, PROVISIONS AND RESERVES Depreciation, Provisions And Reserves Meaning of Depreciation Depreciation means fall in book value of a depreciable fixed asset because of its wear and tear, passage/efflux of time, obsolescence or accident. It is charged on all fixed assets except land because of its infinite economic life. ❖ Characteristics of Depreciation • Depreciation is decline in the book value of tangible fixed asset. • It decreases only the book value of an asset and not the market value of an asset. • It is a non-cash expense as it does not involve cash. • It is permanent, gradual and continuous in nature. • It is an expense and therefore is debited to the profit and loss account. • It is the process of writing off the capital expenditure which has already been incurred over its useful life. • It is a process of allocation of cost of an asset to its useful life span and not the process of valuation of asset. • It is only used for tangible fixed asset and cannot be used for wasting and fictitious assets. For example, depletion of natural resources and amortisation of goodwill. ❖ Concepts Related to Depreciation • Depletion: It is related to the extraction of natural resources such as quarries and mines which leads to decline in the availability of the quantity of asset or material. • Amortisation: Writing off the cost of intangible assets such as trade mark, copyright and patents over its useful life is known as amortisation. • Obsolescence: Obsolescence means decrease in the value of asset because of innovation or improved technology, change in taste or fashion or inadequacy of the existing asset because of the improved demand. ❖ Causes of Depreciation • Use of asset i.e. wear and tear: There exists a normal wear and tear because of constant use of fixed assets which leads to fall in the value of the assets. • Passage/efflux of time: Whether assets are used or not, with the passage of time, its effective life will decrease. • Obsolescence: Because of new technologies, innovations and inventions, assets purchased today may become outdated by tomorrow which leads to the obsolescence of fixed assets. • Accidents: An asset may lose its value because of mishaps such as a fire accident, theft or
(2) 07 DEPRECIATION, PROVISIONS AND RESERVES by natural calamities and are permanent in nature. ❖ Need for Providing Depreciation • To ascertain the true profit or loss: True profit or loss can be ascertained when all the expenses and losses incurred for earning revenues are charged to profit and loss account. Assets are used for earning revenues and its cost is charged in the form of depreciation from profit and loss account. • To show true and fair view of the financial position: If depreciation is not charged, assets will be shown at a higher value than their actual value in the balance sheet. Consequently, the balance sheet will not reflect true and fair view of financial statements. • To retain out of profit funds for replacement: Unlike other expenses, depreciation is a non-cash expense. So, the amount of depreciation debited to the profit and loss account will be retained in the business. These funds will be available for replacement of fixed assets when its useful life ends. • To ascertain correct cost of production: Depreciation on the assets, which are engaged in production, is included in the cost of production. If depreciation is not charged, the cost of production is underestimated which will lead to low selling price, and thus leads to low profit. • To comply with legal requirement: To comply with the provisions of the Companies Act and Income Tax Act, it is necessary to charge depreciation. ❖ The factors involved in providing depreciation are • Historical (Original) cost of the asset: The total cost of an asset is taken into consideration for ascertaining the amount of depreciation. The total cost of an asset includes all expenses incurred up to the point where the asset is ready for use such as freight expenses and installation charges. Total cost =Purchase price+ Freight expenses+ Installation charges • Estimated net residual value: It is estimated as the net realisable value of an asset at the end of its useful life. It is deducted from the total cost of an asset and the difference is written off over the useful life of the asset. For example, furniture acquired at ₹1,30,000 has its useful life estimated to be 10 years and its estimated scrap value is ₹10,000. Depreciation per annum = 1,30,000–10,000/10 years = ₹12,000 • Estimated useful life: Every asset has its useful life other than its physical life (in terms of number of years, units) used by a business. The asset may exist physically but may not be able to produce the goods at a reasonable cost. For example, an asset is likely to lose its useful value within 15 years; its useful life i.e. life for purpose of accounting should be considered as only 15years.
(3) 07 DEPRECIATION, PROVISIONS AND RESERVES Methods of Recording Depreciation In the books of account, following are the two methods of recording depreciation of fixed assets: • When depreciation is charged or credited to the assets account. • When depreciation is credited to provision for depreciation/accumulated account. When Depreciation is Charged or Credited to the Assets Account In this method, depreciation is deducted from the asset value and charged (debited) to profit and loss account. Hence, the asset value is reduced by the amount of depreciation. Journal entries for recording under this method are as follows: Journal Purchase of an asset Date Particulars L.F. Dr. ₹ Cr. ₹ 2016 1 Jan Asset A/c To Cash/Bank A/c (Being the asset purchased and the cost of an asset including installation expenses and freight) Dr. Following entries are recorded at the end of each year 31 Dec Depreciation A/c To Asset A/c (Being the amount of depreciation charged) Dr.