1.78 Query
Determination of Proper Depreciation A company was incorporated on 13th May, 1976, and started commercial production in May 1978. The first accounting year adopted by the company was the year ending 30th September. Later on it was changed to December, after complying with the various provisions of the Companies Act and the Income–tax Act. During the year ended 31st December, 1978, the company provided depreciation on Straight Line Method (SLM) basis after taking into consideration the provisions of Section 205 of the Companies Act and the “specified period” with reference to the depreciation rates prescribed in the Income-tax Rules. The company arrived at the depreciation rates under the SLM by dividing 95% of the cost of its assets by the “specified period” so arrived at. The SLM rates so arrived at have been applied on technical consideration. It was also decided on technical considerations that as these rates were with reference to single shift, therefore for double shift these rates were with reference to single shift, therefore for double shift the rates will be taken at twice the rates and at thrice the rates for triple shift, in order to arrive at the appropriate and commercial depreciation. On this basis the company provided depreciation on its Plant and Machinery for the year ended 31st December, 1978, and 1979 e.g. the rate on items falling in the 10% category as per Income-tax Rules, the SLM rate worked out to be 3.39% for single shift, 6.78% for double shift and 10.17% for triple shift as against 15% and 20% respectively for double and triple shift respectively as per the written down value method under the Income-tax Rules.
This
method of depreciation has been found acceptable to the company and also to the
three firms of auditors. The auditors of the company for the year ending 31st December, 1978 and 1979 as well as the firm of internal auditors of the company
have concurred with the basis adopted by the company as being well within the
law. The basis was adopted in 1978 and was consistently followed in 1979.
The
said company is a Joint Sector company promoted by an SIDC with a private
technical entrepreneur who has the option to buy back the shares of the Joint
Sector company from the SIDC at the net worth to be calculated by the auditors
at the time of buy back whenever such an event occurs or within a stipulated
period of 8 years.
The company could have adopted the WDV method from its inception without any restriction and in such a situation the net worth could have been below par value or near to the par value but the company adopted the SLM for depreciation keeping in view the growth of the company and to make a realistic charge for depreciation.
The SIDC has raised the following objections:
(a) The SLM as adopted by the company is inconsistent with law;
(b) The company must provide only the minimum depreciation so that its net worth is reflected at a higher book value;
(c) The SIDC is not taking into consideration the views of those directors who are either nominees of other Financial Corporations or the independent directors.
(d) The SIDC is withholding the Accounts as a director of the SIDC is the nominee Chairman/Director of the company.
In view of the above facts, the following queries are submitted for the examination and valuable opinion of the Committee:
1. Whether the basis of depreciation as adopted by the company is consistent with the provisions of the Companies Act?
2. Whether the quantum of depreciation, if reduced to minimum in subsequent years, will meet the requirement of Section 205 (2) (b) of the Companies Act? 3. Whether the company is justified in providing the depreciation on SLM basis at thrice the rate for triple shift and whether it represents commercial depreciation relatable to the actual usage?
4. Whether the said SIDC can lawfully insist upon the company to provide only the minimum depreciation in its accounts?
5. Can an interested Director in a situation, as described hereinbefore, act as the Chairman of the meeting for adopting the accounts and hold the accounts from being adopted, so that the company is forced to reduce the quantum of depreciation to suit the requirements of the SIDC?
Opinion October 19,1981
The opinion/comments of the committee on the queries are as follows: - (1) The Companies Act, 1956, does not specify any one particular method of providing for depreciation in the accounts of a company prepared under the provisions of the Act. Section 205 requires that depreciation must be provided in accordance with the provisions of sub-section (2) of that section before a company can distribute dividend in any year. Sub-section (2) of Section 205 specifies four alternative bases for provision of depreciation. The first of these is depreciation “to the extent specified in Section 350”. The straight line method of depreciation is one of the methods recognised in Section 205 and also is a recognised method in accounting. Where no depreciation has been provided in the accounts, there is a requirement under paragraph 3 (iv) of Part II of Schedule VI to the Companies Act to disclose the quantum of arrears of depreciation computed in accordance with Section 205 (2) of the Act, by way of a note on the Profit and Loss Account.
(2) From the above it is apparent that, for the purpose of preparation of
its annual accounts, a company has to provide depreciation in any manner
recognised by generally accepted accounting principles and in case of
non-provision, the amount of depreciation computed under Section 205(2) needs to
be disclosed. The Research Committee of the Institute has expressed the view in
the booklet, “Compendium of Notes”, under the heading “Provision for
Depreciation”, that it is open to a company to provide for depreciation either
on the written down value method or on the straight line basis. In arriving at
the rates at which depreciation should be provided the company must consider the
true commercial depreciation, i.e. the rate which is adequate to write
off the asset over its normal working life. If the rate so arrived at is higher
than the rates prescribed under Section 205(2), the company should provide
depreciation at such higher rate but if the rate so arrived at is lower, then
the company should provide depreciation worked out in the manner prescribed by
the Section 205(2) since this represents the minimum amount of depreciation to
be provided before a dividend can be paid out of the profits of the company.
Accordingly, in the opinion of the Committee, computation of depreciation by the
company on the straight line method for preparation of its annual accounts is in
accordance with the provisions of the Companies Act.
(3) It is not clear from the query what the querist means by “reduced to
the minimum”. However, assuming that he means the reduction in rate in future to
bring it in conformity with Section 205 (2) (b), that would not be in violation
of the provisions of that section. However, this would amount to a change in the
basis of accounting. Hence, to comply with the requirements of paragraph 3(xv)
of part II of Schedule VI to the Companies Act, 1956, a note, disclosing the
amount, if material, by which the depreciation shown in the profit and loss
accounts is affected by that change should in that case, be included in the
Accounts.
(4)Charging depreciation at thrice the rate of the basic SLM rate does
not appear to be in accordance with Section 350 or with Section 205. The rates
of depreciation including multiple shift depreciation rates as per Section 350
are to be obtained from the Income-tax Rules. Under the Income-tax Rules, for
double shift working, the shift allowance is 50% of the normal depreciation and
for triple or multiple shift working, it is 100% of the normal depreciation.
Converting the WDV rate of 10% under the Income-tax Rules, the querist has
arrived at a corresponding basic SLM rate of 3.39%. Section 205 has explained
the specified period by reference to which the straight line method is to be
applied as the number of years at the end of which 95% of the original cost of
that asset to the company will have been provided for by way of depreciation if
depreciation were to be calculated in accordance with the provisions of section
350. In other words, if the straight line method of depreciation is to be
followed pursuant to the provisions of Section 205(2)(b) of the Companies Act,
1956, it is necessary that the exact correspondence between the WDV rate as per
Section 350 in terms of basic rate and multiple shift allowances has got to be
maintained in deriving the SLM rates for extra shift working. It is, therefore,
apparent that the company has worked out depreciation at rates higher than the
rates based on such conversion. However, if technical reasons support the
additional higher charge for shift working, disclosure of a true and fair view
by the Accounts would no be impaired.
(5)Whether the SIDC can lawfully insist on provision of depreciation of only the minimum amount required under Section 205(2) for the purpose of fixation of the buy back price of its shareholding would depend upon the exact agreement between the collaboration parties about the manner of calculation of the net worth, and/or the manner of providing depreciation in the annual accounts, if the net worth is to be computed by reference to the book value of the assets. If the agreement is silent on these matters, and if the method of charging depreciation is specifically approved by the Board of Directors on a proper consideration of the need for a higher charge, so far as the company’s accounts are concerned, this would be in order. In such circumstances, in the opinion of the Committee, the SIDC would no be entitled to insist on a lower rate of depreciation being charged in the company’s annual accounts. (6)In view of the Expert Advisory Service Rules, the Committee expresses its inability to comment on the competence of a director to act as the chairman of the meeting for adoption of accounts as this is a legal matter.
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