Depreciation, Reserves and Provision

In this chapter, we will discuss auditing related to Depreciation, Reserves and Provision. We will proceed by discussing Depreciation and move on to discussing Reserves and Provision further.

What is Depreciation?

Value of depreciation reduces the value of assets on residual basis and also the current year profits.

Depreciation indicates the reduction in value of any fixed assets. Reduction in value of assets depends on the life of assets. Life of assets depends upon the usage of assets.

There are many deciding factors which ascertain the life of assets; in case of a building, the deciding factor is time, the deciding factor for leased assets is the lease period, the deciding factor for plant and machinery is both production and time. There may be many factors but ascertainment of life should be based on some reasonable basis.

Reason of Depreciation

Following are the main causes of depreciation −

Wear and Tear

One of the main reasons of depreciation is normal wear & tears, it depends upon the usage of machinery. More the machinery is in use, more will be the wear and tear. Wear and tear of a machine in use for one shift will be less than with a machine being used in two shifts.

Exhaustion

Some assets may lose their value due to consumption, for example, mines, quarries, oil walls and forest stands. Due to continuous extraction a stage will come where all above are completely exhausted

Obsolescence

New technology or invention may bring down the value of old asset and outdated technology become cheaper. For example, television became obsolete with the introduction of new LED Television, the users are discarded old televisions although they are in good condition.

Effusion of Time

Value of assets may reduce over a passage of time. For example, a patent becomes useless after expiry of the period of patent.

Other Causes

  • Assets also lose their value due to weather conditions.
  • Market value of assets may fall down drastically.
  • Accidents also lead to a decrease in the value of assets.

Need for Depreciation

  • To ascertain the true profit of the year, it is desirable to charge depreciation.
  • To ascertain true value of assets, depreciation should be charged and without correct value of assets, true financial position of the company cannot be ascertained.
  • Instead of withdrawal of overstated profit, it is desirable to make provisions to buy new asset and replace the old asset. Accumulated value of depreciation provides additional working capital.
  • Depreciation help us to ascertain uniform profit in each accounting year.
  • Depreciation is also useful to gain advantage o tax benefits.

Basis of Depreciation

The important factors related to the depreciation chargeable are as follows −

  • Cost of Asset or Value of Asset
  • Estimated life of an asset
  • Scrap value of asset
  • Addition and extension in asset along with date
  • Provision of Companies Act and Income Tax Act for providing depreciation
  • Working hours of an asset
  • Working conditions of organization and handling skill of operator
  • Major repairing that increases the life of an asset
  • Chances of obsolescence of an asset

Depreciation Methods

Following are the methods of depreciation −

  • Straight line method
  • Written down value method
  • Annuity method
  • Insurance policy method
  • Machine hour rate method
  • Depletion method
  • Revaluation method
  • Depreciation fund method
  • Mileage method
  • Production unit method
  • Global method
  • Accelerated Method
  • Double-declining Method
  • Year’s digit method

Depreciation may be charged by applying any of the above methods. We will discuss a few important methods −

Straight Line Method

Under this method, fixed amount of depreciation is charged every year. The formula to determine the amount of depreciation is as follows;

Depreciation=CostofAssestScrapValueEstimatedLifeofanAssest

 

Written Down Value Method

It is also called the Diminishing Balance or the Reducing Balance Method. Under this method, a fixed percentage of depreciation is charged on written down value of asset. Written down value of asset means (Cost of asset – depreciation).

Auditor’s Duty Regarding Depreciation

The Auditor cannot be held responsible for estimating the working life of an asset; it is the job of an expert valuer.

  • A company can adopt different methods for different type of assets provided that the methods are adopted consistently over the years.
  • If a company opts to choose new depreciation methods, then depreciation should be recalculated applying new methods from the date on which the asset is put to use for the first time. The difference of amount of depreciation as charged with old rate and the amount calculated from new rate should be debited to profit and loss account in case of loss and difference should be credited to general reserve in case of profit.
  • According to Schedule II of the Companies Act, if asset is sold or discarded during the year, depreciation will be charged on pro-rata basis up to date of sale or discard. Similarly, depreciation will be charged on pro-rata basis, in case of addition to fixed asset.
  • Account must disclose method of depreciation.
  • Depreciation must be according to provisions of Companies Act and Income Tax Act.
  • If depreciation is charged more than prescribed rate, Auditor should examine whether it is based on some professional and technical advice.
  • Depreciation should be charged on revalued amount, if there is revaluation of assets.

What is Provision?

Provisions means “any amount written off or retained by way of providing depreciation, or diminution in the value of assets or for providing any known liability of which the amount cannot be determined with substantial accuracy.” –

The Institute of Chartered Accountants of India

Debiting Profit and Loss account, provisions are created and shown either by deduction on the assets side or on the liabilities side under relevant subheads in the balance sheet.

Provision for bad and doubtful debts, provisions for repair & renewals, provision for discounts and depreciation are the most common examples of provision.

What are Reserves?

Reserve is an appropriation of profit and on the other hand, provision is a charge against profit. Reserves are not meant to meet out contingencies or liabilities of business. Reserve increases working capital of a company to strengthen the financial position. There are two types of reserves −

Capital Reserve

Capital reserve is not readily available for distribution as dividends among the shareholders of the company and it is created only out of capital profit of the company; this works like premium on issue of shares or debentures and Profit prior to incorporation.

Revenue Reserve

Revenue reserves are readily available for distribution of profit as dividend to the shareholders of the company. Some of the examples of revenue reserves are – general reserve, staff welfare fund, dividend equalization reserve, debenture redemption reserve, contingency reserve, and investment fluctuation reserves.

Auditor’s Duty Regarding Capital Reserves

Auditor should examine the following −

  • Capital reserve can be created out of capital gains only.
  • If the Article of the company permitted, capital reserve can be utilized for the distribution of dividends.
  • Capital reserve should be shown separately from revenue reserve and general reserve in the balance sheet.

Secret Reserves

Banking companies, insurance companies and electricity companies create secret reserves, where public confidence is required. In this case, to create secret reserve assets are shown at lower cost or liabilities at higher value; following examples will help you understand how this is done −

  • By undervaluing goodwill or stock.
  • By excessive depreciation.
  • By creating excessive provisions.
  • Showing free reserves as creditors.
  • By charging capital expenditure to profit and loss account.

Auditor’s Duty Regarding Secret Reserves

Duties of Auditors regarding secret reserves are as follows −

  • Creation of secret reserve is not permitted by the Companies Act.
  • Only Banking Company, Insurance Company and Electricity companies are allowed to create secret reserve.
  • In some cases where the creation of secret reserves is allowed under the Companies Act, the Auditor should examine the necessity of creating such a reserve. If the Auditor is satisfied he need not to qualify his report.

General and specific Reserves

Specific reserves are created and utilized for the purpose only for which they are created like dividend equalization reserve and debenture redemption reserve.

General reserves are created for any future contingency or to utilize at the time of expansion of business. The purpose behind the creation of general reserve is to strengthen the financial position of the company and to increase the working capital.

Auditor’s Duty Regarding General Reserves

There is no liability on the Auditor’s part to report on the creation, adequacy or inadequacy of such reserve. He may advice to the management towards the long term interests of the company.

Auditor’s Duty Regarding Specific Reserves

The Auditor should examine that specific reserve should not be available for distribution as this reserve is meant to meet out specific liabilities only.

Sinking Fund

Sinking funds are of great help when it comes to repayment of liabilities or replacement of fixed assets, for this some amount is charged or appropriated from profit and loss account every year and invested in any outside securities. Without any extra ordinary burden, replacement of asset may be done in a systematic manner or pay any known liability on maturity of sinking fund.

Auditor’s Duty Regarding Sinking Fund

Following are the duties of an Auditor regarding sinking fund −

  • Sinking fund should be shown separately in the Balance-sheet.
  • Purpose of fund should be clearly indicated.
  • It should be according to Article of Association and the Trust Deed meant for this purpose.

Investment of Reserves

It is a controversial issue, whether reserve should be invested in outside securities or not. Thus, to decide anything, it is important to study the needs and the requirements of a firm according to financial position of a firm. Therefore, investment in outside securities is justified only in case where company have extra fund to invest.

Nature of Reserve

In spite of showing reserves on the liabilities side of a balance sheet, reserves are actually not at all any liabilities of a firm. Reserves represent accumulated profits which are available to be disbursed among shareholders −

Distinction between Provisions and Reserves

  • Reserves can be made only out of profit and provisions are a charge to profit.
  • Reserves reduced divisible profits and provisions reduce the profit.
  • Reserves, if remain unutilized for some period can be distributed as dividends but provisions cannot be transferred to General Reserve for distribution.
  • Purpose of provision is very specific but reserve is created to meet out any probable future liabilities or losses.
  • Creation of provisions is legally necessary but reserves are created to save a concern from future losses and liabilities.