Account 4 Marks Question

Capital Reserves are set aside out of capital profits and are normally not available for distribution as dividend. In other words, reserve created out of capital profits and which is not readily available for distribution as dividend among the shareholders is called Capital Reserve. Examples of capital reserves are:

1. Profit prior to incorporation.
2. Premium on issue of shares or debentures.
3. Profit on redemption of debentures.
4. Profit on forfeiture of shares.
5. Profit on sale of fixed assets.
6. Capital Redemption Reserve.
7. Profit on revaluation of fixed assets and liabilities.

In every business there are certain assets of a fixed nature that are needed for the conduct of business operations. Some examples of such assets are Building, Plant and Machinery, Motor Vehicles, Furniture, Office equipments etc. These assets have a definite span of life after the expiry of which the assets will lose their usefulness for the business operations. Fall in the value and utility of such assets due to their constant use and expiry of tine is termed as depreciation. In other words, the process of allocation of the cost of a fixed asset over its useful life is known as depreciation.
The causes (reasons) of Depreciation are:

1. Use of Asset: Use of asset leads to its wear and tear and thus fall in its value.
2. Obsolescence: If a better and cost effective machine becomes available, old machine may have to be discarded even though it is capable of being used. Thus, it leads to reduction of useful life of the asset.
3. Accidents: Accidental loss may be permanent but is not continuing and gradual.

Note: Repair charges of ₹ 2,000 are categorised under revenue expenditure because these are incurred on December 31, 2012 but machinery has been purchased on September 30, 2012.

Working Notes: Calculation of Loss by fire,

Working Note: Calculation of Profit or Loss on Sale,

Working Notes: Calculation of Profit or Loss on Sale,

Merits:

1. Easy Calculation: It is easy to calculate the depreciation under this method, even if some new assets are purchased year after year. Different assets are grouped for the purpose of providing depreciation.
2. Equal charge against income: In this method, the total burden on Profit & Loss Account in respect of depreciation and repairs put together remains almost equal year after year. This is so because in the initial years depreciation is more in comparison to repair charges whereas, in the later years, as the asset gets older, the amount of depreciation goes on decreasing while the expenses on repairs go on increasing, thus keeping the combined charge of depreciation and repairs almost uniform.
3. No Undue pressure in later year: The efficiency and usefulness of a machine is more in the earlier years than in later years. Hence, the depreciation in first few years should be more in comparison to the later years. This is ensured by adopting the Diminishing Balance Method.
4. Balance of asset is never written off to zero: This method ensures that the asset is never reduced to zero so that some depreciation, however small, is debited to Profit & Loss Account so long as the asset remains in use.
5. Approved method by income Tax Authorities: This method of providing depreciation is permissible under Income Tax regulations.

Basis of Difference	Straight Line Method	Written Down Value Method
Basis for calculation	Depreciation is calculated on the original cost of an asset.	Depreciation is calculated on the reducing balance, i.e., the book value of an asset.
Amount of depreciation	Equal amount is charged each year over the effective life of the asset.	Diminishing amount of depreciation (on the written down value of asset) is charged each year over the effective life of the asset.
Book value of asset	Book value of the asset becomes zero at the end of its effective life.	Book value of the asset can never be zero.
Suitability	It is suitable for the assets like patents, copyright, land and buildings, etc., which have lesser possibility of obsolescence and lesser repair charges.	It is suitable for assets that needs more repair in the later years like, plant and machinery, car, etc.
Effect of depreciation and repair on profit and loss account	Unequal effect over the life of the asset, as depreciation remains same over the years but repair cost increases in the later years.	Equal effect over the life of the asset, as depreciation cost is high and repairs are less in the initial years but in the latter years the repair costs increase and depreciation cost decreases.
Recognition under Income Tax Act	It is not recognised under the income tax act.	It is recognised under the income tax act.

Reserve: Reserves are the amounts set aside out of profits. It is an appropriation of profits or accumulated profits to strengthen the financial position of the business. Reserves are not set aside to meet a liability or depreciation in the value of assets but is set aside to meet known or unknown contingency that may arise in future. Examples are General Reserve, Reserve for Expansion, Reserve for Equalisation of Dividends, Reserve for Increased Costs of Replacement, etc.Provision:
Provision is an amount set aside, by charging it to the Profit and Loss Account or Statement of Profit and Loss (in case of companies), to provide for a known liability the amount of which cannot be determined with accuracy. It is charged in the Profit and Loss Account on the basis of best estimate. In other words, a provision is a charge against profit for the purpose of providing for any liability or loss. Provision for Depreciation, Provision for Doubtful Debts, Provision for Repairs and Provision for Tax are few examples of provisions. Provision differs from liability to the extent that provision is an estimated amount while liability is determined amount. For example, providing for wages of 50,000 pavable for the month of march is a liability. Thus, Provision is an estimated amount set aside to meet an uncertain loss or expense in future.

Advantages of Straight Line Method:

1. It is a simple method of calculating the Depreciation.
2. In this method, asset can be depreciated up to the estimated scrap value.
3. In this method, it is easy to know the amount of Depreciation.
4. Every year, the Profit and Loss Account is debited by the same amount of Depreciation, so there is same effect on the Profit and Loss Account every year.

	Basis of Distinction	Straight Line or Original Cost Method	Witten Down Value Method
1.	Amount of depreciation.	Equal depraeciation charged every year.	Depreciation goes on decreasing year after year.
2.	Basis of calculation of depreciation.	Depreciation is charged on the original cost of the asset.	Depreciation is changed on the reducing balance of the asset.
3.	zero level.	The book value of the asset can be reduced to zero.	The book value of the asset can never be reduced to zero.
4.	Combined effect of depreciation and repairs on P & L A/c.	Combined burden on account of depreciation and repairs will be lighter in earlier years and heavier during the later years.	Combined burden on account of depreciation and repairs will be almost equal over different years.