Depreciation, Provisions and Reserves

 

Imortant Point :

Total Depreciation is charged on Machine sold : 7,800+3,608 = 11,408

Provisions :

  1. Provision is to be made is respect of a liability, which is certain to be incurred, but its accurate amount is not known.
  2. It is charged in the Profit and loss Account on estimate basis. It should be clearly understood that if the amount of a known liability can be determined with reasonable accuracy, it can not a provision.

Note : Provision is a charge against profits it means provision has to be made irrespective of business enterprise is earning enuogh profit or loss.

Examples of Provisisons :

  • Provision for Depreciation of assets.
  • Provision for Repairs and Renewals of assets.
  • Provision for Taxation.
  • Provision for Discount on Debtors.
  • Provision for Bad and doubtfu Debts.

Reserves :

  1. Reserves are the amount set aside out of profits. It is an appropriation of profits and not a charge on the profits. The amount of profit retained is used in the businesss when difficult time comes.
  2. Since reserves are neither expenses nor losses, so these are not charged to profit & loss Account rather these are debited to Profit & Loss Appropriation Account which is prepared after Profit and Loss Account.
  3. Reserves are also known as 'Ploughing Back of Profits'. Reserves are created to strengthening the financial positions of the business enterprise. Examples are General Reserve, Dividend Equalization Reserve etc.
  4. If the amount of reserve is invested outside the business then, it is called 'Reserve Fund'.
  5. Creation of reserve does not reduce the net profit but only reduces the divisible profits. General Reserves and Specific Reserves Capital Reserves and Secret Reserves.

General Reserve :

If the purpose of creating the reserve is to meet any unforeseen contingency (Liability which is not known) in future, the reserve is called 'General Reserve'. These are retained for strengthening the financial position of the enterprise.
Specific Reserve :

Specific reserves are those reserves which are created for a specific purpose and can be utilized only for that purposed. 'Dividend Equalization Reserve' and 'Reserve for Replacement of Asset' are the examples of Specific Reserve.

Capital Reserve :

In addition to the normal profits, capital profits are also earned in the business from many sources. Reserves created out of capital profits which are.

  1. Not of recurring nature
  2. Not readily available for distribution as dividend among the shareholders.
  3. These reserve can be utilized for writing off capital losses.

Capital Reserves may be created out of such profits as :

  1. Profit on sale of any fixed asset.
  2. Profit on revaluation of assets.
  3. Profit from forfeiture of shares,
  4. Profit prior to incorporation of company.

Secret Reserve :

A secret reserve is created by undervaluing the fixed assets. Existence of secret
reserve

  1. Reduce the profits of the business enterprise and
  2. Reduces its tax liability.
  3. Secret reserve is secret in the sense that it is not known to the outsiders.
  4. such reserves are created by showing the assets at a lower amount and liabilities at a higher amount.

Difference between Provisions and Reserve

Basis Provision Reserve
1. Meaning It is created meet a known liability. It is created to strengthen the finan cial position of business enterprise.
2. charge or Appropriation Provisions are charge against profits. Reserve is an appropriate of profit.
3. Objective The object is to provide for known liability but cannot be calculated accurately. It is created to strengthen the financial position and to meet unforeseen liability.
4. Effect on Profit It is debited to the Profit & Loss Account. Hence,
profit is reduced.		 Reserve reduces divisible profits.
5. Creation Provisions are to be created even if there are insufficient profit only. Reserve is created out of adequate profits only.
6. Mode of creation Provision are created by debiting the Profit & loss account. It is created through Profit & Loss Appropriation Account.
7. Investment It cannot be invested outside the business. Creation of provision is necessary as per law. Reserve can be invested outside the business.
8. Necessity Creation of provision is necessary as per law. Its creation is not necessary. It is created as a matter of prudence.

Points to Remember :

  1. Fixed assets are those assets which are used for many years.
  2. Depreciation means reduction in value of fixed assets.
  3. Through accounting treatment of depreciation we can distribute the total cost of fixed assets over the years of their useful life.
  4. There are two main methods of charging of charging depreciation : Straight Line Method and Diminishing Balance Method.
  5. Depreciation is charged on fixed assets only and at the end of accounting period.
  6. In Staight Line Method, depreciation is charged on original cost and the amount of depreciation remains same year after year.
  7. In Diminishing Balance Method the amount of depreciation is reducing year after year becaused depreciation is charged on opening balance of the asset in every year.
  8. In Staight Line Method, the book value of asset can be reduced to zero but in Diminishing Balance Method, the book value of asset can not be reduced to zero.
  9. Provisions are made for known liabilities which can not be calculated accurately.
  10. Reserves are created for strengthening the financial position of enterprise but can be created if adequated profits are available.

 

CBSE Accountancy Class XI ( By Mr. Aniruddh Maheshwari ) 
Email Id : [email protected]

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