General reserve is the part of profits or money kept aside to meet future uncertainties and obligations of the entity. General reserve is created out of revenue profits for unspecified purposes and therefore is also a part of free reserves. General reserve forms a part of the Profit & Loss ApprRead more
General reserve is the part of profits or money kept aside to meet future uncertainties and obligations of the entity. General reserve is created out of revenue profits for unspecified purposes and therefore is also a part of free reserves.
General reserve forms a part of the Profit & Loss Appropriation account and is created to strengthen the financial position of the entity and serves as a sources of internal financing. It is upon the discretion of the management as to how much of a reserve is to be created. No reserve is created when the entity incurs losses.
General reserve is shown in the Reserves & Surplus head on the liability side of the balance sheet of the entity and carries a credit balance.
Suppose, an entity, ABC Ltd engaged in the business of electronics earns a profit of 85000 in the current financial year and has an existing general reserve amounting to 100000. The management decides to keep aside 20% of its profits as general reserve.
Then the amount to be transferred to general reserve will be = 85000*20% = 17000.
In the financial statements it will be shown as follows-
Now, in the next financial year, the entity incurs losses amounting to 45000. In this case, no amount shall be transferred to the general reserve of the entity and will be shown in the financial statement as follows-
The creation of general reserve can sometimes be deceiving since it does not show the clear picture of the entity and absorbs losses incurred.
The main objective of depreciation is to calculate net profit. Depreciation is an expense allowed on the fixed assets of an entity to provide for the cost of benefit utilized by the entity in that particular year. Since the such assets are used for more than one financial year, profits for the furthRead more
The main objective of depreciation is to calculate net profit.
Depreciation is an expense allowed on the fixed assets of an entity to provide for the cost of benefit utilized by the entity in that particular year. Since the such assets are used for more than one financial year, profits for the further years would be misstated if such depreciation expense is not provided for.
Further, depreciation in no way shows previous profits or satisfies the tax department and a reduction in tax is secondary since it will only be allowed if charged in the profit & loss account. Thus, B is the correct answer.
2. Depreciation is generated due to wear and tear.
Depreciation is provided for to compensate for the wear and tear of the asset while being used by the entity. Depreciation is not generated due to increase in the value of liability, decrease in capital or decrease in the value of assets. Rather the vice versa is true, that is an increase in liability, decrease in capital and decrease in asset is created due to depreciation.
Thus, C is the correct answer.
3. The purpose of making a provision for depreciation in the accounts is to charge the cost of fixed assets against profits.
Fixed assets are long term assets with useful life of more than one accounting year and therefore the full cost of such assets are not provided for in the year of purchase rather a fixed portion is charged every year in the profit and loss account.
Thus, A is correct and others are incorrect.
4. According to the straight line method of depreciation, the depreciation remains constant.
In the straight line method of depreciation, depreciation is calculated on the historical or purchase cost of the asset and the same amount is charged every year till the useful value of the asset, thus depreciation remains constant.
Also, depreciation decreases each year in case of written down value method but depreciation can never increase. Thus, A is the correct answer.
5. Total amount of depreciation of an asset cannot exceed its depreciable value.
The depreciable value is the purchase cost of the asset less the scrap value. The total amount of depreciation can never exceed the depreciable value since depreciation is allowed on an asset till its useful life at a certain percentage. Even when the value of the asset becomes nil, no further depreciation would be charged and total depreciation would be equal to depreciable value but obviously cannot be more.
Thus, A is the correct answer and other are wrong.
6. According to fixed installment method, the depreciation is calculated on original cost.
In the fixed installment method, also known as the straight line method, depreciation is calculated on the basis of the original or purchase cost of the asset using the formula-
Depreciation = (Original cost – Scrap value)/Useful life of asset
Thus, B is the correct answer.
7. Salvage value means estimated disposal value.
Salvage value is the value of the asset that can be realized by the entity on its sale after the useful life of the asset has been exhausted and is now obsolete for the entity.
Salvage value is not definite but an estimation. Salvage value can be positive or nil but not negative. Thus, D is the correct option.
8. Depreciation is calculated under diminishing balance method, based on book value.
Under the diminishing value method, the depreciation is calculated at a certain percentage of the book value of the asset which is calculated after providing for depreciation in the previous year.
Depreciation cannot be calculated on scrap value since it is the disposable value of the asset and depreciation on original value is calculated under straight line method. Thus, B is the correct option.
9. Depreciation amount charged on a machinery will be debited to depreciation account.
Depreciation is an expense and depreciation account will be debited since depreciation is a nominal account, as per traditional method, and all expenses are debited. Also, as per modern rules of accounting, increase in expenses are debited.
When depreciation is charged there is a decrease in the value of assets therefore machinery account will be credit also depreciation cannot be classified under repair account or cash account heads. Thus, C is the correct option.
10. In accounting, becoming out of date or obsolete is known as obsolescence.
Amortization means decrease in the value of intangible assets of an entity. Depletion means exhaustion of existing wasting assets such as coal mines. Physical deterioration means fall in value of asset due to physical damage to the asset. Therefore, the correct answer is Obsolescence.
There are two types of ledger accounts in the accounting system – temporary and permanent. Temporary accounts are those whose balances zero out and we do not carry forward balances to the next year. Examples are revenue and expenses accounts or nominal accounts. The balances of such accounts are traRead more
There are two types of ledger accounts in the accounting system – temporary and permanent.
Temporary accounts are those whose balances zero out and we do not carry forward balances to the next year. Examples are revenue and expenses accounts or nominal accounts. The balances of such accounts are transferred to the profit and loss account and therefore are not balanced.
Permanent accounts are those whose balances are carried forward to the next accounting year in form of opening balances. These accounts are balanced and such balances are transferred to the balance sheet. Examples are assets, liability and capital accounts or personal and real accounts.
Balancing an account means equaling both the debit and the credit side of the account. Generally, there is a difference between the accounts recorded as a carry down balance in the case of permanent accounts and as a transfer balance in the case of temporary accounts.
Balancing serves as a check to the double-entry rule of accounting.
Balanced accounts
As discussed above, the balanced accounts are shown in the balance sheet and the balancing figure for such accounts are carried forward to the next accounting period.
Unbalanced accounts
As per the above discussion, the balancing figures of unbalanced accounts are transferred to the profit and loss account and no balances are carried forward to the next accounting period.
Suppose a company Shine Ltd. has machinery costing 5,00,000 at the beginning of the accounting period and charges depreciation of 10% on the asset. The company also has creditors amounting to 50,000 at the beginning of the period and purchases goods amounting to 30,000 on credit. It has a cash balance of 95,000 at the beginning of the period and earns interest amounting to 10,000.
Following ledgers would be prepared to record the above entries:
The above ledgers can be shown as follows:
The balance of the machinery account will be shown in the balance sheet and therefore it is a balanced account.
The balance is transferred to the profit and loss account and therefore depreciation account is an unbalanced account.
The balance of creditors account will be shown in the balance sheet and therefore it is a balanced account.
The balance is transferred to the profit and loss account and therefore purchases account is an unbalanced account.
The balance of the cash account will be shown in the balance sheet and therefore it is a balanced account.
The balance is transferred to the profit and loss account and therefore interest account is an unbalanced account.
Let us first understand the concepts of Amortization and Impairment. Amortization refers to the expense recorded on the decline of the value of intangible assets of a company. Intangible assets include goodwill, patents, copyrights, etc. It reflects the reduction in the value of Intangible assets ovRead more
Let us first understand the concepts of Amortization and Impairment.
Amortization refers to the expense recorded on the decline of the value of intangible assets of a company. Intangible assets include goodwill, patents, copyrights, etc. It reflects the reduction in the value of Intangible assets over its life span.
Amortization is similar to Depreciation, however, while depreciation is over tangible assets amortization is over Intangible assets of the company.
For example, Cipla Ltd. acquired a patent over a new drug for a period of 10 years. The cost of creating the new drug was 80,000 and the company must record its patent at 80,000. However, the company must amortize this cost by dividing the cost over the patent’s life, i.e., the amortization cost would be 8,000 (80,000/10) p.a. for the next 10 years.
Impairment means a decline in the value of fixed assets due to unforeseen circumstances. Assets are impaired when the carrying value of assets increases its market value or “realizable value” and such increase is recorded as an impairment loss.
Now suppose, Cipla Ltd. had existing machinery which suffered physical damage and is recorded at 50,000 in the books but the realizable value of the asset would only be 20,000. Hence, the asset would be written down to 20,000 and an impairment loss of 30,000 will be recorded.
Impairment Vs Amortization
Differences between the two can be shown as follows:
Amortization
Impairment
Amortization is a reduction in the value of Intangible Assets over their useful life.
Impairment is a reduction in the value of assets due to unforeseen circumstances.
Amortization is a continuous process and the value of an asset reduces over time.
Value of asset reduces drastically, creating a need to write down the value to its fair market value.
Amortization is charged annually.
Impairment is not an annual charge.
Amortization is shown as an amortization expense.
Impairment is shown as an impairment loss.
Reasons for amortization includes consumption, obsolescence, etc.
Reasons for impairment include damage to the asset, change in preferences, etc.
Amortization is charged on Intangible assets
Impairment is charged on fixed assets whether tangible or intangible.
Suppose Unilever Ltd. has a patent over one of its products for a period of 5 years. The cost of the patent was 1,00,000. Then after 2 years one of its rivals, say ITC Ltd., launches a new product which is more preferred by the consumers over the one produced by Unilever Ltd. and the fair market value of the patent of Unilever Ltd. changes to 10,000.
Now in this scenario, Unilever Ltd. would have amortized the patent (costing 1,00,000) at 20,000 (1,00,000/5) p.a. for 2 years and the book value at the end of the 2nd year is 60,000 (1,00,000 – 40,000). Now due to the new launch by ITC Ltd. the drastic change in the value of the asset from the book value of 60,000 to the realizable value of 10,000 will be recorded as an Impairment loss. Hence Impairment loss would be recorded at 50,000 (60,000 – 10,000).
Capital Expense Capital expenses are incurred for acquiring assets including incidental expenses. Such expenses increase the revenue earning capacity of the business. These are incurred to acquire, upgrade and maintain long term assets such as buildings, machines, etc and are non-recurring in natureRead more
Capital Expense
Capital expenses are incurred for acquiring assets including incidental expenses. Such expenses increasethe revenue earning capacity of the business. These are incurred to acquire, upgrade and maintain long term assets such as buildings, machines, etc and are non-recurring in nature.
Revenue Expenses
Revenue expenses are incurred to carry on operations of an entity during an accounting period. Such expenses help in maintaining the revenue earning capacity of the business and are recurring in nature.
These include ordinary repair and maintenance costs necessary to keep an asset working without any substantial improvement that leads to an increase in the useful life of the asset.
Suppose, company Takeaway ltd. purchases machinery for 50,000 and pays installation charges of 10,000. Salary of 15,000 is paid to the employees and existing machinery is painted costing 8,000. Here, the cost of machinery 50,000 and installation charges of 10,000 are treated as capital expenditure and the salary of 15,000 and painting cost of 8,000 is treated as revenue expenditure.
Identification
Points to categorize an expenditure as Capital or Revenue are as follows:
An expenditure that neither creates assets nor reduces liability is categorized as revenue expenditure. If it creates an asset or reduces a liability, it is categorized as capital expenditure.
For example, a company Motors ltd. purchases furniture for 65,000, repays loans amounting to 1,00,000 and pays salary of 25,000.
Here the company creates an asset of 65,000 and reduces liability by 1,00,000 as shown below and therefore is considered as capital expenditure.
However, payment of salaries neither creates assets nor reduces liability. It only reduces profits and therefore is considered as revenue expenditure.
Usually, the amount of capital expenditure is larger than that of revenue expenditure. But it is not necessary that if the amount is small it is revenue expenditure and if the amount is large, it is a capital expenditure.
For example, a company Stars ltd purchases machinery for 1,20,000, furniture for 35,000 and has a rental expense of 80,000.
Here, the purchase of machinery is capital expenditure since it results in higher expense. However, the purchase of furniture cannot be regarded as a revenue expense and payment of rent cannot be regarded as a capital expense only because the rental expense is higher than the amount expended for the purchase of furniture.
Usually, capital expenditure is not frequent and is made at a time, in lump sum. On the other hand, revenue expenditure is paid periodically. However, it is possible that capital expenditure is paid in installments.
For example, a company Caps ltd. purchases land for 1,00,00,000 on an equal monthly installment basis. Then such payments cannot be considered as revenue expense only because the payments are recurring. Since the installments are paid in lieu of the purchase of land which is a long term asset, the payments will be considered as capital expenditure.
Mostly capital expenditures are met out of capital whereas revenue expenditures are met out of revenue receipts. However, payments can be made vice-versa.
If an expenditure is incurred by the payer as a capital expenditure, it will remain a capital expenditure even if the amount may be revenue receipt in the hands of the payee.
For example, a company Marks Ltd. purchases machinery directly from the manufacturer for 50,000. For the manufacturer, the proceeds from the sale of machine are revenue in nature but the amount expended by Marks Ltd. will be categorized as capital expenditure.
Following conclusion can be inferred from the above explanation:
*Such transactions may or may not hold true as explained above.
What is Impairment of Assets? Impairment of assets means a decline in the value of assets due to unforeseen circumstances. Assets are impaired when the carrying value of assets increases its market value or “realizable value”. Impairment can be caused due to factors that are internal or external toRead more
What is Impairment of Assets?
Impairment of assets means a decline in the value of assets due to unforeseen circumstances. Assets are impaired when the carrying value of assets increases its market value or “realizable value”.
Impairment can be caused due to factors that are internal or external to the firm. Internalfactors such as physical damage, obsolescence or poor management and externalfactors such as a change in legal or economic circumstances, increased competition or reduction in asset’s fair value in the market result in impairment.
Impairment Vs Depreciation
Asset impairment is often confused with asset depreciation, which is rather a recurring and expected event, unlike impairment that reflects an abrupt decrease in the value of the asset.
Impairment Loss
Impairment is always treated as a loss in accounting. It is the amount by which the carrying value or the asset’s book value exceeds its fair market value.
Before recording Impairment loss, a company must determine the recoverable value of the asset which is higher of the asset’s net realizable value or value in use. Then it is to be compared with the book value of the asset.
If the carrying value exceeds the recoverable value then the impairment loss is to be recorded at the exceeding value i.e. difference of carrying value and realizable value.
Example
Suppose a company Royal Ltd. has an asset with a carrying value of 50,000, which has suffered physical damage. According to the company’s calculation, the asset has a net realizable value of 30,000 and a value in use of 25,000.
Then, the recoverable value would be higher of the asset’s net realizable value or value in use, i.e., 30,000 which is still lower than the carrying amount of 50,000. Therefore, Royal ltd. will have to record 20,000 (50,000-30,000) as impairment loss.
This is will increase Royal Ltd’s expenses by 20,000 and decrease the asset’s value by the same amount.
Depreciation refers to that portion of the value of an asset that a company uses in an accounting year to generate revenue. Assets are written off in form of depreciation over time also called the useful life of the asset. It denotes the wear and tear of an asset over time. Suppose, a company namedRead more
Depreciation refers to that portion of the value of an asset that a company uses in an accounting year to generate revenue. Assets are written off in form of depreciation over time also called the useful life of the asset. It denotes the wear and tear of an asset over time.
Suppose, a company named Johnson ltd. purchases machinery for 50,000 that has a useful life of 5 years with nil salvage value. Then the yearly depreciation to be charged can be calculated as:
Is Depreciation a Cash Flow?
Cash flows are inflows and outflows of cash and cash equivalents in an entity. The payments made by the entity denote the outflows whereas the revenues or incomes of the entity denote the inflows. Talking about cash flows, depreciation is a non-cash item of expense which means it neither results in inflow nor outflow of cash resources.
In the adjacent Profit and Loss statement, a cash payment of 7,000 for electricity implies outflow of cash however, depreciation of 10,000 is merely an imputed cost to write off an asset or we can say, a part of profits set aside each year so that there are sufficient funds available to procure a new asset after the currently available asset is discarded.
However, cash flow statements are affected by depreciation. Depreciation is added back to the net profits while calculating cash flows from operating expenses since it is a non-cash item and has been deducted while calculating net profits in the profit and loss statement.
Depreciation does not directly impact the amount of cash generated or expended by a business but it is tax-deductible and will reduce the cash outflows related to income taxes. Thus, depreciation affects cash flow by reducing the amount of cash a business has to pay for income taxes.
Let us first understand what working capital is. Working capital means the funds available for the day-to-day operations of an enterprise. It is a measure of a company’s liquidity and short term financial health. They are cash or mere cash resources of a business concern. It also represents the exceRead more
Let us first understand what working capital is.
Working capital means the funds available for the day-to-day operations of an enterprise. It is a measure of a company’s liquidity and short term financial health. They are cash or mere cash resources of a business concern.
It also represents the excess of current assets, such as cash, accounts receivable and inventories, over current liabilities, such as accounts payable and bank overdraft.
Sources of Working Capital
Any transaction that increases the amount of working capital for a company is a source of working capital.
Suppose, Amazon sells its goods for $1,000 when the cost is only $700. Then, the difference of $300 is the source of working capital as the increase in cash is greater than the decrease in inventory.
Sources of working capital can be classified as follows:
Short Term Sources
Trade credit: Credit given by one business firm to the other arising from credit sales. It is a spontaneous source of finance representing credit extended by the supplier of goods and services.
Bills/Note payable: The purchaser gives a written promise to pay the amount of bill or invoice either on-demand or at a fixed future date to the seller or the bearer of the note.
Accrued expenses: It refers to the services availed by the firm, but the payment for which is yet to be done. It represents an interest-free source of finance.
Tax/Dividend provisions: It is a provision made out of current profits to meet the tax/dividend obligation. The time gap between provision made and payment of actual payment serves as a source of short-term finance during the intermediate period.
Cash Credit/Overdraft: Under this arrangement, the bank specifies a pre-determined limit for borrowings. The borrower can withdraw as required up to the specified limits.
Public deposit: These are unsecured deposits invited by the company from the public for a period of six months to 3 years.
Bills discounting: It refers to an activity wherein a discounted amount is released by the bank to the seller on purchase of the bill drawn by the borrower on their customers.
Short term loans: These loans are granted for a period of less than a year to fulfil a short term liquidity crunch.
Inter-corporate loans/deposits: Organizations having surplus funds invest with other organizations for up to six months at rates higher than that of banks.
Commercial paper: These are short term unsecured promissory notes sold at discount and redeemed at face value. These are issued for periods ranging from 7 to 360 days.
Debt factoring: It is an arrangement between the firm (the client) and a financial institution (the factor) whereby the factor collects dues of his client for a certain fee. In other words, the factor purchases its client’s trade debts at a discount.
Long Term Sources
Retained profits: These are profits earned by a business in a financial year and set aside for further usage and investments.
Share Capital: It is the money invested by the shareholders in the company via purchase of shares floated by the company in the market.
Long term loans: These loans are disbursed for a period greater than 1 year to the borrower in his account in cash. Interest is charged on the full amount irrespective of the amount in use. These shareholders receive annual dividends against the money invested.
Debentures: These are issued by companies to obtain funds from the public in form of debt. They are not backed by any collateral but carry a fixed rate of interest to be paid by the company to the debenture holders.
Another point I would like to add is that, although depreciation is recorded in expense and fixed assets accounts and does not affect working capital, it still needs to be accounted for when calculating working capital.
No, Land is not a Current asset. Current Assets are assets that are expected to provide benefit to the company and convert into cash within one year. These help entities maintain liquidity. In short, we can say these Short term assets help in the day-to-day operations of an entity. Some common exampRead more
No, Land is not a Current asset.
Current Assets are assets that are expected to provide benefit to the company and convert into cash within one year. These help entities maintain liquidity.
In short, we can say these Short term assets help in the day-to-day operations of an entity.
Some common examples are Debtors, Inventory and Cash as they are liquid in nature.
Land as a Current Asset
Land is not a current asset but a fixed asset which is shown under the head Non-Current assets in the Balance sheet. Such assets are not sold or consumed by the entity but are held to produce goods and services.
The full value of such assets will not be realized within one year; hence such assets are useful in the long run. The part of the value of these assets realized in one accounting year is charged as depreciation in the Profit and Loss Account. Such depreciation charged reduces the book value of the assets in the Balance sheet. Depreciation can be calculated as:
Other examples of non-current assets are Machinery, Plant, furniture, etc.
Land is presented in the Balance sheet as;
Also, I would like to add that land is an exception to the concept of depreciation because it does not have a definite useful life so there is no way to depreciate it. Land is considered to have an indefinite life span. Unlike other non-current assets, the value of land tends to increase over time.
Therefore, unless land is used for extraction purposes (i.e. for Mining, etc), charging depreciation on land is prohibited.
What is an example of general reserve?
General reserve is the part of profits or money kept aside to meet future uncertainties and obligations of the entity. General reserve is created out of revenue profits for unspecified purposes and therefore is also a part of free reserves. General reserve forms a part of the Profit & Loss ApprRead more
General reserve is the part of profits or money kept aside to meet future uncertainties and obligations of the entity. General reserve is created out of revenue profits for unspecified purposes and therefore is also a part of free reserves.
General reserve forms a part of the Profit & Loss Appropriation account and is created to strengthen the financial position of the entity and serves as a sources of internal financing. It is upon the discretion of the management as to how much of a reserve is to be created. No reserve is created when the entity incurs losses.
General reserve is shown in the Reserves & Surplus head on the liability side of the balance sheet of the entity and carries a credit balance.
Suppose, an entity, ABC Ltd engaged in the business of electronics earns a profit of 85000 in the current financial year and has an existing general reserve amounting to 100000. The management decides to keep aside 20% of its profits as general reserve.
Then the amount to be transferred to general reserve will be = 85000*20% = 17000.
In the financial statements it will be shown as follows-
Now, in the next financial year, the entity incurs losses amounting to 45000. In this case, no amount shall be transferred to the general reserve of the entity and will be shown in the financial statement as follows-
The creation of general reserve can sometimes be deceiving since it does not show the clear picture of the entity and absorbs losses incurred.
See lessCan you please explain these depreciation MCQs?
The main objective of depreciation is to calculate net profit. Depreciation is an expense allowed on the fixed assets of an entity to provide for the cost of benefit utilized by the entity in that particular year. Since the such assets are used for more than one financial year, profits for the furthRead more
Depreciation is an expense allowed on the fixed assets of an entity to provide for the cost of benefit utilized by the entity in that particular year. Since the such assets are used for more than one financial year, profits for the further years would be misstated if such depreciation expense is not provided for.
Further, depreciation in no way shows previous profits or satisfies the tax department and a reduction in tax is secondary since it will only be allowed if charged in the profit & loss account. Thus, B is the correct answer.
2. Depreciation is generated due to wear and tear.
Depreciation is provided for to compensate for the wear and tear of the asset while being used by the entity. Depreciation is not generated due to increase in the value of liability, decrease in capital or decrease in the value of assets. Rather the vice versa is true, that is an increase in liability, decrease in capital and decrease in asset is created due to depreciation.
Thus, C is the correct answer.
3. The purpose of making a provision for depreciation in the accounts is to charge the cost of fixed assets against profits.
Fixed assets are long term assets with useful life of more than one accounting year and therefore the full cost of such assets are not provided for in the year of purchase rather a fixed portion is charged every year in the profit and loss account.
Thus, A is correct and others are incorrect.
4. According to the straight line method of depreciation, the depreciation remains constant.
In the straight line method of depreciation, depreciation is calculated on the historical or purchase cost of the asset and the same amount is charged every year till the useful value of the asset, thus depreciation remains constant.
Also, depreciation decreases each year in case of written down value method but depreciation can never increase. Thus, A is the correct answer.
5. Total amount of depreciation of an asset cannot exceed its depreciable value.
The depreciable value is the purchase cost of the asset less the scrap value. The total amount of depreciation can never exceed the depreciable value since depreciation is allowed on an asset till its useful life at a certain percentage. Even when the value of the asset becomes nil, no further depreciation would be charged and total depreciation would be equal to depreciable value but obviously cannot be more.
Thus, A is the correct answer and other are wrong.
6. According to fixed installment method, the depreciation is calculated on original cost.
In the fixed installment method, also known as the straight line method, depreciation is calculated on the basis of the original or purchase cost of the asset using the formula-
Depreciation = (Original cost – Scrap value)/Useful life of asset
Thus, B is the correct answer.
7. Salvage value means estimated disposal value.
Salvage value is the value of the asset that can be realized by the entity on its sale after the useful life of the asset has been exhausted and is now obsolete for the entity.
Salvage value is not definite but an estimation. Salvage value can be positive or nil but not negative. Thus, D is the correct option.
8. Depreciation is calculated under diminishing balance method, based on book value.
Under the diminishing value method, the depreciation is calculated at a certain percentage of the book value of the asset which is calculated after providing for depreciation in the previous year.
Depreciation cannot be calculated on scrap value since it is the disposable value of the asset and depreciation on original value is calculated under straight line method. Thus, B is the correct option.
9. Depreciation amount charged on a machinery will be debited to depreciation account.
Depreciation is an expense and depreciation account will be debited since depreciation is a nominal account, as per traditional method, and all expenses are debited. Also, as per modern rules of accounting, increase in expenses are debited.
When depreciation is charged there is a decrease in the value of assets therefore machinery account will be credit also depreciation cannot be classified under repair account or cash account heads. Thus, C is the correct option.
10. In accounting, becoming out of date or obsolete is known as obsolescence.
Amortization means decrease in the value of intangible assets of an entity. Depletion means exhaustion of existing wasting assets such as coal mines. Physical deterioration means fall in value of asset due to physical damage to the asset. Therefore, the correct answer is Obsolescence.
See lessWhich accounts are balanced and which are not?
There are two types of ledger accounts in the accounting system – temporary and permanent. Temporary accounts are those whose balances zero out and we do not carry forward balances to the next year. Examples are revenue and expenses accounts or nominal accounts. The balances of such accounts are traRead more
There are two types of ledger accounts in the accounting system – temporary and permanent.
Temporary accounts are those whose balances zero out and we do not carry forward balances to the next year. Examples are revenue and expenses accounts or nominal accounts. The balances of such accounts are transferred to the profit and loss account and therefore are not balanced.
Permanent accounts are those whose balances are carried forward to the next accounting year in form of opening balances. These accounts are balanced and such balances are transferred to the balance sheet. Examples are assets, liability and capital accounts or personal and real accounts.
Balancing an account means equaling both the debit and the credit side of the account. Generally, there is a difference between the accounts recorded as a carry down balance in the case of permanent accounts and as a transfer balance in the case of temporary accounts.
Balancing serves as a check to the double-entry rule of accounting.
Balanced accounts
As discussed above, the balanced accounts are shown in the balance sheet and the balancing figure for such accounts are carried forward to the next accounting period.
Unbalanced accounts
As per the above discussion, the balancing figures of unbalanced accounts are transferred to the profit and loss account and no balances are carried forward to the next accounting period.
Suppose a company Shine Ltd. has machinery costing 5,00,000 at the beginning of the accounting period and charges depreciation of 10% on the asset. The company also has creditors amounting to 50,000 at the beginning of the period and purchases goods amounting to 30,000 on credit. It has a cash balance of 95,000 at the beginning of the period and earns interest amounting to 10,000.
Following ledgers would be prepared to record the above entries:
The above ledgers can be shown as follows:
The balance of the machinery account will be shown in the balance sheet and therefore it is a balanced account.
The balance is transferred to the profit and loss account and therefore depreciation account is an unbalanced account.
The balance of creditors account will be shown in the balance sheet and therefore it is a balanced account.
The balance is transferred to the profit and loss account and therefore purchases account is an unbalanced account.
The balance of the cash account will be shown in the balance sheet and therefore it is a balanced account.
The balance is transferred to the profit and loss account and therefore interest account is an unbalanced account.
See lessDifference between Amortization & Impairment?
Let us first understand the concepts of Amortization and Impairment. Amortization refers to the expense recorded on the decline of the value of intangible assets of a company. Intangible assets include goodwill, patents, copyrights, etc. It reflects the reduction in the value of Intangible assets ovRead more
Let us first understand the concepts of Amortization and Impairment.
Amortization refers to the expense recorded on the decline of the value of intangible assets of a company. Intangible assets include goodwill, patents, copyrights, etc. It reflects the reduction in the value of Intangible assets over its life span.
Amortization is similar to Depreciation, however, while depreciation is over tangible assets amortization is over Intangible assets of the company.
For example, Cipla Ltd. acquired a patent over a new drug for a period of 10 years. The cost of creating the new drug was 80,000 and the company must record its patent at 80,000. However, the company must amortize this cost by dividing the cost over the patent’s life, i.e., the amortization cost would be 8,000 (80,000/10) p.a. for the next 10 years.
Impairment means a decline in the value of fixed assets due to unforeseen circumstances. Assets are impaired when the carrying value of assets increases its market value or “realizable value” and such increase is recorded as an impairment loss.
Now suppose, Cipla Ltd. had existing machinery which suffered physical damage and is recorded at 50,000 in the books but the realizable value of the asset would only be 20,000. Hence, the asset would be written down to 20,000 and an impairment loss of 30,000 will be recorded.
Impairment Vs Amortization
Differences between the two can be shown as follows:
Suppose Unilever Ltd. has a patent over one of its products for a period of 5 years. The cost of the patent was 1,00,000. Then after 2 years one of its rivals, say ITC Ltd., launches a new product which is more preferred by the consumers over the one produced by Unilever Ltd. and the fair market value of the patent of Unilever Ltd. changes to 10,000.
Now in this scenario, Unilever Ltd. would have amortized the patent (costing 1,00,000) at 20,000 (1,00,000/5) p.a. for 2 years and the book value at the end of the 2nd year is 60,000 (1,00,000 – 40,000). Now due to the new launch by ITC Ltd. the drastic change in the value of the asset from the book value of 60,000 to the realizable value of 10,000 will be recorded as an Impairment loss. Hence Impairment loss would be recorded at 50,000 (60,000 – 10,000).
See lessHow to know which expense is capital and which is revenue?
Capital Expense Capital expenses are incurred for acquiring assets including incidental expenses. Such expenses increase the revenue earning capacity of the business. These are incurred to acquire, upgrade and maintain long term assets such as buildings, machines, etc and are non-recurring in natureRead more
Capital Expense
Capital expenses are incurred for acquiring assets including incidental expenses. Such expenses increase the revenue earning capacity of the business. These are incurred to acquire, upgrade and maintain long term assets such as buildings, machines, etc and are non-recurring in nature.
Revenue Expenses
Revenue expenses are incurred to carry on operations of an entity during an accounting period. Such expenses help in maintaining the revenue earning capacity of the business and are recurring in nature.
These include ordinary repair and maintenance costs necessary to keep an asset working without any substantial improvement that leads to an increase in the useful life of the asset.
Suppose, company Takeaway ltd. purchases machinery for 50,000 and pays installation charges of 10,000. Salary of 15,000 is paid to the employees and existing machinery is painted costing 8,000. Here, the cost of machinery 50,000 and installation charges of 10,000 are treated as capital expenditure and the salary of 15,000 and painting cost of 8,000 is treated as revenue expenditure.
Identification
Points to categorize an expenditure as Capital or Revenue are as follows:
For example, a company Motors ltd. purchases furniture for 65,000, repays loans amounting to 1,00,000 and pays salary of 25,000.
Here the company creates an asset of 65,000 and reduces liability by 1,00,000 as shown below and therefore is considered as capital expenditure.
However, payment of salaries neither creates assets nor reduces liability. It only reduces profits and therefore is considered as revenue expenditure.
For example, a company Stars ltd purchases machinery for 1,20,000, furniture for 35,000 and has a rental expense of 80,000.
Here, the purchase of machinery is capital expenditure since it results in higher expense. However, the purchase of furniture cannot be regarded as a revenue expense and payment of rent cannot be regarded as a capital expense only because the rental expense is higher than the amount expended for the purchase of furniture.
For example, a company Caps ltd. purchases land for 1,00,00,000 on an equal monthly installment basis. Then such payments cannot be considered as revenue expense only because the payments are recurring. Since the installments are paid in lieu of the purchase of land which is a long term asset, the payments will be considered as capital expenditure.
For example, a company Marks Ltd. purchases machinery directly from the manufacturer for 50,000. For the manufacturer, the proceeds from the sale of machine are revenue in nature but the amount expended by Marks Ltd. will be categorized as capital expenditure.
Following conclusion can be inferred from the above explanation:
*Such transactions may or may not hold true as explained above.
See lessWhat is Impairment of Assets?
What is Impairment of Assets? Impairment of assets means a decline in the value of assets due to unforeseen circumstances. Assets are impaired when the carrying value of assets increases its market value or “realizable value”. Impairment can be caused due to factors that are internal or external toRead more
What is Impairment of Assets?
Impairment of assets means a decline in the value of assets due to unforeseen circumstances. Assets are impaired when the carrying value of assets increases its market value or “realizable value”.
Impairment can be caused due to factors that are internal or external to the firm. Internal factors such as physical damage, obsolescence or poor management and external factors such as a change in legal or economic circumstances, increased competition or reduction in asset’s fair value in the market result in impairment.
Impairment Vs Depreciation
Asset impairment is often confused with asset depreciation, which is rather a recurring and expected event, unlike impairment that reflects an abrupt decrease in the value of the asset.
Impairment Loss
Impairment is always treated as a loss in accounting. It is the amount by which the carrying value or the asset’s book value exceeds its fair market value.
Before recording Impairment loss, a company must determine the recoverable value of the asset which is higher of the asset’s net realizable value or value in use. Then it is to be compared with the book value of the asset.
If the carrying value exceeds the recoverable value then the impairment loss is to be recorded at the exceeding value i.e. difference of carrying value and realizable value.
Example
Suppose a company Royal Ltd. has an asset with a carrying value of 50,000, which has suffered physical damage. According to the company’s calculation, the asset has a net realizable value of 30,000 and a value in use of 25,000.
Then, the recoverable value would be higher of the asset’s net realizable value or value in use, i.e., 30,000 which is still lower than the carrying amount of 50,000. Therefore, Royal ltd. will have to record 20,000 (50,000-30,000) as impairment loss.
This is will increase Royal Ltd’s expenses by 20,000 and decrease the asset’s value by the same amount.
See lessIs depreciation a cash flow?
Depreciation refers to that portion of the value of an asset that a company uses in an accounting year to generate revenue. Assets are written off in form of depreciation over time also called the useful life of the asset. It denotes the wear and tear of an asset over time. Suppose, a company namedRead more
Depreciation refers to that portion of the value of an asset that a company uses in an accounting year to generate revenue. Assets are written off in form of depreciation over time also called the useful life of the asset. It denotes the wear and tear of an asset over time.
Suppose, a company named Johnson ltd. purchases machinery for 50,000 that has a useful life of 5 years with nil salvage value. Then the yearly depreciation to be charged can be calculated as:
Is Depreciation a Cash Flow?
Cash flows are inflows and outflows of cash and cash equivalents in an entity. The payments made by the entity denote the outflows whereas the revenues or incomes of the entity denote the inflows. Talking about cash flows, depreciation is a non-cash item of expense which means it neither results in inflow nor outflow of cash resources.
In the adjacent Profit and Loss statement, a cash payment of 7,000 for electricity implies outflow of cash however, depreciation of 10,000 is merely an imputed cost to write off an asset or we can say, a part of profits set aside each year so that there are sufficient funds available to procure a new asset after the currently available asset is discarded.
However, cash flow statements are affected by depreciation. Depreciation is added back to the net profits while calculating cash flows from operating expenses since it is a non-cash item and has been deducted while calculating net profits in the profit and loss statement.
Depreciation does not directly impact the amount of cash generated or expended by a business but it is tax-deductible and will reduce the cash outflows related to income taxes. Thus, depreciation affects cash flow by reducing the amount of cash a business has to pay for income taxes.
See lessWhat are the sources of working capital?
Let us first understand what working capital is. Working capital means the funds available for the day-to-day operations of an enterprise. It is a measure of a company’s liquidity and short term financial health. They are cash or mere cash resources of a business concern. It also represents the exceRead more
Let us first understand what working capital is.
Working capital means the funds available for the day-to-day operations of an enterprise. It is a measure of a company’s liquidity and short term financial health. They are cash or mere cash resources of a business concern.
It also represents the excess of current assets, such as cash, accounts receivable and inventories, over current liabilities, such as accounts payable and bank overdraft.
Sources of Working Capital
Any transaction that increases the amount of working capital for a company is a source of working capital.
Suppose, Amazon sells its goods for $1,000 when the cost is only $700. Then, the difference of $300 is the source of working capital as the increase in cash is greater than the decrease in inventory.
Sources of working capital can be classified as follows:
Short Term Sources
Long Term Sources
Another point I would like to add is that, although depreciation is recorded in expense and fixed assets accounts and does not affect working capital, it still needs to be accounted for when calculating working capital.
See lessIs Land a Current Asset?
No, Land is not a Current asset. Current Assets are assets that are expected to provide benefit to the company and convert into cash within one year. These help entities maintain liquidity. In short, we can say these Short term assets help in the day-to-day operations of an entity. Some common exampRead more
No, Land is not a Current asset.
Current Assets are assets that are expected to provide benefit to the company and convert into cash within one year. These help entities maintain liquidity.
In short, we can say these Short term assets help in the day-to-day operations of an entity.
Some common examples are Debtors, Inventory and Cash as they are liquid in nature.
Land as a Current Asset
Land is not a current asset but a fixed asset which is shown under the head Non-Current assets in the Balance sheet. Such assets are not sold or consumed by the entity but are held to produce goods and services.
The full value of such assets will not be realized within one year; hence such assets are useful in the long run. The part of the value of these assets realized in one accounting year is charged as depreciation in the Profit and Loss Account. Such depreciation charged reduces the book value of the assets in the Balance sheet. Depreciation can be calculated as:
Other examples of non-current assets are Machinery, Plant, furniture, etc.
Land is presented in the Balance sheet as;
Also, I would like to add that land is an exception to the concept of depreciation because it does not have a definite useful life so there is no way to depreciate it. Land is considered to have an indefinite life span. Unlike other non-current assets, the value of land tends to increase over time.
Therefore, unless land is used for extraction purposes (i.e. for Mining, etc), charging depreciation on land is prohibited.
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