Friday 21 January 2011
KERALA COOPERATIVE AUDIT MANUEL VOLUME I PART III CHAPTER I
DEPRECIATION AND RESERVES
1. What is depreciation ?
Depreciation is the shrinkage in the value of an asset due to frequent use for the purpose of earning profits. It may be described as “loss or diminition in the value of an asset consequent on wear and tear, obsolescence, affluxion of time or permanent fall in the value of the asset”.
Depreciation is also defined as “the measure of exhaustion of the effective title of an asset from any cause during a given period”.
The above definitions indicate that depreciation is a loss arising out of wear and tear due to constant use in the business for earning profits or the diminition in the value of an asset from year to year.
Depreciation would arise from Internal or External causes. Internal depreciation is the loss arising from the operation of any natural cause, i.e. by frequent use. External depreciation is that arising from the operation of forces outside asset itself, such as effluxion of time which means automatic loss, in value resulting from the passage of time. The main objects of providing for depreciation are:-
(i) To show the correct profit earned during any particular period. When the profit earned by an asset is taken into account, the loss inherent should also be taken into account simultaneously, in order to ascertain the net income derived by the use of that asset.
(ii) To show the correct value of assets in the Balance Sheet. Unless the assets are shown at their correct values, the Balance Sheet will not exhibit at true and correct picture of the financial position of the institution.
(iii) To make provision for replacement of a wasting asset. Unless depreciation is provided periodically (say every year) and the amount invested outside the business of the society, it would be difficult to replace an asset which has become obsolete. Investment of such depreciation in the business of the society would lead to the locking up of depreciation in the working capital and may create difficulties, to find out necessary funds to replace the assets.
(iv) To keep the original capital in tact.
In order to bring about uniformity in the procedure for charging Depreciation. Circular instructions have been issued. See Registrar’s Circular No. 26/72 in file ADL (1) 21274/72 dated 5-6-1972.
2. Measure of depreciation :
(i) Wear and tear :- After a machine is put to constant use, it may not fetch the same value as time goes on. Broadly speaking, the decrease in the value of a fixed asset by constant use less the probable scrap value represents depreciation.
(ii) Obsolescence :- Obsolescence is a special form of loss in value due to external reasons. This generally arises due to invention of a new and improved type of machinery, which can by applying latest techniques turnout increased production of quality goods in a comparatively cheaper way. But such loss can be ascertained, only when the asset is actually replaced. So it is better to face this contingency separately by means of appropriation from profit to a special Obsolescence Reserve.
(iii) Effluxion of time :- Decrease in the value of an asset by the passage or effluxion of time as in the case of lease concession or patent is also termed as depreciation. In this case, when the period of lease or prescribed time terminates, all value ceases. The amount paid for lease is in effect rent paid in advance and should be fully written off to revenue account over the period of lease.
(iv) Fluctuation in market value :- Fluctuation in the market value of fixed assets has to be disregarded because any fluctuation in price does not affect its earning capacity. Hence the value of such assets is shown at cost price less depreciation. In the case of fixed assets held in investments in it is anticipated that the market value may fall down permanently, it is wise to provide for the same against such contingencies. Reserve should be provided for the shortfall in the market value in each case.
3. Methods of providing for depreciation:
(i) Annuity method :- It is assumed that the asset earns a given rate of interest. So, under this system, the interest expected would be added to the value of asset, and rate of depreciation to be written off would be ascertained from the Annuity Tables and credited to the asset account. This system is considered to be scientific and better. But this method is not generally used for plant and machinery where additions are made from time to time.
(ii) Sinking fund or depreciation fund method :- Under method, no depreciation is written off from the asset, but an equal amount of depreciation is charged to the profit and loss account and credited to depreciation fund account, during the life time of the asset. The asset is shown at its original cost in the balance sheet. The instalment is fixed in such a way that if invested outside every year at compound interest it will produce an amount equal to the original cost of the asset at the end of its effective life. This procedure is allowed until the Depreciation Fund Account equals the asset account. In the meantime the investment must also be shown in the Balance Sheet, under a separate head “Depreciation Fund Investment Account”.
This method of depreciation is best suited for lease, patents etc.
(iii) Depletion unit method :- This system is suitable to wasting assets such as mines, oil wells, quarries etc. The contents of the assets are estimated in terms of quantity. Taking into consideration the quantity of the mine, the value of one unit raised is calculated. Depreciation in any year is calculated on the total output.
(iv) Fixed instalment or straight line method :- Every year a fixed amount is written of as depreciation by charging to the profit and Loss account. The amount to be written off would be determined by estimating the working life of the asset and distributing the cost of the asset less any scrap value, over the Working Life. It is suitable for writing off the cost of short leases and patents where the life of the asset is known exactly. But in the case of plant and machinery, the life cannot be estimated so easily as it depends on its use.
(v) Reducing instalment or diminishing balance method :- This system is adopted with a view that every year the profit and loss account would be charged with depreciation. A fixed percentage is written off every year on the diminishing book value of the asset till it is reduced to scrap value. By applying this method the revenue bears an average burden, as the increased repair charges in the later years are off set by the decrease in the provision for depreciation. In this case no separate calculation is necessary for any additions during the year a the percentage is calculated on the total book value of the asset at the end of the year.
This system is adopted for charging depreciation on plant, furniture machinery etc.
4. How to charge depreciation:
(i) Building (Circular No. 26/72) - Societies construct buildings by utilising their building fund created out of profits and or by the general funds which is recouped in subsequent years. When buildings are constructed out of funds from the building reserve created out of profits, the entire building fund appears on the liability side of the balance sheet while investments from the building fund will appear as building fund investment on the asset side.
Societies which do not have sufficient building fund construct buildings from the general funds with the prior sanction of the Registrar. In such cases, the investments thereon appear on the asset side of the balance sheet, without a corresponding coverage on the liability side. In both cases depreciation should be charged on the prescribed rate on all buildings irrespective of the fact whether they were constructed/acquired by investment of Building Fund, General Fund or any other source. The Co-operative Societies which are recouping expenditure incurred in buildings from General Funds may however be permitted to charge depreciation, as a measure of relief, after the expenditure incurred from general funds is fully recouped. (Registrar’s Circular No. 101/75 dated 15-11-1975). When a building is constructed with the general funds and building fund of the society, the balance sheet has to be prepared in accordance with the principles explained above in proportion to the amounts spent from different sources.
(ii) Furniture and equipments :- The value of furniture and equipments, as on the last day of the Co-operative year, at cost is exhibited on the asset side of the balance sheet. Depreciation every year ( @ 5% of the value for Iron Safe, Almirah, Racks and Tables 10% for Iron chairs, trays and similar articles of rough use, 5% for Teak or Rosewood Almirah, tables and racks and 10% for other wooden articles) at the total value of the furniture as at the end of audit year is taken to “Reserve for Depreciation of Furniture”, on the liability side, after debiting the amount to the profit and loss account year after year. This procedure has to be followed till the amount of “Depreciation Reserve for furniture etc”, equals or value of furniture on the asset side and thereafter no depreciation is allowed. The very same method is applicable to Libraries also.
(iii) Motor vehicles :- The value of vehicles has to be normally written off during the course of five years. The income from a lorry will be higher during the first one or two years, as the cost of repairs and maintenance will be the minimum. During the succeeding years such expenditure will be on the increase, and so depreciation during the first year will have to be the highest and will be decreased during the subsequent years. General scale of depreciation of vehicles is given below :-
1st year 30% of capital investment
2nd ,, 25% ,,
3rd ,, 20% ,,
4th ,, 15% ,,
5th ,, 10% ,,
Thus value of the vehicle has to be written off almost fully within 5 years, and only a nominal value shown in the asset side of the Balance Sheet till the vehicle is condemned or otherwise disposed of.
(iv) Others :- If no provision is made for depreciation in respect of any fixed asset, that fact has to be indicated in the audit note. Bylaws of some of the societies contain specific provisions laying down rates on which depreciation should be charged on different assets. These rates if higher, are to be applied in accordance with the above circular instructions.
In the ordinary course ‘Reserve’ is meant to indicate something kept apart for future use or for emergency. But from the point of accounting, it means that part of the capital which is set apart for any known or unknown or unforeseen losses/contingency-Reserves are broadly classified as under :-
1. General Reserve
2. Specific reserve or provision
3. Sinking Fund
4. Reserve Fund
5. Capital Reserve
6. Secret Reserve
1. General Reserve :- This is created out of net profits. The general reserve can be created only where there is profit. The purpose of creating such a Reserve is three fold.
(i) To provide more working capital
(ii) To provide a cushion to meet any unknown or unforeseen contingencies in future.
(iii) To increase the financial stability of the concern.
The general reserve is an appropriation from profit and not a charge against profit.
2. Specific reserve or provisions :- Specific Reserve is a charge against revenue to provide for losses/contingencies with are known or expected as on the date of making the provisions, to occur at a future date. It is created even if the concern is working on loss.
3. Sinking Fund :- ”A Sinking Fund is a form of Specific reserve set aside for the redemption of along term debt or the replacement of a wasting or a depreciating asset”. It is created out of revenue or divisible profits as the case may be to meet a known liability at a future date. A corresponding amount of the fund is invested outside the business also.
Sinking Fund for redemption of a liability, like debentures, is chargeable to profit and loss account. Creation of this fund avoids any risk involved in the sudden withdrawal of capital from business which may upset its normal continuance.
The two types of Sinking Fund usually referred to as “Depreciation Fund” and “Redemption Fund” have got district characteristics.
(a) Depreciation Fund.
(i) It is a charge against profit & Loss Account.
(ii) On realisation of the investment, the amount thus made available is utilised in replacing the assets.
(iii) It is closed by a transfer to the old asset account.
(iv) It cannot appear in the books after the purpose for which it was created is accomplished.
(b) Redemption fund :
(i) It is by appropriation of profit.
(ii) It can exist only if there is an excess of assets over liabilities.
(iii) On realisation it is utilised for discharging a liability.
(iv) Redemption Fund takes the form of liability and therefore not closed.
(v) When the purpose of creation of the Fund is accomplished, it may be transferred to General Reserve Account.
(vi) It can be used for the purpose for which General Reserve is used.
4. Reserve Fund :- A reserve fund is nothing but a General Reserve created out of divisible profits, except that the surplus of assets represented by the reserve is invested outside the business. The purpose of creating Reserve Fund is to provide ready and liquid funds for any specific purpose at any date which may be obtained by realising investments.
5. Capital Reserve :- Capital Reserve is created out of capital profits which are quite distinct from trade profits. While trade profits mean profits made during the ordinary course of business, capital profits are of extraneous nature earned but not in the usual course of business.
Generally the following extraneous profits are transferred to capital Reserve Account.
(i) Profit on forfeiture of shares.
(ii) Profit on sale of an asset
(iii) Profit on revaluation of an asset,
(iv) Profit on repayment of debentures
(v) Profit on issue of shares of debentures.
6. Secret Reserves :- Secret Reserve is not disclosed on the face of the balance sheet, through in fact, the actual financial position is much better than what is disclosed by a balance sheet. It is also called as “Internal Reserve” or ‘Hidden Reserve’. This reserve represents surplus or assets over Liabilities and capital. It does not appear in the Ledger. Its purpose like that of any other reserve is to increase the financial stability. Eg.-As per the audit certificate the book value of the land & building owned by the institution may be nominal, where as its market value will be much higher. The difference between the bok value and the actual value that it may fetch when, sold out, will represent secret reserve in this case.
II. Statutory Reserves :- (a) Reserve Fund :- Reserves in Co-operative Institutions are being created with a view to strengthening the financial position and to provide for possible depreciation in the value of the assets. Reserves under liabilities can come into existence only in one of the following methods.
(i) By allocation from divisible profits
(ii) By retrenching profits.
Reserves cannot be created by allocation from divisible profits it such reserve is not contemplated in the byelaws of the society. The allocation of the net profits should be done by the general body in the order in which it is provided under the provision of the Kerala Co-operative Societies Act Rules and the Bye-laws.
The statutory reserves must be provided for as per statute (see Sn. 56) and the bye-laws whichever is higher in the order of allocation and the remaining items allocated as per the bye-laws of the society and standing instructions of Register.
Object of Reserve Fund and disposal thereof on the winding up of a society are indicated in Rule 61 of the Rules.
(b) Co-operative Education Fund :- Sub clause (b) of clause (C) of section 56 of the Act lays down that “A society shall, out of its net profits in any year credit such portion of the net profits, not exceeding five per cent, as may be prescribed, to the Co-operative Education Fund referred to in clause (xix) of subsection (2) of Section 109”.
The constitution, maintenance and administration of Co-operative Education Fund have been specified in Rule 53 of the Rules.
6. Other Reserves :- (a) Common good fund :- Appropriation of profit to this fund is governed by Section 56 (2) (d) of the Act and bylaws of the society. After appropriation to the statutory reserves, the General body, subject to the restrictions imposed in the byelaws, may set apart an amount not exceeding ten per cent of the net profits to the Common Good Fund. This fund should be utilised only for the objects specified in section 2 of the Charitable Endowments Act 1890.
Charitable purpose under Section (2) of the Act includes relief of the poor, education, medical relief and advancement of any other objects of general public utility but does not include a purpose which relates exclusively to religious teaching or worship.
(b) Dividend Equalisation Fund :- Allocation to this fund is not mandatory if not provided for in the bylaws. The general body of its discretion, after completing appropriation towards the items provided in the Act may allot a portion of the net profits to this fund at the rates, if any, prescribed under bylaws. The fund is created to enable the society to pay dividend at a uniform rate during the future years.
(c) Building Fund :- The allocation to this fund is not mandatory if not provided in the bylaws. If the general body so desires, it can earmark a portion of the net profits to this fund, in accordance with the bylaws. For utilisation of this fund permission of Registrar is necessary. So, wherever the auditor comes across debit to this fund he should verify whether proper administrative sanction has been obtained for the expenditure.
(d) Bad Debt Reserve :- Allocation to Bad Debt Reserve (otherwise known as Reserve for Bad and Doubtful debts) is made by the General body. This reserve is contemplated not only in credit societies but also in non-credit societies, which have provision in their bylaws for credit sales.
(e) Price Fluctuation Reserve or Fund :- The allocation to this fund is not mandatory if not provided in the bylaws. The rate of contribution to this fund depends upon the rates, if any, fixed in bylaws. The fund is intended to meet any losses in trading due to fluctuation in prices. Where drawals are made from this fund the Auditor has to ensure its proper utilisation.
(f) Wages Equalisation Fund :- Allocation to this fund is permissible but not mandatory unless provided in the bylaws. Drawals are made when in any year, expenditure on wages is abnormally high. The auditor has to ensure proper utilisation of the drawals from the fund.
(g) Reserve for depreciation of investments :- This kind of reserve is provided mainly in State Level and District Level Institutions who have invested substantially in Government and other securities. If they keep the securities till the date of maturity they can realise full value. But loss is likely to arise from depreciation when the securities are disposed of or sold before maturity. Securities purchased should be shown at its face value in the balance sheet. The commission (the difference between the face value and purchase value) if any earned at the time of purchase has to be taken to the profit and loss account. In any year, if there is any fall in the market value to that extent, reserve should be created by charging Profit and Loss Account so that the total of such reserve should not be less than the fall in market price. In the course of redemption of the securities, if the auditor feels that such reserve outstanding is dis-proportionate to the value of total securities outstanding at the end of a particular year, he may with due diligence and care, transfer a portion of the reserve (worked out on the basis of the outstandings) to the profit and loss account. Any appreciation in the price should neither be taken to profit not result in the reduction of the existing reserve.
(h) Business loss reserve :- The allocation to this reserve is permissible. It is usually created in Consumer and Marketing Societies. There are no specific rules or regulations governing the utilisation of this reserve. Hence the Auditor should ascertain whether administrative sanction has been obtained by the Society for its utilisation.
(i) Provision for gratuity :- Circular No.85/75-ADL (1)-49283/75 of the Registrar of Co-op. Societies explain in detail the guidelines to be followed by Auditors for creating provision for payment of gratuity to the employees. The Auditors may strictly follow those guidelines in this regard.
7. Non-Statutory Reserves:
(i) Reserve for stock deficits :- The value of deficits of stock noticed every year is shown on the asset side of the balance sheet with a corresponding reserve on the liability side to cover up the amount of stock deficit. When the value of stocks deficit is recovered from the person responsible the reserve created will be released to that extent, automatically. If the society does not pass necessary entries for such release of reserve, the Auditor can pass necessary entries for the same.
(ii) Depreciation reserve :- Whenever any of the times of asset, viz. Furniture, Vehicle, Buildings etc., are disposed off, the unrealised book value of such items may be adjusted from the depreciation reserve and the loss so incurred by that sale or disposal recouped. If the disposal of items fetched Book value less depreciation of the sale price is less than the loss incurred it should be taken to profit and loss account. If the auditor suspects any unusual practice in the transaction, the loss incurred should be shown as realisable from persons responsible.
(iii) Reserve for excess Profit :- This is usually provided in Weavers’ Societies, the business of which is subjected to heavy price fluctuations. In such cases, profit earned over and above a reasonable percentage due to abnormal price increase for the end product is set apart and credited to a special reserve.
(iv) Specific Bad Debt Reserve :- When Bad Debt Reserve is created by retrenching profit to cover certain specific bad debts, the Auditor may at his discretion release the reserve in case those debts have actually been recovered in full. But any write off from this reserve should be supported by administrative sanction.
(v) Special Bad Debt Reserve :- Contribution to this reserve is made by Government mainly to encourage primary agricultural credit societies and Central/District Co-operative Banks to provide necessary credit to increase agricultural production, and in particular to advance loans for small farmer and weaker section in the community.
Loan issued for agricultural production alone is taken into consideration for the purpose of payment of contribution towards this. This reserve can be drawn upon only with the previous sanction of the Registrar of Co-op: Societies.
(vi) Provision for Income-tax :- Income-tax liability for a particular financial year/accounting year is assessed on the profits earned during the preceding assessment/accounting year. So the auditor has to make provision for income-tax, if any based on this. So the auditor has to make provision for income-tax, if any based on this. Since the profit of the year under audit forms the basis of assessing income-tax, it is only just that the assessment of income tax for a particular year is debited to the profit and loss account of the same year. If, on the last day of the co-operative year, the tax is pending payment, it is to be shown as liability in terms of the order of assessment of the Income-Tax Authorities.
When an institution earns substantial income in a particular year due to some unexpected favourable circumstances, but does not expect similar, income in the succeeding years, the auditor has to provide sufficient Reserves in consultation with the Income-tax authorities, for meeting the income-tax liability.
(vii) Reserves for objected payments :- The auditor should create reserves for all objected payments except those which can surely be recovered. Otherwise the balance sheet of the society will not exhibit a true and correct financial position. At the time of objecting a payment the auditor will not be in a position to assess the realisability to the amount. There fore, when a payment is objected without creating a reserve, the assets of the society will be shown enhanced to that extent and is likely to be distributed as profit in due course. In order to avoid such a contingency the auditor has to provide for sufficient reserve, for the amounts objected. He should also explain the circumstances under which the items are objected in audit.
(viii) Reserves directly chargeable to Profit and loss account :- Reserves for gratuity, income-tax, sales tax, bad debt, depreciation, etc, are specific reserves which are debited directly to profit and loss account. The reserves for the above items must be created even if the result is profit or loss. Creation of such reserves is necessary to that the balance sheet can exhibit a true and fair picture on the affairs of the institution.
No. ADL (2) 12314/75. Office of the Registrar of Co-operative
Societies, Trivandrum 15-11-1975.
CIRCULAR No. 101/75
Sub :- Co-operative Department - Assets acquired Utilising General Funds
Charging of Depreciation - Instructions issued.
Ref :- (1) This office endorsement on ADL (3) 18572/69 dated 9-7-1969.
(2) Letter No. ACD (T) 3430/P (8) 74/5 dated 10-3-1975 of the Assistant Chief Officer, Agricultural Credit Departments, Trivandrum.
(3) Letter No. ACD (T) 1521/P (8) 75/6 dated 28-10-1975 of the Assistant Chief Officer, Agricultural Credit Department, Trivandrum.
In Chapter I of Volume II of the Madras Co-operative Manual, it is laid down that no depreciation need be charged on the value of buildings constructed/acquired investing Building Fund or by utilising General Funds which is recouped in subsequent years. The general principle underlying the above procedure is that the “Building Fund” and the “Building Recoupment Reserve” are created charging the profit and loss account and if depreciation is charged on the assets acquired out of the above Fund Reserve, it will result in the profits being cut twice for the same purpose. An extract of the above procedure as contained in the Madras Co-operative Manual was communicated to the Deputy Registrars (Audit) for information and guidance vide reference Ist cited. The Reserve Bank of India have since pointed out in the letters referred to as 2nd and 3rd papers above, that the “Building Recoupment Reserve” created to recoup expenditure incurred from General Funds for construction of buildings will not in any way be a substitute for reserve for depreciation on building, besides being a requirement in scientific accounting is also essential in prudent financial management. Moreover, in respect of Co-operative Societies coming under the purview of the Banking Regulation’s Act, it would also be a requirement of law as depreciated value of the premises is to be shown in the balance sheet prepared under Section 29 of the Act. Under the above circumstances, the following instructions are issued for strict compliance.
(1) Depreciation should be charged at the prescribed rate on all buildings irrespective of the fact whether they were constructed/acquired by investment of Building Fund, General Fund or any other source.
(2) The Co-operative Societies which are recouping expenditure incurred on buildings from General funds may however be permitted to charge depreciation, as a measure of relief, after the expenditure incurred from general funds is fully recouped. (3) The above instructions will apply also to other assets acquired utilising General Funds to be recouped in subsequent years.