Depreciation, Provisions and Reserves

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Test Your Understanding – I
1. You are looking at the profit and loss account of three business enterprises. You find the term depletion in first case and amortisation in third case. State the type of businesses, the three enterprises are into. (Exhaustion of natural resources, Fixed assets and specific contract business.)

2. A pharmaceutical manufacturer has just developed and registered a patent for a rare medicine. Which term will appear in its profit and loss account regarding the cost of patent written-off. (Amortization)
Test Your Understanding – II
State whether the following statements are true or false:

  1. Depreciation is a non-cash expense. (✔ True)
  2. Depreciation is also charged on current assets. (❌ False)
  3. Depreciation is decline in the market value of tangible fixed assets. (❌ False)
  4. The main cause of depreciation is wear and tear caused by its usage. (✔ True)
  5. Depreciation must be charged so as to ascertain true profit or loss of the business.(✔ True)
  6. Depletion term is used in case of intangible assets. (❌ False)
  7. Depreciation provides fund for replacement. (✔ True)
  8. When market value of an asset is higher than book value, depreciation is not charged. (❌ False)
  9. Depreciation is charged to reduce the value of asset to its market value. (❌ False)
  10. If adequate maintenance expenditure is incurred, depreciation need not be charged. (❌ False)
Test Your Understanding – III
There are two dentists Dr. Aggarwal and Dr. Mehta in your locality who are competitors. Both of them have recently bought an equipment for treatment of patients. Dr. Aggarwal has decided to write-off an equal amount of depreciation every year while Dr. Mehta wants to write-off a larger amount in earlier years. They do not know anything about the methods of depreciation. Who is wise in your opinion? Give reasons in support of your answer. (Written down value method is more appropriate because this method is suitable for those assets which are affected by technological changes. Moreover, this method is recognised by income tax hand.)
Test Your Understanding – IV
Basaria Confectioner bought a cold storage plant on July 01, 2014 for Rs.1,00,000.
Compare the amount of depreciation charged for first three years using:

  1. Rate of depreciation @ 10% on original cost basis;
  2. Rate of depreciation @ on written down value basis;
  3. Also, plot the computed amount of depreciation on a graph.
Accounting Period Ending Basis
Original Cost Written Down Value
31 March, 2015 7,500 7,500
31 March, 2016 10,000 9,250
31 March, 2017 10,000 8,325


Test Your Understanding – V

  1. State with reasons whether the following statements are True or False ;
    • Making excessive provision for doubtful debits builds up the secret reserve in
      the business. (✔ True)
    • Capital reserves are normally created out of free or distributable profits. (❌ False)
    • Dividend equalisation reserve is an example of general reserve. (❌ False)
    • General reserve can be used only for some specific purposes. (❌ False)
    • ‘Provision’ is a charge against profit. (✔ True)
    • Reserves are created to meet future expenses or losses the amount of which is not certain. (❌ False)
    • Creation of reserve reduces taxable profits of the business.(❌ False)
  2. Fill in the correct words :
    • Depreciation is decline in the value of ……….. (Assets)
    • Installation, freight and transport expenses are a part of ……….. (Acquisition Cost)
    • Provision is a ……….. against profit. (Charge)
    • Reserve created for maintaining a stable rate of dividend is termed as……….. (Dividend equalization fund)
Short Answer Questions
What is Depreciaion?
Depreciation refers to the measure by which a depreciable asset has been

  1. worn out
  2. consumed
  3. undergone any other loss of value

as a result of

  1. regular use
  2. effluxion of time
  3. obsolescence through advancement in the technology or market-changes

State briefly what is the need of providing depreciation.
Depreciation is needed to be provided due to the following reasons.

  1. Matching costs and revenue: The businesses acquire the fixed assets primarly to use them in earning the revenue. Once the business starts using the asset, the asset will go through depreciation. So, like other expenses depreciation is a charge against revenue generated in the corresponding period and must be deducted before calculating the net profit in accordance with the Generally Accepted Accounting Principles.
  2. Consideration of Tax: Depreciation comes under the costs that can be deducted for tax purposes. However, to qualify for the tax deduction the method used for calculating the depreciation should be the one that is approved under tax rules.
  3. True and Fair Financial Position: When the depreciation is accounted for, then only the balance sheet reflect the exact financial position of the business. Otherwise, the assets will be overvalued. Also, calculation of depreciation is in accordance with the established accounting practices or by specific provisions of law.
  4. Compliance with law: It is not just the tax regulations but there are few other specific legislations that will indirectly compel that the depreciation on fixed assets should be provided for by some businesses.
What are the causes of depreciation?
The following are the causes of depreciation.

  1. Wear and Tear due to use or Passage of time: As the assets are used in the business operations to earn revenue, they naturally will wear and tear and diminish in value. The wear and tear results in reduction in the technical capacity. Few assets, even though they’re not put to use and do not go through wear and tear will still diminish in value with the passage of time, especially when they are exposed to severe natural conditions like weather, wind, rains etc.
  2. Expiration of Legal Rights: Few categories of assets like copyrights, legal, patents etc lose their value as soon as the agreemenet that gives legal rights to use these assets in the business will expire after expiry of their valid period.
  3. Obsolescence: Obsolescence is synonymous to being Out-of-Date. As soon as an asset with better features is available in the market, the existing asset becomes Obsolete. Few of the factors that contribute to obsolescence are:
    1. Availability of improved production methods.
    2. Better technology has arrived into the market.
    3. Change in the demand for the product or service produced by this asset
    4. Description of legal or other definitions are changed.
  4. Abnormal factors: Losses due to abnormal factors like earth quakes, floods, fire etc is permanent. It is not gradual like other causes of depreciation. This will decrease the usefulness of the asset.
Explain basic factors affecting the amount of depreciation.

The following are the basic factors affecting the amount of depreciation.

  1. Cost of Asset: The cost of a fixed asset is the total cost spent in connection with its acquisition, installation and commissioning as well as for addition (such as software addition etc.) or improvement (like the initial repair cost to put the asset to use in case it is a second hand asset) of the fixed asset. The depreciation is directly proportional to the cost of the asset and hence the cost is one of the basic factors affecting the amount of depreciation.
  2. Estimated Net Residual Value: Net resitual value is also known as scrap value or salvage value is the net realisable value or sale value of the asset at the end of its useful life. if there are any expenses for disposing the asset, then the net residual value is calculated after subtracting these expenses. If the net residual value is more, it will slightly reduce the amount of depreciation and vice versa. Thus net residual value is also one of the basic factors affecting the amount of depreciation.
  3. Estimated Useful Life: This is the estimated economic or commercial life of the asset and is defind as the period over which the fixed asset is expected to be used by the enterprise. This is not the same as the physical life of the asset. This can expresessed interms of the number of years or even the number of units of output (mostly applied in case of mines) or even the number of working hours. Thus the estimated useful life of the asset is also one of the basic factors affecting the amount of dpreciation.
Distinguish betweeen the straight line method and written down value method of calculating the depreciation.
The following are the differences between the straight line method and written down value method of calculating the depreciation.

Basis of Difference Straight Line Method Written Down Value Method
1. Basis of charging depreciation. Original cost Book value i.e. original cost minus the depreciation charged till date.
2. Annual depreciation charge. Fixed or constant each year. Reduces year after year.
3. Total charge against profit and loss account with respect to the depreciation and repairs. Smaller during initial years and increases during later years. Remains almost the same each year.
4. Recognition by income tax law. Not recognised. Recognised.
5. Suitability Can be applied for assets in which the repair charges are less and the possibility of obsolescence is low and scrap value depends on the time period involved. Suitable for assets which are affected by technological changes and require more repair expenses with the passage of time.
“In case of a long term asset, repair and maintenance expenses are expected to rise in later years than in earlier years”. Which method is suitable for charging depreciation if the management does not want to inrease burden on profit and loss account on account of depreciation and repair.
If the management does not want to increase burden on profit and loss account on account of depreciation and repair, they should adopt the Written Down Value Method where in the sum of depreciation and repair charges remain aproximately the same over the estimated useful life of the asset.
What are the effects of depreciation on profit and loss account and balance sheet?
Effect of depreciation on profit and loss account: Depreciation is debited in the profit and loss account. So, if the depreciation considered is more, it will result in projection of more expenses resulting in an excess debit balance.
Effect of depreciation on balance sheet: An increase in depreciation results in lower book value of the asset. Due to this the asset side of the balance sheet will be reduced.
Distinguish between provision and reserve.

The following are the differences between provisions and reserves.

Basis of difference Provision Reserve
1. Basic nature Charged against profit. Appropriation of profit.
2. Purpose It is maintained to meet a specific liability or expense under the current accounting period and the amount of which is not known. It is created to strengthen the financial position of the business and at times to follow the mandatory laws.
3. Effect on taxable profits. Lowers the taxable profits. Does not impact the taxable profits.
4. Representation in balance sheet. It is reflected in the balance sheet either by

  1. by way of deduction from the item on the asset side for which it is created.
  2. in the liabilities side along with the current liabilities.
Shown on the liabilities side after capital amount.
5. Element of compulsion Creation of provision is necessary to ascertain tru and fair profit or loss in compliance with the Prudence or Conservatism concept. It should be considered even if there are no profits. Creation of reserve is left to the descretion of the management. This can only be created when there are profits. However, creation of Debenture, Redemption reserves is mandatory as per the law.
6. Use for the payment of dividend Can not be used for distributing the dividends. Can be used for distributing the dividends.
Give four examples each of Provision and Reserves.
Examples of Provision:

  1. Provision for bad and doubtful debts
  2. Provision for depreciation
  3. Provision for discount on debtors
  4. Provision for repairs and renewals
  5. Provision for taxation

Examples of Reserves:

  1. Capital Reserve
  2. Dividend Equalisation Reserve
  3. General Reserve
  4. Investment fluctuation fund
  5. Provision for taxation
  6. Reserve for redemption of debenture
Distinguish between revenue reserve and capital reserve.

The following are the differences between revenue reserve and capital reserver.

Basis of Difference Revenue Reserve Capital Reserve
1. Source of creation Revenue profits which results from regular opertating activities of the business are used to create the revenue reserves by cutting down from the dividend distribution Capital reserves are created from the capital profit. It should be noted that the capital profit does not arise out of the normal operating activities of the business and is not used for dividend distribution. However, if required, the revenue profits can also be used to create capital reserve.
2. Purpose Revenue reserves are created to strengthen the financial position, to meet unforeseen contingencies or for some specific purposes. Capital reserves are created to comply with the legal requirements or accounting practices.
3. Usage General reven reserves can be used for any purpose including the dividend distribution. A specific revenue reserve can be used only for the intended purpose and can not be used for any other purpose. Capital reserve can be utilized for specific purposes specified in the law. For instance, it can be used to write off capital losses or issue of bonus shares.
Give four examples each of revenue reserve and capital reserve.
Examples of revenue reserves:

  1. Debenture redemption reserve
  2. Dividend equalisation reserve
  3. General reserve
  4. Investment fluctuation fund
  5. Workmen compensation fund

Examples of capital reserve:

  1. Premium on issue of shares or debentures
  2. Profit prior to incorporation
  3. Profit on redemption of debentures
  4. Profit on reissue of forfeited shares
  5. Profit on revaluation of fixed assets and liabilities
  6. Profit on sale of fixed assets.
Distinguish between general reserve and specific reserve.
The following are the differences betweeen general reserve and specific reserve.

Basis of Difference General reserve Specific Reserve
1. Purpose The purpose for which the reserve is created is not specified. The reserve is created for some specific purpose.
2. Usage Can be freely used for any purpose. Can not be used for any purpose other than the specific purpose for which it is created.
3. Financial position They can be used to meet and congingencies in the future or for the growth and expansion of the business. Can be used, only if required, for purposes other than the specific purpose for which they are created. This is bound to permission by law.
Explain the concept of secret reserve.

Secret reserve is a reserve that is omitted from the balance sheet and is called so as it is not know to the outside stakeholders.It helps to reduce the profits projected and hence the payable tax. Companies use this reserve to merge with the profits during the lean periods and project improved profits. Secret reserves within reasonable limits is justifiable for the sake of expediency, prudence and preventing competition from other companies. It can be created in the following ways:

  1. Charging higher depreciation
  2. Charging capital expenditure on profit and loss account
  3. Excessive provision for doubtful debts
  4. Showing contingent liabilities as actual liabilities
  5. Undervaluation of stock or inventory.
Long Answers

Explain the concept of depreciation. What is need for charging the depreciation and what are the causes of depreciation.
Concept Definition: Depreciation refers to the measure by which a depreciable asset has been

  1. worn out
  2. consumed
  3. undergone any other loss of value

as a result of

  1. regular use
  2. effluxion of time
  3. obsolescence through advancement in the technology or market-changes

Need for charging the depreciation:

  1. Matching costs and revenue: The businesses acquire the fixed assets primarly to use them in earning the revenue. Once the business starts using the asset, the asset will go through depreciation. So, like other expenses depreciation is a charge against revenue generated in the corresponding period and must be deducted before calculating the net profit in accordance with the Generally Accepted Accounting Principles.
  2. Consideration of Tax: Depreciation comes under the costs that can be deducted for tax purposes. However, to qualify for the tax deduction the method used for calculating the depreciation should be the one that is approved under tax rules.
  3. True and Fair Financial Position: When the depreciation is accounted for, then only the balance sheet reflect the exact financial position of the business. Otherwise, the assets will be overvalued. Also, calculation of depreciation is in accordance with the established accounting practices or by specific provisions of law.
  4. Compliance with law: It is not just the tax regulations but there are few other specific legislations that will indirectly compel that the depreciation on fixed assets should be provided for by some businesses.

Causes of depreciation:

  1. Wear and Tear due to use or Passage of time: As the assets are used in the business operations to earn revenue, they naturally will wear and tear and diminish in value. The wear and tear results in reduction in the technical capacity. Few assets, even though they’re not put to use and do not go through wear and tear will still diminish in value with the passage of time, especially when they are exposed to severe natural conditions like weather, wind, rains etc.
  2. Expiration of Legal Rights: Few categories of assets like copyrights, legal, patents etc lose their value as soon as the agreemenet that gives legal rights to use these assets in the business will expire after expiry of their valid period.
  3. Obsolescence: Obsolescence is synonymous to being Out-of-Date. As soon as an asset with better features is available in the market, the existing asset becomes Obsolete. Few of the factors that contribute to obsolescence are:
    1. Availability of improved production methods.
    2. Better technology has arrived into the market.
    3. Change in the demand for the product or service produced by this asset
    4. Description of legal or other definitions are changed.
  4. Abnormal factors: Losses due to abnormal factors like earth quakes, floods, fire etc is permanent. It is not gradual like other causes of depreciation. This will decrease the usefulness of the asset.
Discuss in detail the straight line method and writtend down value method of depreciation. Distinguish between the two and also give situations where they are useful.

Method 1: Straight Line Method: In this method, a fixed and equal amount is charged as depreciation in every accounting period throughout the lifetime of the asset. The depreciation amount is charged in such a way that it reduces the original cost of the asset to its scrap value a the end of the useful life of the asset. This method is known as the straight line method owing to the fact that when a graph is plotted depicting the amount of depreciation and corresponding time period it forms a straight line. As the amount of depreciation remains constant, this method is also known as fixed installment method. On a similar note, as the percentage of depreciation remains same, it is also called as fixed percentage on original cost method.
The depreciation amount is computed using the formula:

Depreciation =
Cost of asset – Estimated Residential value
Estimated useful life of the asset

In this method, the rate of depreciation is defined as the percentage of the total cost of the asset to be charged as depreciation during the useful lifetime of the asset i.e.,

Rate of Depreciation =
Anual depreciation amount
Acquisition cost
× 100

This method is the earliest methods of computing the depreciation and is one of the widely used ones.
Advantages:

  1. Applicable for assets whose useful life can be estimated accurately and where in the asset will be used consistently over the years such as leasehold buildings
  2. As it is simple, it can easily understood and applied. Due to this reason it became popular.
  3. Comparision of profits during different years is easier as the depreciation charged in profit and loss account remains the same over the years.
  4. As it is possible to depreciate the asset to net scrap value or zero value, the depreciable cost can be fully distributed over the useful life of the asset.

Disadvantages:

  1. This method is falsely based on the assumption that the utility of the asset remains the same during different accounting periods.
  2. As the time passets, the asset becomes less work efficient and requires more repair and maintenance expenses. Due to this reason, the total amount charged against profit considering both depreciation and repair will increase from year to year.

Method 2: Written Down Value Method: This method is based on the assumption that the benefit accruing to the business from the assets keeps on diminishing as the asset becomes old. In this method depreciation is calculated by considering a pre-determined proportion or percentage of the book value of the asset at the beginning of the accounting period. As such, the amount of depreciation reduces from year to year. This is due to the fact that a pre-determined percentage is applied to a gradually reducing balance on the asset account every year. Due to this reason, a large amount is recovered as depreciation charge during initial years than in later years. As the book value reduces after charging the depreciation, this method is also known as reducing balance method or reducing installment or diminishing value method.
In this method, the rate of depreciation is calculated using the formula
Where

R = Rate of depreciation
n = Expected useful life
s = scrap value
c = Cost of an asset

Advantages:

  1. This method is more realistic in assuming that the usability of the asset will diminish with the passage of time. So, the cost is properly allocated because the depreciation charged is more during the initial years when the usability of the asset is more as compared to later years where in the usability of the asset is less effective.
  2. The charges against the profit on account of depreciation and repair expenses combined will remain the same and the same is reflected in the profit and loss account.
  3. Approved by Income Tax Act for tax calculations
  4. Most of the cost is recovered in the initial years and this reduces the loss due to obsolescence.
  5. This method suits more for fixed assets which have longer estimated useful time and which require increased repair and maintenance expenses with the passage of time. It can also be used where obsolescence rate is higher.

Disadvantages:

  1. Ascertaining a suitable rate of depreciation is difficult.
  2. As depreciation is computed at fixed percentage of written down value, the depreciable cost of the asset cannot be fully written-off. In otherwords, the book value never reaches zero.

The following are the differences between the straight line method and written down value method of calculating the depreciation.

Basis of Difference Straight Line Method Written Down Value Method
1. Basis of charging depreciation. Original cost Book value i.e. original cost minus the depreciation charged till date.
2. Annual depreciation charge. Fixed or constant each year. Reduces year after year.
3. Total charge against profit and loss account with respect to the depreciation and repairs. Smaller during initial years and increases during later years. Remains almost the same each year.
4. Recognition by income tax law. Not recognised. Recognised.
5. Suitability Can be applied for assets in which the repair charges are less and the possibility of obsolescence is low and scrap value depends on the time period involved. Suitable for assets which are affected by technological changes and require more repair expenses with the passage of time.

Suitability of straight line method: Straight line method is more suitable to be used in:

  1. Freehold land
  2. Buildings
  3. Capitalized software
  4. Patents
  5. Trademarks

Suitability of Written Down Value method: Written down value method is more suitable to be used in:

  1. Plants
  2. Machinery
  3. Vehicles
Describe in detail the two methods of recording depreciation. Also, give the necessary journal entries.

The following are the two methods of recording depreciation.
Method 1: Charging depreciation to Asset Account:
As per this method, the depreciation is deducted from the depreciable cost of the asset (credited to the asset account) and charged (or debited) to profit and loss account. The following are the corresponding journal entries.

1. For recording the purchase of the asset.
Asset A/c
Dr
To Bank/Vendor A/c
(Being the asset purchased (only in the year of purchase) with the cost including installation, freight etc.)

2. Following two entries are recorded at the end of every year.
a. For deducting the depreciation amount from the cost of the asset.
Depreciation A/c
Dr
To Asset A/c
(Being the amount of depreciation charged.)

b. For charging depreciation to profit and loss account.
Profit & Loss A/c
Dr
To Depreciation A/c
(Being the amount of depreciation charged.)

3. Balance Sheet Treatment:
In this method, the fixed asset appears at its net book value (i.e. cost minus the depreciation charged so far) on the asset side of the balance sheet and not at its original/historical cost.

Method 2: Creating provision for Depreciation Account / Accumulated Depreciation Account:
In this method, a separate account named Provision for Depreciation or Accumulated Depreciation account is maintained to accumulate the depreciation charged on an asset. When this account is used, the asset account is not disturbed and it continues to show at its original cost year after year during the useful life of the asset. The basic characteristics of recording using this method are:

  1. Asset account continues to appear at its original cost year after year over the estimated useful life of the asset.
  2. Depreciation is recorded and accumulated in a different account instead of in the asset account at the end of each accounting period.

The following are the correponding journal entries.

1. For recording the purchase of the asset.
Asset A/c
Dr
To Bank/Vendor A/c
(Being the asset purchased (only in the year of purchase) with the cost including installation, freight etc.)

2. Following two entries are recorded at the end of every year.
a. For crediting the depreciation amount to provision for depreciation account.
Depreciation A/c
Dr
To Provision for depreciation A/c
(Being the amount of depreciation charged.)

b. For charging depreciation to profit and loss account.
Profit & Loss A/c
Dr
To Depreciation A/c
(Being the amount of depreciation charged.)

3. Balance Sheet Treatment:
In this method, the fixed asset continues to appear at its original cost on the asset side. The depreciation charged till date appears in the provision for depreciation account, which is recorded either on the liabilities side of the balance sheet or by way of deduction from the original cost of the asset concerned on the asset side of the balance sheet.
Explain determinants of amount of depreciation.
The following are the determinants of the amount of depreciation.

  1. Cost of Asset: The cost of a fixed asset is the total cost spent in connection with its acquisition, installation and commissioning as well as for addition (such as software addition etc.) or improvement (like the initial repair cost to put the asset to use in case it is a second hand asset) of the fixed asset. The depreciation is directly proportional to the cost of the asset and hence the cost is one of the basic factors affecting the amount of depreciation.
  2. Estimated Net Residual Value: Net resitual value is also known as scrap value or salvage value is the net realisable value or sale value of the asset at the end of its useful life. if there are any expenses for disposing the asset, then the net residual value is calculated after subtracting these expenses. If the net residual value is more, it will slightly reduce the amount of depreciation and vice versa. Thus net residual value is also one of the basic factors affecting the amount of depreciation.
  3. Estimated Useful Life: This is the estimated economic or commercial life of the asset and is defind as the period over which the fixed asset is expected to be used by the enterprise. This is not the same as the physical life of the asset. This can expresessed interms of the number of years or even the number of units of output (mostly applied in case of mines) or even the number of working hours. Thus the estimated useful life of the asset is also one of the basic factors affecting the amount of dpreciation. This useful life again depends on the following factors:
    1. Innovation/improvement in the production method.
    2. Legal or other restrictions
    3. Pre-determined by legal or contractual limits, e.g. in case of leasehold asset, the useful life is the period of lease.
    4. Repairs and maintenance policy of the business organisation.
    5. Technological obsolescence
    6. The number of shifts during which the asset is put to use.
Name and explain different types of reserves in detail.

Reserves are created by retaining profit of the business and classified as general and specific reserves.

  1. General reserve: When the purpose for which reserves are created are not specified, such reserves are treated as General Reserves. As these reserves can be freely utilized by the management for any purpose, they are also called as free reserves. These reserves strengthen the financial position of the business.
  2. Specific reserves: A reserve created specifically for a specific purpose is called as Specific reserve These reserves can be utilized only for the specific purpose for which they are created. The following are few examples.
    1. Dividend equalisation reserve: This reserve helps in stabilising or maintaining a dividend rate. This is achieved by transferring the profits to the Dividend Equalisation reserve during high profit years and then using them to maintain the rate of dividend during low profit years.
    2. Workmen compensation fund: This reserve helps to meet the claims of the workers due to accidents.
    3. Investment fluctuation fund: This reserve helps decline the value of investment under fluctuating market conditions.
    4. Debenture redemption reserve:This reserve helps to provide funds for redemption of debentures.

Apart from the above general or specific types of reserves, they can be further classified as revenue and capital reserves based on the nature of profit out of which they are created.

  1. Revenue reserves: Revenue reserves are created from the revenue profits which are derived from the normal operating activities of the business. These profits, if not reserved as revenue reserves, would have been used for distribution as dividend. The following are examples:
    1. General Reserve
    2. Investment fluctuation fund
    3. Debenture redemption reserve
    4. Dividend equalisation reserve
    5. Workmen compensation fund
  2. Capital reserves: Capital reserves are created from the capital profits which are not resulted from the normal operating activities of the business. These reserves can not be used for distribution of dividend. They are used to write off capital losses or issue of bonus shares in the company. The following are the examples of capital reserves:
    1. Premium on issue of shares or debentures
    2. Profit on redemption of debentures
    3. Profit on reissue of forfeited shares
    4. Profit on revaluation of fixed assets and liabilities.
    5. Profits prior to incorporation
    6. Profits on sale of fixed assets.
What are provisions? How are they created? Give accounting treatment in case of provision for doubtful debts.
The amount of certain expenses/losses which are related to the current accounting period are not known with certainity as they are not yet incurred. To arrive at the true net profit the business should make a provision for these expenses/losses. For instance, when the business is done on credit basis, it is not know with certainity that whether the debtor would pay only partially or would default. So it is necessary to take the into account such an expected loss while computing the true and fair profit/loss. To take care of these expected losses at the time of realisation from the debtors, the business creates a Provision for Doubtful Debts. This is in accordance with the principle of Prudence or Conservatism.
The following are few more examples:

  1. Provision for bad and doubtful debts.
  2. Provision for depreciation
  3. Provision for discount on debtors
  4. Provision for repairs and renewals
  5. Provision for taxation

It must be noted that this provision is a charge agains revenue of the current period. It ensures that there is proper matching of revenues and expenses and helps in arriving at true profits. These provisions are created by debiting the profit and loss account. These provisions can be shown in the balance sheet either

  1. By deducting from the respective asset on the assets side. For instance, provision for doubtful debts is projected by deducting from the amount of sundry debtors and provision for depreciation can be projected by deducting from the corresponding fixed asset.
  2. By including on the liabilities side of the balance sheet along with current liabilities. For instance provision for repairs and renewals and provision for taxes.

Accounting Tratment for Provision of Doubtful Debts: Doubtful debts are those debts which can be paid by the debtors but the business is not sure whether they pay the full amount or not. It is known from the business experience that that certain percentage of sub debtors are not likely to pay the debts and hence treated as doubtful debt. To consider this, a suitable provision for doubtful debts is made at the time of ascertaining true profit or loss. First all the bad debts are written off. Then doubtful debts are calculated as a certain percentage of rest of the amount due from the sundry debtors. It is also know as Provision for bad and doubtful debts. To create it is debited from the profit and loss account and credited to the provision for doubtful debts account.
The following is the journal entry

Profit and Loss A/c
Dr
To Provision for doubtful debts A/c
(Being provision with the amount related to the doubtful debts)