DEPRECIATION

Question 1 : What is depreciation? What are depreciable assets? What are the
causes of depreciation and the factors determining the amount of depreciation?
Answer 1 : Depreciation is a permanent, continual and gradual shrinkage in the
book value of a fixed asset due to use, passage of time, obsolescence of
technology or market changes. A fair proportion of the depreciable amount is
charged during the expected useful life of the asset.
Depreciable assets are those assets that can be depreciated i.e. on
whom depreciation
can be charged like fixed assets. For
example machinery, furniture, etc. Current assets are never
depreciated.
The following are the main causes for depreciation:
1) PHYSICAL DEPRECIATION
It is caused from the wear and tear of the asset. It is also caused by
erosion, rot, rust and decay from being exposed to wind, rain and
other natural elements.
2) ECONOMIC FACTORS
These causes are those that cause the asset to be put out of use
even when it is in good physical condition. This is due to
obsolescence and inadequacy. Obsolescence means the process of
becoming obsolete or out of date while inadequacy means the
termination of the use of the asset because of growth and changes in
the size of the firm.
For example: An old machinery in good physical condition may be
rendered obsolete by the introduction of the new model which
produces more than the old machinery.
3) TIME FACTORS
There are certain assets with a fixed period of legal life like patents,
copyrights and lease.
For example: A lease can be entered into for any period of time while
a patents legal life is for some years but on certain grounds it can
be extended.
Provision for the compensation of these assets is called amortisation
i.e. writing off rather than depreciation.
4) DEPLETION
Some assets are of a wasting character due to extraction of raw
materials from them like natural oil wells, mines and quarries. These
materials are used to make something else out of them or are sold in
raw state to other firms. Depletion is provided for such assets for its
consumption.

5) ACCIDENT
An asset may reduce in value because of meeting with an accident.
The following are the factors determining the amount of
depreciation:
Question 2 (i): Distinguish between straight line method and diminishing balance
method,
annuity and depreciation fund method.
(ii): Distinguish between straight line method and diminishing balance
method,
depreciation fund and insurance
policy method.
(iii): Distinguish between depreciation, obsolescence and
fluctuations.
Answer 2: (i) The distinction between straight line method and diminishing
balance method is as follows:
Points Of Distinction

Straight Line Method

1) Change in
depreciation
amount

Throughout the life of the

asset, the amount of
depreciation remains to
be equal.

2) Balance in
assets a/c

Assets a/c at the expiry

of the expected life
becomes nil.
The overall charge, i.e.,
depreciation and repairs
taken together go on
increasing from year to
year. In other words the
amount of depreciation
and repairs is relatively
less during the earlier
years of the life of the
asset than later years
because repairs go on
increasing with the use
asset.
Profits under this method
are more during the
earlier years of the life of
the asset.

3) Overall Charge

4) Profits

Diminishing Balance
Method
Amount of depreciation is
more during earlier years
of the life of the asset
than later years and
therefore amount is
never equal.
The amount never
becomes nil.
Overall charge remains
more or less same for
every year throughout
the life of the asset
because depreciation
goes on decreasing and
amount of repairs goes
on increasing.

Profits are less during

earlier years than the
later years.

Points Of Distinction

Annuity Method

Depreciation Fund
Method

1)

Points Of Distinction
1)

Points Of
Distinction

Points Of
Distinction

Straight Line Method

Depreciation Fund Method

Depreciation

Depletion Method

Insurance Policy
Method

Obsolescence

Fluctuations

Question 3: Distinguish between a sinking fund to replace a wasting asset and

sinking fund to repay a liability.
Answer 3: The following points help to distinguish between a sinking fund to
replace a wasting asset and sinking fund to repay a liability.
1) The annual instalment in case of sinking fund to replace a wasting asset is
actually depreciation and which is a charge against profit and loss account
while in case of sinking fund to repay a liability it is an appropriation of
profits.
2) In the case of sinking fund to replace a wasting asset at the time of
replacing an asset sinking fund is used to write off the old asset account
but in the case of sinking fund to repay a liability it is closed by
transferring the balance to general reserve as the annual charge was on
profit and loss appropriation account.
3) A sinking fund to replace a wasting asset does not enhance the capital as
it maintains the asset on the original cost but in the other case the asset
are increased to the extent of redemption carried out.

Question 4: Is reserve fund a liability in real sense of the term? If not, then why is
it shown on the liability side of the balance sheet?
Answer 4: Though reserves are shown on the liability side of the balance sheet,
they are not a liability in real sense of the term. The reason why it is shown on
the liability side of the balance sheet is because it represents accumulated
divisible profits which belong to the shareholders just like capital and not have
been distributed as dividend as yet.
Question 5: Differentiate between provisions and reserves.
Answer 5:
Points Of Distinction
1) Meaning

2) Shown in
balance sheet

3) Purpose of
making

Provisions
Money kept aside for a
known event is known as
provision.

Reserves
Money kept aside for an
unknown event is known
as reserve.

It can be on the liability

or the asset side but as a
negative asset. It is
shown by the way of
deduction from the
amount of the item for
which it was created.
It is made because its a
legal necessity.

It belongs to the owners

equity. It is shown under
the head Reserves and
surplus

4) Distributed as
profits

It cannot be distributed
as profits or transferred
to any general reserve.

5) Objective of
creation

It is created for specific

objectives and must be
utilised for them only.

6) Investment in
outside
securities

It reduces the net profit

and therefore is not
invested in outside
securities.
It is a charge to profit
and loss a/c and it must
be charged to profit &
loss a/c before
calculating the net profit
or loss.

7) Nature

It is made for financial

prudence to save the
concern from prospective
losses and liabilities.
It can be distributed as
profits if these remain
unutilised for some
period. These can even
be transferred to
provisions if needed.
It is created for probable
losses and can be used
for any future liability or
loss.
It reduces the divisible
profits and can be
invested in outside
securities.
Reserve is an
appropriation of profit but
it can be made only when
there is profit.

8) Examples

Provision for
depreciation, provision
for repairs and renewals,
provision for taxation,
etc.

Capital reserve, general

reserve and specific
reserve.