1.21 Query
Adjustment of Depreciation on Revaluation of Plant and Machinery. A company installed plant and machinery at a cost of Rs. 25 lakhs in the year 1960. The Company had been charging depreciation on straight line method at 7% on its plant and machinery. For a variety of reasons, Directors want a revaluation of plant and machinery and have got the same valued by an expert. The expert, after taking into account depreciation according to the expert’s own method, has arrived at the present value of Rs. 30 lakhs in respect of the above plant and machinery. The written down value as per books on straight line method as on date is Rs. 7.5 lakhs. In view of the revaluation the difference of Rs. 22.5 lakhs will be credited to Capital Reserve or Revaluation Reserve. Evidently there can be no objection to the crediting of difference to either of these can be no objection to the crediting of difference to either of these reserves as long as such amount is not available for distribution as dividend.
The question that has arisen in the current year is regarding depreciation. With the increase in valuation by Rs. 22.5 lakhs the book value of the machinery will be Rs. 30 lakhs. The Company’s contention is that depreciation at 7% is to be adjusted on Rs. 30 lakhs for the current year. The following problems arise: -
1. (a) The prescribed period calculated while determining the rate of depreciation by a straight line method was 14 years. Is it not necessary that 95% of the value of the value of the machinery is written off in 14 years? If only 7% is written off for the current year and subsequent years, the value of plant and machinery will be written off in 14 years from now, i.e., by 1985 while if that has been written off within the specified period from the date of acquisition, it would have been written off by 1975. Can the Company’s contention that it should be written off at 7% on the book value be accepted?
(b) Where a present revaluation (after depreciation being taken by the value in his own method) is included in cost, for the purpose of depreciation will there be adjustment required for arrears of depreciation as the asset has been in use since 1961? The Company’s view is that the valuer has already taken depreciation into account and any such arrears in depreciation adjustment would amount to adjustment of depreciation twice.
(c) Can it be contended that the plant and machinery as revalued should be written off within the balance of the specified period viz., 4 years? What possible objection the company can raise against this contention?
2. Under Section 205 (2) (b) what is required to be written off in the specified period is 95% of the cost. If, as a result of revaluation, any additional amount is written off, it is an amount of write-off in excess of the requirements of Section 205 (2) (b). Any write off at 7% on the book value will definitely include the write-off at 7% on the original book value before revaluation and as such according to the Company the write-off at 7% is in full compliance with the provisions of Section 205 (2) (b). Is this contention correct?
3. (a) It is said that when a revaluation is made, the depreciation to be adjusted in books is the depreciation on the increased value arising from revaluation. The Company is of the view that for the purpose of considering whether any profit is available for dividend, the depreciation to by taken into account is 7% on the original cost and not 7% on the value increased by revaluation.
(b) Is it necessary that the depreciation at 7% on the increased value be charged to the Profit and Loss Account keeping in view the provisions of Company Law, requirement of Schedule VI and general accounting principles? Will it be in order for the company to charge 7% on the original cost to the Profit and Loss Account and debit the increased cost of depreciation arising from revaluation to the Revaluation Reserve?
4. (a) Is it necessary to show every year in the statement of accounts that there had been a revaluation of the assets or is it required to be so specified only for a specific number of years? There does not appear to be any requirement in the Company Law that there should be a mention about revaluation.
(b) In the Schedule of Fixed Assets, in the column required for cost of the assets, will it be alright if it is stated ‘book value or cost’? Will this description be alright where the revaluation took into account accrued depreciation up to the date of valuation on the basis considered adequate by the value? Opinion July 29, 1972
1. We would begin by referring to the last sentence of the first paragraph. If what is stated therein implies that a company is free to book alleged increases in value of individual fixed assets from time to time by debiting the assets account and crediting a reserve account, as long as such amount is not regarded as available for distribution as dividend, we would wish to caution that this is not the correct position. A company’s periodic Statements of Accounts have to be prepared in such a manner as to truly and fairly reflect its financial position and the trend of its working results over the respective periods. This implies that the Accounts must be prepared in accordance with generally accepted accounting “principles”, which in turn are based on well established and generally accepted accounting concepts and conventions. For the purpose of the queries, the relevant basic concept is that under which accounts are prepared on the assumption of a “going concern concept’ of the accounting entity. Under this concept, generally accepted accounting principles require the valuation of assets on the following basis: -
(a) Short term or current assets: at the lower of cost and market value (based on the accounting convention of conservatism); and
(b) Long term or fixed assets: at cost less depreciation (based on the value to the company as a going concern of such assets intended to be held in the same form over a relatively long period of time).
It would not be in accordance with generally accepted accounting principles to book unrealized appreciations in value of fixed assets merely on the basis that their current re-sale or replacement price is higher than the written down value at which they are carried in the Company’s books. Hence there would have to be genuine and compelling reasons to justify a revaluation of fixed assets on the basis that the written down book value no longer reflected a true and fair view of the value of the assets concerned to the company as a going concern. In any event, revaluation would not be justified unless it is more or less permanent, it does not merely reflect a current scarcity value that is liable to change with a more liberal import policy or better indigenous product and there has been long term accretion to the value of the asset in terms of its life, its utility and its profitability.
2. In addition to the position mentioned above, which is based on general accounting considerations, regard would also have to be paid to the position under the law in respect of distribution as dividend of surpluses resulting on revaluation of a part of the fixed assets. As is well known, three conditions have to be satisfied before a company can distribute such a profit. These are –
(1) the surplus must be genuine, i.e., must be based on competent independent expert evidence of the fact and amount of the surplus, and it must have been realized.
(2) there should be an overall surplus of at least the amount distributed, on a revaluation of all the fixed assets.
(3) the company’s Articles of Association should allow the booking and distribution of such revaluation surplus.
3. The rate of depreciation applicable to the assets in question under the income-tax law has not been stated in the query. This is an essential item of information because, under Section 205(2) and (5) read with Section 350, the “specified period” has to be determined with reference to –
(1) the cost or written down value of the assets as shown by the books of the Company at the end of the first relevant financial year ; and
(2) the rate of depreciation specified for the asset under the Income-tax Law.
We have therefore assumed that, since depreciation was originally calculated on the straight line method at 7%, the applicable rate under the Income-tax Law would be approximately 15% or such higher rate as results in 95% of the cost being written off on the diminishing value method in about 14 years, which apparently was the original estimate of useful life of the asset.
4. The scrap or sale value at the end of the useful working life has not been stated and this is assumed by us to be Nil.
5.1 The Companies Act contains three sets of requirements regarding Depreciation for three separate and distinct purposes. The requirement for one particular purpose, e.g., profit available for dividend, should not be confused and read as also applicable for another purpose, e.g., provision of depreciation in accounts.
5.2 The three separate purposes for which the Act contains requirements regarding Depreciation are: -
(1) For calculation of managerial remuneration where it is based on profits. (2) For calculation of profits that may be distributed as dividend. (3) For provision and presentation of depreciation in the Company’s periodical Accounts.
5.3 the requirement for these three purposes are contained respectively in –
(1) Sections 348 to 350. (2) Section 205 read with Section 350. (3) Sections 210 and 211 read with Schedule VI.
6.1 Subject to what has been stated in the preceding paras, we proceed to answer the queries seriatim.
6.2 The “problems” listed under queries 1(a) to (c) are apparently related to the requirements regarding provision and presentation of depreciation in the Company’s Accounts alone, and not the other two purposes mentioned earlier by us.
6.3 The expert’s valuation at Rs. 30 lakhs as the present value of the assets purchased for Rs. 25 lakhs in 1960, (and then estimated to have a working life of about 14 years and a ‘Nil’ scrap or sale value at the end of that life), obviously indicates that, apart from the effect of increase in price levels, there has been re-assessment of the presently remaining useful life of these assets which is now expected to extend well beyond the earlier estimated expiry date 1975.
6.4 If the three conditions stated in para 2 above are satisfied, the Company can book the increase on revaluation of the assets by debiting the Asset Accounts and crediting a Capital Reserve Account with the surplus of Rs. 22.5 lakhs, which would then even be available for distribution as dividend.
6.5 If the Company books this surplus and this increases the present book value of this Asset to Rs. 30 lakhs, it must provide depreciation for the current year onwards in accordance with any of the recognized methods (including the straight line, and the written down value methods) of such amount as will –
(1) write off this amount of Rs. 30 lakhs over the reassessed useful working life of the asset ; and
(2) represent a charge for depreciation of the asset to the Account of each of the years of this life which allows disclosure of a true and fair view of the working result of each of those years.
6.6 What we have stated in paras 6.4 and 6.5 above is in answer to the “problems” raised in the queries 1(a) to (c) and 3(b), in so far as is relevant to the determination of the quantum of depreciation to be charged in the periodic accounts of the company from the current period up to the end of the useful life of the asset.
7.1 The problems raised in the queries 2 and 3(a) apparently relate to the requirements of the Act regarding deduction of depreciation for use of the assets in determining the Company’s profits available for distribution as dividend.
7.2 as already mentioned, the requirements of the Act for this purpose are contained in Section 205 read with Section 350. Reference to Section 205(5) (a) will show that the “specified period” has to be determined by considering “the original cost of that asset to the Company”, and not the revised book value. Hence, under the law as it stands today, and subject (we once again stress) to compliance with the conditions listed in para 3 and the assumptions stated in the other preceding para’s there is no bar in law to the company declaring dividends out of profit arrived at after deducting only such depreciation as will result in 95% of the cost of the assets having been provided for by way of depreciation in the same number of years as would be required if depreciation were to be calculated in accordance with Section 350. This would mean an amount of depreciation calculated on the original cost of Rs. 25 lakhs or such part of it as represented the written down value of the asset as appearing in the books of the company at the end of the first accounting period for which Section 350—as presently worded—became applicable to the Company at the rate of depreciation applicable to these assets under the income-tax law. Thus the Company’s contentions as stated at items 2 and 3(a) would, subject as stated above, appear not be in contravention for the requirement of Section 205, so far as It relates to the quantum of profits available for distribution as dividend by the Company.
8.1 This leaves for consideration the problems listed in the queries 4(a) and (b), which relate to the requirements of the Act as to the presentation in the Company’s periodic accounts of the revaluation and the consequent changes in depreciation provision on these assets.
8.2 The answer to queries 4(a) and (b) is given in the column headed “Instructions in accordance with which assets should be made out of Part I of Schedule VI” in the Company’s Act. This requires that where sums have been added by writing-up the assets, every Balance Sheet subsequent to such writing up shall show the increased figures with the date of the increase in place of the original cost. In addition, such Balance Sheet for the first five years subsequent to the date of writing-up shall also show the amount of increase made.
8.3 In compliance with the requirements of Part I, including the first para under the above mentioned column and Note (c) of the Notes of “General instructions for preparation of Balance Sheet” at the end of the Form in Part I, the total amount of depreciation written off, or provided up to the date of the Balance Sheet (including the depreciation written off or provided on the changed basis for the current period) has to be allocated under the different asset heads presented in the balance sheet and deducted in arriving at the value of the Fixed Assets.
8.4 We may add that compliance with paras 3(iv) and (xv) of Part II of Schedule VI will require disclosure in the Profit and Loss Account of –
(1) The total amount provided for depreciation of fixed assets for the current period (including the provision on revised basis for these assets); (2) the fact of change in the basis of provision for depreciation of these assets ; and (3) the effect of the change on the results of the year’s working. _______________________________ |