Closely connected with the question of valuation of assets is that of depreciation which vitally influences the ascertainment of correct value for each asset. With regard to this we will discuss about depreciation, provision and reserves.


Meaning and Nature of Depreciation:

Depreciation may be defined as the gradual reduction in the value of an asset due to wear and tear as in the case of physical assets like building, machinery etc., or by mere passing of time as in the case of lease, patent and-copyright.

Assets are subject to diminution in working capacity or value and such diminution is known as depreciation, which should be clearly distin­guished from obsolescence and fluctuation as under:

Description, Nature, Causes and Treatment in Accounts

Evidently, proper depreciation must be charged to revenue and deducted from the cost of an asset in order to find out its correct working value to the business.


There is a misconception in the minds of many about the real nature and implications of depreciation. It should be remembered that provision for depreciation is not a safeguard against actual diminution in value, because no amount of such provision can stop the physical deterioration due to use or prevent the efflux ion of time.

The real idea behind depreciation is to make adequate arrangement for replace­ment of an asset on its becoming useless or on the expiry of its normal life, by setting aside a part of the profits every year and allowing it to accumulate.

The amount so provided may be either merged in the work­ing capital of the business or invested out­side so as to provide a ready fund of money unaffected by any deterioration in the finan­cial condition of the business that may prevent the payment of a requisite sum out of liquid resources at the time of replace­ment.


Depreciation is also essential for re­couping the loss of capital invested in ac­quiring an asset and also for indicating the correct worth of fixed assets to a business as a going concern.

Principles of Measurement of Depreciation:

It is essential that depreciation should be accurately assessed on some reasonable basis.

Various factors must be taken into account in arriving at a proper amount of depreciation for each asset they are summarised below:

(1) The original cost of acquiring the asset.


(2) Interest that might have been earned if the amount utilised in buying the asset had been invested otherwise or interest on funds borrowed for acquiring the asset.

(3) Estimated working life of the asset having regard to the standard of maintenance of each asset in proper working order through normal re­pairs and renewals.

(4) Estimated scrap value or residual value of the asset.

On the basis of the aforesaid principles the following may be taken as a standard formula for calculating depreciation, which, however, may require suitable modifications according to circumstances of each particu­lar case:


Depreciation = Original Cost + Interest – Scrap Value/ Working Life

Apparently, with the exception of origi­nal cost, all the other factors are variable and uncertain and, as such, they should be very carefully estimated. Even the ‘original cost’ factor may require adjustments due to changes in the price-level.

As one of the chief aims of providing depreciation is to build up funds for replacement of an asset, it is only reasonable that the aggregate amount of depreciation should be adequate to cover the full cost of replacement on expiry of the effective life of the asset concerned.

Calculation of depreciation is usually based on the original cost of acquir­ing asset, widely described as “historical cost”, but it is argued by some authorities that if the prices of similar assets show a rising trend, depreciation on this basis may not be sufficient to cover the cost that would have to be incurred at the time of acquiring a new asset in place of the old one; on the other hand, the amount of depreciation pro­vided on a fixed basis may be unduly large if the price-level registers a fall.


According to this view, therefore, original cost should be subjected to periodical review on the basis of changing trends of the price-level of capital goods and the rates of deprecia­tion should be revised accordingly, i.e., they should be raised when prices go up and reduced when prices fall.

This matter is a highly controversial one. A prudent and more practical method would be to ignore purely temporary price fluctuations and to consider the need for variations in the depreciation rates only when there is a fairly lasting change in the trend of prices—rea­sonable reserve being created to provide for additional funds expected to be required for replacement based on proper revaluation of concerned assets by experts.

Methods of Charging Depreciation:

Based on one or more of the factors discussed above, actual amount of deprecia­tion may be calculated under the following methods according to the nature of the asset concerned:

Description, Nature and Details and Important Assets

Legal and Commercial Points of View regarding Depreciation:

Sometimes controversy arises as to whether depreciation should be provided or not in respect of a particular asset or group of assets. This question may be considered from two different angles, viz., whether it is legally necessary to charge depreciation and/or whether such provision is desirable in terms of prudent financial policy.


The legal principles are laid down by the deci­sions in a number of well-known Case Laws whereas the commercial principles are the outcome of long-standing convention.

Both the aspects of the problem are enumerated below:


Legal and Commercial Point of View

The Case Law decisions cited above are not applicable to Indian companies. As provided in Section 205 read with Section 350 of the Companies Act, 1956, before payment of any dividend for any year depreciation must be provided for in respect of depreciable assets out of profits for that year or previous years on any of the follow­ing basis, viz.:

(a) An amount calculated with reference to the written-down value of the assets at the end of each financial year (as per books of the company) at rates specified in Sched­ule XIV to the Act, these rates are delinked from those prescribed under the Income Tax Act, 1961; or

(b) An amount calculated by dividing 95% of the original cost of the assets by the specified period for each asset, i.e., the number of years at the end of which at least 95% as above shall have been written-off at rates as per Sec. 350; or

(c) On any other basis approved by the Central Government having the effect of writing-off 95% of the original cost of an asset on expiry of the specified period; or


(d) In respect of any other asset, for which no rate of depreciation is prescribed, on a basis approved by a general or special order of the Central Government.

In case an asset is sold, discarded, demolished or destroyed in any year before providing full depreciation thereon, the excess of the written-down value thereof over the sale proceed must be written-off in that year.

The Central Government may, however, allow any company to declare or pay divi­dend without providing for depreciation if it thinks it necessary to do so in the public interest.

Auditor’s Duties towards Depreciation:

Before certifying the final accounts an auditor must satisfy himself about the ad­equacy of the provision for depreciation on various assets. In case of concerns other than companies he should generally follow the commercial principles which are more safe and prudent.

If, however, any of his clients insist on applying the relevant case law decisions he cannot prevent them from doing so. He is also to see whether the method of depreciation is reasonable and whether the same is uniformly followed.

In case of com­panies he should satisfy himself that the requirements of the company law are fully com­plied with. An auditor’s work is much facilitated when a fixed assets register is maintained containing a page for each in­dividual asset properly ruled to record all the relevant factors that influence the deter­mination of depreciation rates as discussed in Art. 2.

In any case, if an auditor is not fully satisfied about the amount of depre­ciation written-off or provided for in respect of different assets he should unhesitatingly qualify his report stating his opinion.

Repairs and Renewals:

Repairs and renewals of fixed assets are meant for keeping the assets in good work­ing order and should not be confused with depreciation which is intended to provide funds for replacement of such assets at the end of their effective working lives. Repairs and renewals should be treated as charges on revenue and they should not be capital­ised unless they are essentially required to bring an asset into a workable stage.

Provisions and Reserves:

(a) Classification:

Various types of reserves are created and maintained by a business concern for different purposes; they are summarised below:

Types of Reserves, Nature and Object and Treatment in Accounts

According to Clause 7 of Part III of Schedule VI to the Companies Act, 1956, unless the context otherwise require:

1. (a) The expression “provision” shall, subject to sub-clause (2) of this clause, mean any amount written-off or retained by way of providing for depreciation, renewals or diminution in value of assets, or retained by way of providing for any known liability, of which the amount cannot be determined with substantial accu­racy;

(b) The expression “reserve” shall not, subject as aforesaid, include any amount written-off or retained by way of providing for depreciation, renewals or diminution in value of assets or retained by way of provid­ing for any known liability;

(c) The expression “capital reserve” shall not include any amount regarded as free for distribution through the profit and loss account; and the expression “revenue reserve” shall mean any reserve other than a capital reserve; and in this sub-clause the expression “liability” shall include all liabilities in respect of expenditure contracted for and all disputed or contingent liabilities.

2. Where any amount:

(a) written-off or retained by way of providing for depreciation, renewals or diminution in value of assets, not being an amount written-off in rela­tion to fixed assets before the com­mencement of this Act; or

(b) Retained by way of providing for any known liability; is in excess of the amount which, in the opinion of the directors, is reasonably nec­essary for the purpose, the excess shall be treated for the purposes of this Schedule as a reserve and not as a provision.

Maintenance reserve:

For businesses wherein repair and renewal charges in Re­spect of fixed assets are considerable and subject to variation from year to year it is better to create a repairs and renewals re­serve or maintenance reserve by transferring an equal sum every year from profit and loss account and debiting actual repair and re­newal charges to this reserve account as and when incurred.

The amount to be set apart from profit and loss account annually is calculated on the basis of the average annual cost of repair etc. This method helps in equalising the burden on revenue from year to year; otherwise actual repair and renewal expenses would tend to increase as years pass and the assets become older.

Distinction between Provision and Reserve

Auditor’s Duties towards Provisions and Reserves:

An auditor should see that specific reserves or provisions are created to cover all possible contingencies and are adequately provided for. He should verify these items carefully and discuss the matter with the management in case of any doubt. He should also get a certificate from a high official about adequate provision for all contingen­cies. Inadequate provisions, if not rectified, should be reported to clients.

Creation of general and special reserves is generally a matter of discretion for the management. Bond vs. Barrow Haematite Steel Co. case clearly established the principle that, subject to provisions in the Articles, directors have full authority to create any reserve they think necessary before recommending distribution of dividend and that no shareholder could challenge such authority.

Sub-section (2A) of Section 205 of the Act, however, requires that no dividend can be declared or paid by a company out of profits for any financial year except after transfer to reserve of such percentage of profit not exceeding 10, or voluntary transfer of more than 10 per cent under certain circumstances, as prescribed by the Companies (Transfer of Profits to Reserves) Rules, 1975. The auditor should see that reserves are created out of genuine surplus profits and, as per statutory provi­sions mentioned above in the case of a company, and that they are properly dis­closed in the balance sheet.

An auditor should also satisfy himself about disclosure in the profit and loss ac­count of provisions and reserves and also withdrawals there from, if any, as per Part II, Clause 3(viii) and (ix), of Schedule VI to the Companies Act, 1956.

Secret Reserves:

Known also as internal reserve, a secret reserve signifies a reserve the existence of which is not disclosed in the balance sheet. This means that the financial condition of the business is in reality better than what is apparent from the balance sheet.

(i) Methods of creating secret reserves:

(a) Writing-down assets below their real value including undervaluation of goodwill and stock and excessive provision for depreciation and for bad and doubtful debts, etc.

(b) Ignoring appreciation in the value of assets.

(c) Providing excessive sums for liabili­ties, outstanding expenses, contin­gencies etc.

(d) Ignoring prepaid expenses or incomes accrued but not received.

(e) Charging capital expenditure to rev­enue.

(ii) Objects of secret reserve:

(a) Financial condition is rendered stronger than is actually disclosed.

(b) Avoidance of undue competition or State interference by keeping down dividend rates.

(c) Avoidance of disrepute or loss of public confidence due to fluctuations in profit and variations in the market value of shares. Particularly useful for financial institutions including banks, insurance companies etc. whose very existence is largely gov­erned by the degree of public con­fidence in their organisations.

(iii) Dangers of secret reserve:

(a) Untrue and misleading picture is exhibited in the balance sheet.

(b) Shareholders or owners are deprived of a portion of profits to which they are otherwise legitimately entitled.

(c) Value of shares may be adversely affected to some extent if the fall in value of assets and reduction in the rate of dividend is excessive due to creation of a secret reserve beyond reasonable limits.

(d) True results are obscured and a fall­ing trend in the current revenue earning capacity due to mismanage­ment or otherwise may be concealed by drawing upon accumulated secret reserve with a view to maintaining uniform rates of dividend.

(e) Possibility of improper use by direc­tors or other officers of secret re­serves for their personal benefit.

(iv) Case Laws on Secret Reserve:

Newton vs. Birminghan Small Arms Co. Ltd.

Any provisions in the articles of a company restricting an auditor’s right to disclose the existence of secret reserve is illegal.

Re: Royal Mail Steam Packet Co. Ltd.

Although not illegal it is improper to utilise a portion of secret reserve created in the past for augmenting current profit with a view to paying dividend there out without disclosing this fact in the profit and loss account. By such non-disclosure valuable information regarding the trend of current profit earning capacity of a business is withheld from the shareholders. In such a case an auditor also runs the risk of being held liable for negligence for not disclosing the fact in his report.

(v) Auditor’s position re: secret reserves:

Auditor’s position is fairly difficult in regard to secret reserves. If he decides to report the existence of such a reserve it no longer remains a secret and bona fide pur­pose of strengthening the financial condition of the business and thereby safeguarding the genuine interests of shareholders is frus­trated.

On the other hand, by passing over a secret reserve without mention an auditor may be held guilty of signing a false cer­tificate or deliberately trying to cover improper use of secret reserves by unscru­pulous directors or other officers.

An audi­tor’s risk of liability for not disclosing a secret reserve and also his absolute right to disclose if he so, desires have been estab­lished in unmistakable terms by the two Case Laws mentioned above.

An auditor should, therefore, decide his course of action according to the circumstances of each par­ticular case having regard to the possible merits and dangers of a secret reserve and after proper enquiries as to the circum­stances under which and the purpose for which such a reserve has been created.

He may keep this secret only if he is fully satisfied about the reasonableness and bona fides of the reserve, but that too at his own risk. In case there is the slightest of doubt or suspicion, an auditor should unhesitat­ingly report the matter to the shareholders.

Capitalisation of Reserves:

1. If the accumulated general reserve is considered much in excess of estimated requirements it may be decided to pay the excess amount to shareholders who were deprived of higher dividend at the time of creating the reserve.

Instead of paying this amount in cash it is better to capitalise the excess reserve and pay the dividend in kind viz., by issue of bonus shares, particularly when assets representing the reserve are permanently employed in the business. The issue of bonus shares may be either as fully paid or to make partly paid shares fully paid. Capital redemption reserve account, if any, may also be used for issue of fully-paid bonus shares.

Capitalisation of reserves is better from all points of view as described below:

(i) Advantages for the business:

(a) A more correct picture is shown by increasing share capital so as to be really representative of the difference between assets and outside liabili­ties.

(b) Very high rates of dividend, which would invite fresh competition or Government interference on suspi­cion of profiteering, can be avoided by increasing the amount of share capital.

(c) The fund represented by the reserve is permanently absorbed and retained in the business, thereby strengthen­ing the financial condition.

(d) A large depletion of cash or bank balance with adverse repercussion on the working capital of the business can be avoided.

(ii) Advantages for shareholders:

(a) Bonus shares constitute valuable securities and a permanent future source of earning by way of divi­dend.

(b) If necessary, cash may be realised at any time by selling the shares.

2. Auditor’s position re: Bonus Shares:

An auditor should certify a bonus issue application to the Securities & Exchange Board of India (SEBI). While checking such issues he should see the articles of associa­tion, resolutions of directors as well as of shareholders authorising capitalisation of reserves and permission from the SEBI and should verify actual issue of bonus shares. Compliance with the official guidelines for issue of bonus shares and with provisions re: taxation of bonus issues, if any, should be checked.

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