A. Facts of the Case

1.  A garment manufacturing and exporting company was charging depreciation on written down value (WDV) method on all its assets till 31.3.1995.  In the year 1995-96, the company changed the method of charging depreciation from WDV to straight line method (SLM).  The company stated that keeping the line of business in view, the method of charging depreciation had been changed from WDV to SLM.

2. New plant and machinery was under installation and a substantial part was capitalised in the year 1995-96.  The commercial production started in September, 1996 and depreciation on new plant and machinery was charged for the first time in the year 1996-97.  The board of directors of the company was of the view that straight line method of depreciation would be more appropriate for the new plant and machinery.  Accordingly, the company charged depreciation on straight line basis for the financial year 1996-97 and 1997-98.

3. In the year 1998-99, the company changed the method of charging depreciation again from SLM to WDV with retrospective effect. The reason for the change in the method of charging depreciation was stated by the company to be the technological advancement and upgradation and that the current market value of assets was more in line with WDV method of depreciation rather than SLM.  To justify the technological advancement and upgradation the company placed the valuation report of a government approved valuer before the Board for Industrial and Financial Reconstruction (BIFR).  As per the querist, the valuer had revalued the existing assets by indexing the original prices of assets with current foreign exchange rate for imported assets and prices provided by the company for indigenous assets and had applied the depreciation rates on straight line basis.  The valuer did not consider the pre-operative expenses and installation charges for arriving at the revalued figure.  The company had not got the assets evaluated by a technical expert which could have indicated the extent of obsolescence and technological advancement in the plant and machinery.  The company had changed the method of depreciation from SLM to WDV only on the basis of the valuer’s report.

4. The difference between the depreciation to be charged as per WDV method and depreciation already charged as per SLM method was debited to profit and loss account for the year 1998-99 which resulted in additional depreciation of Rs. 307.85 lakh and increased the overall losses of the company to the same extent.  This change in the method of depreciation had a material impact on the net worth of the company as on 31.3.1999, which led to significant erosion in the net worth of the company.  As a result, the company made a reference to BIFR to be registered as a sick company under the Sick Industrial Companies (Special Provisions) Act, 1985.

5. In the hearing before BIFR, the financial institutions/banks raised objections to the change of method of charging depreciation by the company.  The Hon’ble Bench of BIFR directed that opinion of the Institute of Chartered Accountants of India be obtained on the issue.

B. Query

6. The querist has sought the opinion of the Expert Advisory Committee as to whether the company could change the method of depreciation so frequently and claim arrears of depreciation.

C. Points considered by the Committee

7. The Committee notes that depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes (paragraph 3.1 of Accounting Standard (AS) 6, ‘Depreciation Accounting’).  The basic objective of the adoption of a depreciation method is to provide for periodic matching of revenue and expense by allocating the cost of the depreciable asset systematically over its estimated useful life.  The straight line method of depreciation is appropriate when the use of the asset is expected to be relatively even over its estimated useful life or there is no discernible pattern of decline in service potential.  However, if the expected productivity or revenue-earning power of the asset is relatively greater during the earlier years of its life, or where maintenance charges tend to increase during later years, the written-down value method is more appropriate. The most appropriate method should be selected “based on various important factors, e.g., (i) type of asset, (ii) the nature of the use of such asset and (iii) circumstances prevailing in the business” (paragraph 12 of AS 6).  Once a method of depreciation is selected keeping in view the aforesaid factors, any change in the method would be appropriate if there is a change in one or more of the aforesaid factors.  Normally, in such a situation, the change in the method of depreciation would result into more appropriate preparation or presentation of the financial statements of the enterprise, as envisaged in paragraph 21 of AS 6, which states as below:

“21. The depreciation method selected should be applied consistently from period to period. A change from one method of providing depreciation to another should be made only if the adoption of the new method is required by statute or for compliance with an accounting standard or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements of the enterprise. When such a change in the method of depreciation is made, depreciation should be recalculated in ac­cordance with the new method from the date of the asset coming into use. The deficiency or surplus arising from retrospective recomputation of deprecia­tion in accordance with the new method should be adjusted in the accounts in the year in which the method of depreciation is changed. In case the change in the method results in deficiency in depreciation in respect of past years, the deficiency should be charged in the statement of profit and loss. In case the change in the method results in surplus, the surplus should be credited to the statement of profit and loss. Such a change should be treated as a change in accounting policy and its effect should be quantified and disclosed.”

8. The Committee notes from the facts of the query that the company got its assets revalued by a government approved valuer.  The Committee has not gone into the appropriateness of the methodology adopted by the valuer which is a separate issue.  However, the Committee is of the view that a revaluation of assets does not, in itself, call for a change in the method of depreciation.  Any appreciation or diminution in the value of assets should be accounted for in accordance with AS 10.  In this respect, paragraph 30 of the Standard states as below:

“30. An increase in net book value arising on revaluation of fixed assets should be credited directly to owners’ interests under the head of revaluation reserve, except that, to the extent that such increase is related to and not greater than a decrease arising on revaluation previously recorded as a charge to the profit and loss statement, it may be credited to the profit and loss statement. A decrease in net book value arising on revaluation of fixed asset should be charged directly to the profit and loss statement except that to the extent that such a decrease is related to an increase which was previously recorded as a credit to revaluation reserve and which has not been subsequently reversed or utilised, it may be charged directly to that account.”

D. Opinion

9.  On the basis of the above, the Committee is of the opinion that under the circumstances of the given case, the change in the method of charging depreciation does not seem to be appropriate.  However, in case a change in the method of depreciation is justified, it should be effected retrospectively and the difference arising on account of retrospective application of the changed method should be charged to the profit and loss account of the year in which the change is effected.

1Opinion finalised by the Committee on 17.1.2001.

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