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Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES

Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES

Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES:Matching principle requires that the revenue of a given period is matched against the expenses for the same period. This ensures ascertainment of the correct amount of profit or loss. If some cost is incurred whose benefit extend to more than one accounting period, it is not justified to charge the entire cost as expense in the year in which it is incurred. In fact, such a cost must be spread over the periods in which it provides benefits. Depreciation, on fixed assets, which is the main subject matter of the present chapter, deals with such a situation. Further, it may not always be possible to ascertain with certainty the amount of some particular expense. Recall the principle of conservatism (prudence) which requires that instead of ignoring such items of costs, adequate provision must be made and charged against profits of the current period. Moreover, a part of profit may be retained in the business in the form of reserves to provide for growth, expansion or meeting certain specific needs of the business in future. This chapter deals with two distinct topics and hence is being presented in two different sections. First section deals with depreciation and second section deals with provisions and reserves.

Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES:

Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES

Karnataka class 12 commerce Accountancy CH1 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 as depreciation. 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. For example, a machine is purchased for Rs.1,00,000 on April 01, 2014. The useful life of the machine is estimated to be 10 years. It implies that the machine can be used in the production process for next 10 years till March 31, 2015. You know that by its very nature, Rs. 1,00,000 is a capital expenditure during the year 2014-15. However, when income statement (Statement of Profit and Loss) is prepared, the entire amount of Rs.1,00,000 can not be charged against the revenue for the year 2014-15, because of the reason that the capital expenditure amounting to Rs.1,00,000 is expected to derive benefits (or revenue) for 10 years and not one year. Therefore, it is logical to charge only a part of the total cost say Rs.10,000 (one tenth of Rs. 1,00,000) against the revenue for the year 2014-15. This part represents the expired cost or loss in the value of machine on account of its use or passage of time and is referred to as ‘Depreciation’. The amount of depreciation, being a charge against profit, is debited to Income Statement (Statement of Profit and Loss).

Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES:

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 :

Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES:

  • 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:

Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES:

  • 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 along with current liabilities, for example provision for taxes and provision for repairs and renewals.

Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES:

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:

Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES:

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

Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES:

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.

Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES:

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