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Chapter Analysis
Intermediate42 pages • EnglishQuick Summary
This chapter explains the concept of depreciation, provisions, and reserves in accounting. It highlights the necessity of charging depreciation to match expenses with revenue in the correct accounting period and discusses the computation methods like the straight line and written down value methods. The chapter also examines provisions, which are necessary allocations for uncertain liabilities, and reserves, which are retained profits for future needs. Practical examples and exercises illustrate these concepts clearly .
Key Topics
- •Depreciation: nature and computation methods
- •Differences between amortization, depletion, and depreciation
- •Provisions: purpose and accounting treatment
- •Reserves: types and purposes
- •Journal entries for depreciation
- •Asset disposal accounting
- •Factors influencing asset depreciation
- •Secret reserves and their implications
Learning Objectives
- ✓Explain the concept and importance of depreciation.
- ✓Differentiate between depreciation, amortization, and depletion.
- ✓Compute depreciation using various methods.
- ✓Distinguish between provisions and reserves.
- ✓Record transactions involving depreciation and asset disposal.
- ✓Understand the rationale and implications of creating secret reserves.
Questions in Chapter
What is ‘Depreciation’?
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State briefly the need for providing depreciation.
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What are the causes of depreciation?
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Explain basic factors affecting the amount of depreciation.
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Distinguish between straight line method and written down value method of calculating depreciation.
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What are ‘provisions’. How are they created? Give accounting treatment in case of provision for doubtful Debts.
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Additional Practice Questions
Explain why depreciation is considered a non-cash expense and its impacts on tax and financial statements?
easyAnswer: Depreciation is a non-cash expense because it does not involve actual cash outflow. It reduces taxable income, thus impacting tax liabilities. It reflects in financial statements as a deduction from the asset's book value and affects profit calculations.
Illustrate with examples how provisions differ from reserves in terms of financial reporting.
mediumAnswer: Provisions are for liabilities that are expected but uncertain, such as doubtful debts, and are charges against profits. Reserves are appropriations of profit, retained for future needs like expansion. Provisions appear as liabilities or contra-assets, whereas reserves are retained earnings.
Discuss in detail how the straight line method and written down value method affect financial statements differently.
hardAnswer: In the straight line method, equal depreciation expense is charged yearly, affecting profits uniformly. In contrast, the written down value method leads to higher expenses initially, reducing taxable income more significantly in earlier years, impacting the asset's book value differently over time.
Why is it important for a business to create a secret reserve, and what ethical considerations might this involve?
mediumAnswer: Secret reserves provide a buffer for financial uncertainties, allowing companies to manage fluctuations in profit reporting. Ethically, it involves transparency issues, as it might mislead stakeholders regarding the company’s true financial position.
How would a change in depreciation method affect financial analysis for stakeholders?
hardAnswer: Changing depreciation methods can significantly affect profit reporting and asset values, altering key financial ratios like ROA and ROS, thus impacting stakeholders' perception of the company's performance and stability.