1.30 Query: Applicability of depreciation rates prescribed in Schedule XIV to assets existing on the date of the Schedule coming into force.
1. A Government corporation, established under the Companies Act, 1956, is under the administrative control of the Ministry of Civil Aviation. The corporation was incorporated on 15th October, 1985 and commenced its commercial operations on 6th October, 1986. The corporation is engaged in operating a fleet of helicopters mainly to provide necessary logistic support to another public sector corporation for transporting their men and materials.
2. The corporation purchased 21 Westland helicopters from M/s. Westland Helicopters Limited, U.K., and 27 Dauphin Helicopters from M/s. Aerospatiale, France, alongwith related inventories, ground support equipments, etc. About 45% of the fleet and related equipment was delivered to the corporation during 1986-87 and the balance fleet was received during the year 1987-88.
3. The useful economic life for each type of helicopter as indicated by the manufacturer is 15 years and the same was accepted by the Board of Directors of the corporation. In view of the fact that the helicopter operations are basically highly capital incentive, it was decided by the Board of Directors to charge depreciation on helicopters and aero-engines on a straight line basis rather than on the written down value method. In accordance with this policy, depreciation rate was derived at 6.33% per annum based on writing off 95% of the original cost over 15 years with 5% residual value. This rate of depreciation was used for the purpose of accounts for the year 1986-87. It may be mentioned that the actual stipulated rate of depreciation on straight line basis corresponding to the Income-tax rates for 1986-87 was 11.88% for helicopters and 14.62% for aero-engines. Necessary disclosure was made in the accounts relating to shortfall in the provision for depreciation, amounting to Rs. 5.10 crores.
4. The corporation had also imported a large inventory of repairables and rotables alongwith the fleet of helicopters and spare aero-engines. The nature of these repairables and rotables is such that each type of item under this category has a fixed life based on number of flying hours. Its scheduled maintenance is carried out once that particular item has completed the prescribed number of hours related to that item. On completion of this scheduled maintenance, its life is again brought back equivalent to that of a new item. Except for 4% to 5% which could get damaged during the course of its use on a helicopter, each of these major items are expected to have an economic life equivalent to the useful life of the related helicopters. It is, therefore, a common practice in the aviation industry worldwide to charge off the original cost of the inventory relating to the repairables and rotables over the economic life of the related type of helicopters. The term used is ‘Obsolescence Reserve’ which is something similar to depreciation charge. Since the economic life of the helicopters is assumed to be 15 years as stated above, the Board of Directors had approved the creation of Obsolescence Reserve at a rate of 6.67% per annum which is derived by writing off 100% value over 15 years. The provision for Obsolescence Reserve does not have a corresponding requirement for charge under the Companies Act. The same is, however, also considered for Income-tax purposes.
5.The prescribed rates of depreciation under Schedule XIV to Companies (Amendment) Act, 1988 are 11.31% for helicopters and 16.21% for Aero-engines effective from 1987-88. The corporation is, however, using the old rates till now. It has accumulated book losses of Rs. 21 crores upto the end of 1988-89 based on depreciation and Obsolescence Reserve at the pre-revised rates. The audit is complete upto 1986-87 and the Auditors’ Report for 1987-88 is awaited. The audit for 1988-89 and 1989-90 is pending due to appointment of Statutory Auditors by the C.A.G. The total arrears on account of revision of rates upto 1989-90 for depreciation and Obsolescence Reserve amounts to Rs. 38 crores (Depreciation Rs. 30 crores and Obsolescence Reserve Rs. 8 crores). The corporation had requested the Company Law Board for exemption from the requirements of Schedule XIV. It has, however, turned it down. It is proposed to take effect, if considered necessary, of making provision of the arrears in 1990-91 or thereafter. After making certain proposed prior years credit adjustments (excluding depreciation and Obsolescence Reserve at revised rates) a book profit of Rs. 8.00 crores is expected for the year 1989-90.
6. The corporation had received part of the fleet and the related equipments during l986-87 and the balance during 1987-88. From 1986-87 through 1989-90, the corporation has charged depreciation on helicopters and spare aero-engines at consistent rate of 6.33%. However, during 1986-87 the prescribed rates were 11.88% and 14.62% for helicopters and spare aero-engines respectively. According to the querist, the Department of Company Affairs’ Circular No. 1/86, dated 21.3.86 will strictly not be applicable to the corporation since it had not adopted the stipulated minimum rates of depreciation to the additions made to the fleet during the year 1986-87 as stated above.
7. As stated by querist above, the practice of creating an Obsolescence Reserve for repairables and rotables exists in the aviation industry generally based on the useful economic life of the related type of helicopter. The corporation has been creating Obsolescence Reserve at the rate of 6.67% over the years commencing from 1986-87. Although the rate charged for creation of this reserve has not been specifically indicated under the Companies Act, according to the querist, prudent accounting practices require that existing rate of 6.67% be enhanced to 11.90% based on the revised specified period of 8.40 years for helicopters. The charge for Obsolescence Reserve at an enhanced rate and the treatment of provision for arrears will have to be made, in view of the querist, on lines similar to the depreciation charge.
8. The querist has sought the opinion of the Expert Advisory Committee on the following issues arising from the above:
(i) With a change in the specified period from the assumed 15 years to the prescribed 8.40 years under the Companies (Amendment) Act, 1988 for helicopters, whether it will be appropriate to charge depreciation at 11.31% for helicopters and 16.21% for spare aero-engines on original cost from 1990-91 onwards for additions made during 1986-87, 1987-88 and the later years.
(ii) What should be the treatment for provision for arrears of depreciation arrived at on account of the difference between the statutory rates and the rates at which depreciation is actually charged in the books for the years 1986-87 and 1987-88 to 1989-90? What will be the position about the true and fair view of the accounts if such a provision is (a) either not made at all or (b) entirely made during the year 1990-91 or (c) the provision is spread over the next 5 years commencing from 1990-91 till the end of the specified period of 8.40 years for helicopters. The company is not in a position to declare dividends due to its heavy unabsorbed losses and depreciation arrears.
(iii) Can the provisions of the Deptt. of Company Affairs’ Circular No. 1/85 dated 10/1/85 be applied as an alternative to the above, i.e., depreciation at the existing rate of 6.33% be applied from 1986-87 to 1989-90. Thereafter, the entire unamortised cost of the fleet is written off during the remaining revised specified period of 8.40 years at a derived depreciation rate.
(iv) What would be the position in case of Obsolescence Reserve in respect of (i), (ii) & (iii) above.
Opinion December 6, 1990
1. The Committee notes that the Research Committee of the Institute of Chartered Accountants of India has issued ‘Guidance Note on Accounting for Depreciation in Companies’. Paras 8 to 11 and Paras 17 to 23 which are relevant to the present query are reproduced below:
“8. A question may arise as to whether it is obligatory on a company to provide for depreciation only on the basis mentioned in Section 205 (2) read with section 350 and Schedule XIV of the Act or whether these bases can be considered as indicating the minimum depreciation which must be provided by the company, insofar as the accounts of the company are concerned and insofar as it is required to exhibit a true and fair view of the state of affairs of the company as on a given date and of the profit or loss for the year.
9. The Committee is of the view that 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 assets over its normal working life. If the rate so arrived at is higher than the rates prescribed under Schedule XIV the company should provide depreciation at such higher rate but if the rate so arrived at is lower than the rate prescribed in Schedule XIV, then the company should provide depreciation at the rates prescribed in Schedule XIV, since these represent the minimum rates of depreciation to be provided. Since the determination of commercial life of an asset is a technical matter, the decision of the Board of Directors based on technological evaluation should be accepted by the auditor unless he has reason to believe that such decision results in a charge which does not represent true commercial depreciation. In case a company adopts the higher rates of depreciation as recommended above, the higher depreciation rates/lower lives of the assets must be disclosed as required in Note no. 5 of Schedule XIV to the Companies Act, 1956.
10. This view is supported by the Department of Company Affairs and it has clarified that “the rates as contained in Schedule XIV should be viewed as the minimum rates, and, therefore, a company will not be permitted to charge depreciation at rates lower than those specified in the Schedule in relation to assets purchased after the date of applicability of the Schedule. If, however, on the basis of bona fide technological evaluation, higher rates of depreciation are justified, they may be provided with proper disclosure by way of a note forming part of annual accounts”*
11. The Committee is, however, of the view that in respect of assets existing on the date of Schedule XIV coming into force, and where the company is following the Circular of the Department of Company Affairs bearing No. 1/86, dated 21st May, 1986, whereby depreciation under straight line method was worked out based on depreciation rates in force under Income-tax Act, 1961 and Rules made thereunder at the time of the acquisition of the asset, it would be permissible to the company to follow Circular no. 1/86, dated 21st May, 1986. An appropriate note will be required to be given in this regard.
Applicability of the rates prescribed in Schedule XIV to assets existing on the date on which Schedule XIV came in to force.
17. Where a company has been following the straight line basis of depreciation in respect of its assets the position prevailing at present is discussed hereunder.
18. In January, 1985, the Department of Company Affairs issued a Circular No. 1/85, dated 10.1.1985. In this Circular, the Government recognised the need for recalculating the specified period consequent to changes in the income-tax rates. For determining depreciation consequent upon changes in the income-tax rates it recommended the following method: -
(i) As far as recomputation of specified period is concerned, the specified period be recomputed by applying to the original cost, the revised rate of depreciation as prescribed under Income-tax Rules.
(ii) As far as charge of depreciation is concerned, depreciation be charged by allocating the written down value as per books over the remaining part of the recomputed specified period.
19. The Department of Company Affairs issued another Circular (No. 1/86 dated 21st May, 1986, enclosed as Annexure III) wherein it re-examined its earlier Circular of 1985. The Department accordingly expressed its view that “once the ‘specified period’ was determined at the time of purchase of an asset in accordance with the procedure laid down under Section 205(5) read with Section 350 of the Companies Act with reference to the rates of depreciation under the Income-tax Act at that time and the amount of depreciation fixed under Section 205(2)(b) of the Companies Act, the same need not be changed subsequently consequent on changes in the rates of depreciation in the Income-tax Act.” The Circular further stated that it was therefore “open to the companies to provide for depreciation under clause (b) of Section 205(2) of the Companies Act on the basis of rates of depreciation prescribed under Income-tax Act and in force at the time of acquisition/ purchase of the asset.”
20. In its Circular No. 2/89 dated March 7, 1989, the Department has reiterated that the companies which follow Circular No. 1/86 “may, therefore, continue to charge depreciation at the old SLM rates in respect of the already acquired assets against which depreciation has been provided in earlier years on SLM basis.”
21. The Committee is of the view that where a company is following the straight line method of depreciation in respect of its assets existing on the date of Schedule XIV coming into force, it would be permissible to apply the relevant SLM rates prescribed in the said Schedule on the original cost of the assets from the year of the change of rates.
22. The Committee is accordingly of the view that where a company has been following straight line method of depreciation in respect of its assets existing on the date of Schedule XIV coming into force, the following alternative bases may be adopted for computing the depreciation charge:
(a) Where a company follows the manner of charging depreciation recommended by the Department of Company Affairs in its Circular No. 1/85, it has to change its depreciation rates as follows:
(i) The specified period should be recomputed by applying to the original cost, the revised rate as prescribed in Schedule XIV;
(ii) Depreciation charge should be calculated by allocating the unamortised value as per the books of account over the remaining part of the recomputed specified period.
(b) A company which follows the Circular No. 1/86, can continue to charge depreciation on straight line basis at old rates in respect of assets existing on the date on which the new provisions relating to depreciation came into force.
(c) SLM rates prescribed in Schedule XIV can be straightaway applied to the original cost of all the assets including the existing assets from the year of change of the rates.
23. A company which changes the rates of depreciation should make an appropriate disclosure in its accounts pertaining to the year in which the change is made.”
2. The Committee further notes that para 6.1 of Accounting Standard (AS) 2 on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, states, inter alia, as below:
“6.1 ‘Inventories’ mean tangible property held
(i) for sale in the ordinary course of business, or
(ii) in the process of production for such sale, or
(iii) for consumption in the production of goods or services for sale, including maintenance supplies and consumables other than machinery spares.”
3. The Committee also notes that para 8.2 of Accounting Standard (AS) 10 on ‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India, recommends as below:
“Stand-by equipment and servicing equipment are normally capitalised. Machinery spares are usually charged to the profit and loss statement as and when consumed. However, if such spares can be used only in connection with an item of fixed assets and their use is expected to be irregular, it may be appropriate to allocate the total cost on a systematic basis over a period not exceeding the useful life of the principal item.”
4. The Committee is of the view that repairables and rotables purchased along with the helicopters are of the nature of machinery spares. The Committee presumes, on the basis of the facts of the query, that these machinery spares can be used only in connection with the helicopters and that their use is expected to be irregular. The Committee is accordingly of the view that it would be appropriate to allocate their total cost on a systematic basis over a period not exceeding the useful life of the helicopters. Thus, the considerations of depreciation applicable to the helicopters will also apply to the said spares.
5. The Committee is of the view that the company should have provided depreciation during the year 1986-87 at the SLM rates corresponding to the income-tax rates in force at the time. The Committee is also of the view that the company should have provided depreciation during the year 1987-88 to 1989-90 in respect of the assets existing on the date when Schedule XIV came into force in accordance with the recommendations contained in para 22 of the ‘Guidance Note on Accounting for Depreciation in Companies’. Further, in respect of additions made after the date of Schedule XIV coming into force, the company should have provided depreciation at Schedule XIV rates.
6. On the basis of the above, the opinion of the Committee on the issues raised in para 8 of the query is as below:
(i) (a) In respect of the fixed assets acquired after Schedule XIV came into force, the SLM rates prescribed in that schedule have to be applied on the original cost from the date of the acquisition of the assets. In case, the said rates were not so applied, the shortfall/excess in the depreciation in respect of those years should be adjusted in the year in which Schedule XIV rates are made applicable (in the present case 1990-91). Since in the present case, depreciation was provided in respect of the assets acquired after the date of Schedule XIV coming into force, at rates lower than prescribed in Schedule XIV, the company should provide for the arrears in depreciation in respect of the earlier years in the accounts for 1990-91 (refer para 5 above).
(b) In respect of assets acquired before Schedule XIV came into force, rates as per Schedule XIV can be straightway applied to the original cost of the fixed asset, from the year the said Schedule came into force, and not from 1990-91 or any subsequent year. In the present case, if the company applies the Schedule XIV rates in the year 1990-91 on the original cost of the assets in respect of the assets acquired before Schedule XIV coming into force, the company should provide for the arrears of depreciation for the earlier years in the year 1990-91 (refer para 5 above). The method suggested in para 8(i) of the query, is, therefore, not correct.
(ii) The arrears of depreciation relating to prior years as per (a) and (b) of (i) above should entirely be charged to the profit and loss account for the year 1990-91 with an appropriate disclosure as suggested in para 7 below. If provision for arrears of depreciation is not made at all or is spread over the next 5 years as suggested by the querist in para 8(ii) of the query, the true and fair view of the accounts will be adversely affected.
(iii) The treatment suggested by the querist in para 8(iii) of the query is not correct. The company has the option to follow Deptt. of Company Affairs’ Circular No. 1/85, dated 10.1.85, in respect of assets existing on the date of Schedule XIV coming into force, provided-
(a) The company provides for the arrears of depreciation in respect of year 1986-87, i.e., that difference between the depreciation computed as per the SLM rates corresponding to income-tax rates prevalent at that time and the depreciation actually provided by the company, and
(b) The company computes the depreciation rates as suggested in para 22(a) of the ‘Guidance Note on Accounting for Depreciation in Companies’ and applies these rates from accounting year 1987-88. Since, in the present case, the company did not follow the aforesaid rates, it should provide for the arrears of depreciation by applying these rates in respect of accounting years 1987-88 to 1989-90.
(iv) In respect of machinery spares, the same treatment has to be followed as suggested in the above paragraphs subject to the presumptions stated in para 4 above.
7. Difference in depreciation to be charged in the profit and loss account of the current year as per the above mentioned paragraphs is a prior period item as per Accounting Standard (AS) 5 on ‘Prior Period and Extraordinary Items and Changes in Accounting Policies’, issued by the Institute of Chartered Accountants of India. It should, therefore, be disclosed as ‘arrears of depreciation relating to prior years’ as per para 9 of the Standard, which is reproduced below:
“Prior period items should be separately disclosed in the current statement of profit and loss together with their nature and amount in a manner that their impact on current profit or loss can be perceived.” _____________________________
*Circular No. 2/89, dated March 7, 1989 |