1.80     Query

Capital Reserve created out of Revaluation of Assets and

Charging of Depreciation

  A Government shipping company created a Capital Reserve by revaluing its fleet.  The relevant facts are as under: -

(1)        Based on the independent expert’s valuation report, the querist company raised the valuation of its fleet as on 31^st March, 1975, by a net amount of Rs. 5, 78,78,732.

(2)        In the accounts of the company for the year ended 31^st March, 1980, the following items appear:

(a)        In the Profit and Loss Account

(b)      In Schedule ‘B’ headed “RESERVES AND SURPLUS”

forming part of the Balance Sheet :

“Capital Reserve (Unrealised)

(c)      In Schedule ‘E’ headed “Fixed Assets” forming part of the said

Balance Sheet

Notes :

……………………….

3. Based on the valuation report the Board of Directors by a Resolution dated 1^st July, 1975 have raised the valuation of the fleet by Rs. 5,78,78,732/- (net of increase of Rs. 6,12,96,338/- and decrease of Rs. 34,17,606/-) being the amount of enhanced value of fleet which was considered by the Directors to be of permanent nature.  The amount of Rs. 5,78,78,732/- has been credited to Capital Reserve Account (Unrealised).  This revaluation was done on 31^st March, 1975.

4.(a)for the purpose of ascertaining the permanent increase, as a result of revaluation of the fleet as indicated in the Note 3 above, the Board adopted the following formula:

(i)       30% of difference between the book value and market value as on 31.3.1975 in case of new vessels less than 5 years old ;

(ii)      20% of the difference between the book value and market value as on 31.3.1975 in case of vessels more than 5 years old;

            (iii)       No revaluation in case of vessels more than 20 years old;

(vi)       In case of ships where the market value was below the book value, the lower value only was taken into account irrespective of the age of those ships.

(b)        The depreciation in respect of revalued vessels whether second-hand or new is being charged on the basis of balance life from the date of revaluation i.e. 31.3.1975.  In respect of vessels other than revalued, depreciation is charged on the basis of straight line method in respect of new vessels and for second-hand vessels, it is being charged on the basis of balance life of such vessels.

(c)        Depreciation has been calculated in respect of revalued ships by reference to balance life of such vessels from the date of revaluation.  Depreciation on the original cost has been charged to Profit and Loss Account and depreciation on difference between the revalued cost and original cost has been adjusted against Capital Reserve.

5.“Depreciation amounting to Rs. 34,25,402/- (previous year Rs. 34,25,402/-) being the difference of Depreciation on Revalued amount of the fleet and that on its original cost has been adjusted against the Capital Reserve created on revaluation.  The total adjustment of depreciation out of Capital Reserve till 31.3.1980 amounts to Rs. 1,89,24,314/- (previous year Rs. 1,54,98,912/-).  In this connection reference is invited to Director’s reply dated 28.9.1979 to the comments of the Comptroller & Auditor General of India under Section 619(4) of the Companies Act, 1956 on the accounts for the year ended 31^st March, 1979”.

6.On the foregoing presentation in the audited Accounts of the Company, the Comptroller and Auditor-General of India has made the following comments under Section 619(4) of the Companies Act, 1956.

                        “Profit and Loss Account

                        Depreciation on fleet—Rs. 7,55,34,315/-

A reference is invited to the comments on the accounts of the company for the year 1978-79.

The practice of charging the difference between depreciation calculated on the revalued amount and that on the original cost of fleet to Capital Reserve for revaluation of fleet instead of to the Profit and Loss Account of the year, continued in the current year also.

According to generally accepted accounting principles, entire depreciation on the revalued amount should have been charged to Profit and Loss Account.  Hence the above depreciation on fleet for the year is understated by Rs. 34,25,402/-.  The undercharge in respect of previous years (1975-76 to 1978-1979) on this account works out to Rs. 1,54,98,912/-.

Consequently, both accumulated loss up to 31^st March, 1980, and Capital reserve (Unrealised) Account have been understated by Rs. 1,89,24,314/-”.

7.The company has given the following reply to the aforesaid comments of the Comptroller and Auditor General of India:

            “We have considered the comments of the Comptroller and Auditor General of India.

            We are of the view that:

1.         The Companies Act has envisaged that there should be uniformity about the adoption of accounting principles and full disclosure of various facts due to adoption of a particular system of accounting be made in order to have true and fair view of accounts.  In view of these principles, the practice of charging difference between the depreciation calculated on revalued amount and that on original cost to Capital Reserve has been continued in accounts for the year 1979-80. Thus, both these principles and true and fair view have been achieved by Notes Nos. 3, 4 and 5 of Schedule ‘E’ of the Balance Sheet.

2.         Since other shipping companies have also adopted for their accounts the practice of charging depreciation in respect of revalued assets as followed by our company, it will not be correct to generalize that charging of full depreciation on revalued assets to Profit and Loss Account is generally accepted accounting principle.

3.         The Capital Reserve due to revaluation of the fleet was created keeping in view the then permanent increase in the value of the vessels.  No credit was taken for the purpose of arriving at the Profit and Loss Account for the year in which this reserve was created.  The company’s intention from the beginning was to write-off the amount of Capital Reserve within the balance life of the vessels without artificially affecting the Profit and Loss Account. This procedure has been followed by the company from 1974-75 to 1977-78 without any comments from the Comptroller & Auditor General of India.

            It would be incorrect at this stage to debit Profit & Loss Account to the extent of notional depreciation difference debited to Capital Reserve (Unrealised) as now desired by the Audit.

4.         If the procedure which has been suggested by the Audit in 1978-79 is to be accepted, the Capital Reserve (Unrealised) will continue to remain undistributed even beyond the life of the vessels against which the capital reserve was created.  This, in our view, would be unrealistic.

5.         In this connection, the Expert Advisory Committee of the Institute of Chartered Accountants of India have given their opinion on pages 7 and 43 to 50 of the Compendium of Opinions (1978 Edition).  As per their opinion, full depreciation should be provided in Profit & Loss Account in respect of revalued assets.  However, in the Foreword of this publication, the Chairman of the Expert Advisory Committee has indicated that these are only opinions and not final views of the Council.

6.         In view of the above, there is no understatement in respect of accumulated loss and Capital Reserve (Unrealised).”

7.         On the foregoing facts, the opinion of the Expert Advisory Committee has been sought on the following questions:

(i)         Whether the practice followed by the company in respect of charge of depreciation pertaining to revalued assets is incorrect from accounting point of view?

(ii)        Whether adoption of system of adjusting difference on depreciation between revalued cost and original cost from Capital Reserve by some of the companies and using of the same system by the company can now be called as a normal accounting principle?

(iii)       In view of the various notes put by the company under Schedule ‘E’ in respect of Fixed Assets in the accounts, whether it may be said that there is no material misstatement, no suppression of fact, no under-statement of depreciation and loss and the company’s accounts exhibit true and fair view?

Opinion                                                           October 19,1981

            1.         In order to answer the above questions, it is necessary to briefly recapitulate the following relevant provisions of the                                     Companies Act, 1956 by which the querist company is governed: -

(a)        Section 211 (1) and (2) requires every company to lay before the members in general meeting, a balance sheet and a profit and loss account.

(b)        Under Section 211 (1), the balance sheet has to “give a true and fair view of the state of affairs of company as at the end of the financial year” and subject to the provisions of Section 211, the Balance Sheet has to be in the form set out in Part I of Schedule VI, “or as near thereto as circumstances admit”.

(c)        Under Section 211 (2) the profit and loss account has to give a true and fair view of the profit or loss of the company for the financial year and, subject as aforesaid to “comply with the requirements of Part II of Schedule VI, so far as they are applicable thereto”.

(d)        The material part of Section 211 (5) reads as follows:

“(5)      The balance sheet and the profit and loss account of a company shall not be treated as not disclosing a true and fair view of the state of affairs of the company, merely by reason of the fact that they do not disclose……….(v) in the case of any company, any matters which are not required to be disclosed by virtue of the provisions contained in Schedule VI or by virtue of a notification issued under sub-section (3) or an order issued under sub-section (4)”.

3. (a)     The horizontal from of balance sheet prescribed under Sub-Part A of Part I of Schedule VI has been chosen by the querist company.  Regarding the “Instructions in accordance with which assets should be made out”, under each head of Fixed Assets, the original cost and the additions thereto and deductions therefrom during the year and the total depreciation written off or provided up to the end of the year are required to be stated.  However, where the original cost cannot be ascertained without unreasonable expenses or delay, the valuation shown by the books shall be given.

(b)     Part I of Schedule VI does not contain any other specific provision having a bearing on the question under consideration.

(c)     Part II of Schedule VI contains provisions under paragraphs 2 and 3 (iv), (viii) and (xv) which may have a bearing n these questions.

 

(d)     The provision in Part II which is directly concerned with the subject matter under discussion is paragraph 3(iv) which reads as follows:-

“3. The profit and loss account shall set out the various items relating to the income and expenditure of the company arranged under the most convenient heads; and in particular shall disclose the following information in respect of the period covered by the account………….….

(iv)    The amount provided for depreciation, renewals or diminution in value of fixed assets.

1. If such provision is not made by means of a depreciation charge, the method adopted for making such provision. If no provision is made for depreciation, the fact that no provision has been made shall be stated and the quantum of arrears of depreciation computed in accordance with Section 205 (2) of the Act shall be disclosed by way of a note”.

(e)     The Act also contains provisions in other places in regard to the quantum of depreciation required to be charged for ecific purpose such as:

 

(i)      computation of the ceiling on managerial remuneration calculated as a percentage of profits (Section 350); and

(ii)             the ceiling on amounts that may be declared and paid by the company as divided (Section 205).  In substance, Section 205, in so far as concerns the present case, permits the payment of dividend by the company out of its profit arrived at after providing for depreciation to the extent specified in Section 350.

3.The committee’s attention was drawn to Circular No. C/293 A(584) dated 5^th October, 1961, issued by the Department of Company Law Administration, which deals with the computation of depreciation under Section 350 of the Companies Act, 1956. In response to question No.3 the circular states that any addition arising out of a revaluation subsequent to 1^st April, 1956 should not be taken into account for the purpose of providing depreciation under Section 350.

4.It is thus clear that if a company chooses to provide depreciation to the extent specified in Section 350, that would be sufficient compliance with the requirements of Section 350 for determination of the figure of profit out of which a dividend could be paid. It is further clear from the above mentioned Circular of the Department administering the Company Law that, for the purpose of compliance with Section 350, it is not necessary for the company to take into the account additions arising out of the revaluation of fixed assets made after1st April, 1956, for the purpose of providing depreciation.

1.   5.   (a)     Applying the above mentioned provisions of law to the facts of the present case, it will be seen that the querist company has fully complied with the requirements of paragraph 3 (iv) of Part II of Schedule VI in so far as the Profit and Loss Account of the company has clearly disclosed the amount provided for depreciation, renewals or diminution in value of fixed assets, the method adopted for making such provision having also been clearly disclosed.  It is also clear that there is no quantum of arrears of depreciation computed in accordance with Section 205 of the Act requiring disclosure by way of a note on the Profit and Loss Account.

(b)             The foregoing analysis will also bear out that the result of the working of the working of the company during the period covered by the Profit and Loss Account and other material features, in so far as concern the matters relevant to our discussion, have been clearly disclosed and the figure of profit and loss shown by the querist company’s Profit and Loss Account does not exceed the amount available for distribution as dividend by the querist company under Section 205.

           (c)             In view of the specific provisions of Section 211(5)(v) the disclosure of the relevant items by the querist company in its Balance Sheet and Profit and Loss Account is fully in compliance with the requirements of the provisions in that regard contained in Schedule VI.

Accordingly such presentation may be treated as disclosing a true and fair view of the state of affairs of the company, in view of the provisions of Section 211 (5)(v).

6.In the light of the foregoing observations, we would give our answers to the questions raised by the querist company as under: -

The presentation consistently followed by the company in respect of the charge of depreciation on the revalued assets in its accounts in all the years from the date of the revaluation up to and including the close of the accounting year 1979-80 is not in violation of the requirements of the Companies Act, 1956, in this regard.

The querist has made adequate, if not indeed, full, disclosure of all material matters relating to the revaluation and the charge of depreciation in its Accounts, for 1979-80, and there has been no material mis-statement or suppression of facts as regards depreciation, or loss or the Unrealised Capital Reserve in the said Accounts which give the true and fair view required by the Companies Act, 1956.

   7.   (a)     Since the querist company has, in its Case for Opinion, referred to the earlier opinions expressed by the Expert Advisory Committee and published on pages 7 and 43 to 50 of the Compendium of Opinions (1978 edition), where, according to the querist company, it would appear that the Committee’s earlier opinions are contrary to what has been stated by us in the present case, it may be appropriate to make some observations on this aspect.

                   (b)             The opinion published on page 7 of the Compendium of Opinions (1978 edition) is limited to a categorical statement that depreciation has to be provided for on the basis of the revalued figures and not limited to the depreciation on the basis of the original cost. A careful reading of that opinion will bring out that it has nowhere been stated therein that the whole of the amount of such depreciation on the basis of the revalued figures must be deducted in working out the balance of the profit or loss of a particular accounting period. The words “full depreciation should be provided in profit and loss” appearing in the second sentence of paragraph 5 of the querist company’s Case for Opinion do not appear anywhere in the opinion of the Expert Advisory Committee reproduced on page 7 of the Compendium of Opinions.

                   (c)             As regards the opinion published on pages 43 to 50 of the Compendium of Opinions (1978 edition), paragraphs 6.4 and 6.5 on pages 48 and 49 read as follows:

“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 Account 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 recognised 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 accounts of each of the years of this life which allows disclosure of a true and fair view of the working results of each of those years”.

The committee does not find anything in that opinion which warrants the assumption that the Expert Advisory Committee then expressed the view that the full amount of depreciation on the basis of the revalued figure must be deducted in arriving at the balance of profit or loss shown by the Profit and Loss Account if it is to comply with the requirements of the Companies Act, 1956.

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