Query No. 13

Subjects:

(i) Revision of the useful life of an aircraft,
(ii) Charging-off depreciation on 99% of the gross block relating to an aircraft, and
(iii) Provision for obsolescence of stores and spares.¹

A. Facts of the Case

Revision of the useful life of an aircraft

1. A company is engaged in the airlines business for over 50 years and is maintaining the following types of aircrafts:

Type                                          Nos.

A-300                                          3

B-737                                         11

A-320                                         30

2. The company is providing depreciation as per Schedule XIV to the Companies Act, 1956, at the rates applicable to aircrafts by following the Straight Line Method (SLM). Depreciation is provided upto 99% of the value of the aircrafts keeping 1% as the scrap value.

3. The querist has informed that as per the rate given in Schedule XIV, the life of an aircraft comes to 17.67 years. The first two types of aircrafts, mentioned above have completed their lives as per Schedule XIV, and the company has already provided depreciation upto 99% of the cost on these two types of aircrafts.

4. The auditors have expressed their views as follows:

(a) Three A-300 and eleven B-737 aircrafts, either in self-use or leased out to a subsidiary company, have long outlived the company’s initial estimate of their useful lives and have been depreciated to the extent of 99% of their cost. Despite significant differences noted in actual useful lives when compared with the initial estimate of their useful lives, the company has neither reviewed nor revised the remaining useful lives of the aircrafts that are still operating or have been given on lease.

(b) In respect of modifications to aircraft capitalised during the year, particularly in respect of a fleet having a residual value of one percent, depreciation has been provided to the extent of 99% of the cost thereof based on the initial expected useful life of the fleet. However, this rate of depreciation fails to take into account the fact that the fleet is expected to outlive its original estimated useful life due to these modifications.

5. The querist has expressed his views as follows:

(a) The querist has drawn the attention of the Committee to paragraphs 8 and 13 of Accounting Standard (AS) 6, ‘Depreciation Accounting’, issued by the Institute of Chartered Accountants of India, which provide as below:

“8. Determination of the useful life of a depreciable asset is a matter of estimation and is normally based on various factors including experience with similar types of assets. Such estimation is more difficult for an asset using new technology or used in the production of a new product or in the provision of a new service but is nevertheless required on some reasonable basis”.

“13. The statute governing an enterprise may provide the basis for computation of the depreciation. For example, the Companies Act, 1956 lays down the rates of depreciation in respect of various assets. Where the management’s estimate of the useful life of an asset of the enterprise is shorter than that envisaged under the provisions of the relevant statute, the depreciation provision is appropriately computed by applying a higher rate. If the management’s estimate of the useful life of the asset is longer than that envisaged under the statute, depreciation rate lower than that envisaged by the statute can be applied only in accordance with requirements of the statute”.

(b) The life of the aircraft has been worked out based on the rates prescribed in Schedule XIV to the Companies Act, 1956, which is the minimum depreciation to be charged. If the life of the aircraft is assessed to be higher than that envisaged under the statute, this would result in violation of the Companies Act,
1956, as depreciation would be lower.

(c) Where the life of the aircraft as per Schedule XIV has expired, the problem is how to determine the further useful life. The regulatory aviation authority, i.e., DGCA, does not prescribe any particular life span for an aircraft. Certificate of airworthiness is issued by them every year for the first 20 years and semi-annually thereafter.

(d) Reworking of the lives of the aircrafts would require write back of depreciation and accounting for the same in the year of change.

 

(e) The Board of Directors of the company has already approved the acquisition of new aircrafts in March, 2002 to replace the ageing A 300 and B 737 aircrafts and has forwarded the proposal to the Government. It is also pertinent to mention that as per the original schedule, three B-737 aircrafts and four
A-300 aircrafts were to be phased out by 31st March, 2004.

However, these aircrafts continue to be in the fleet and under operations due to delay in receipt of the Government approval for the fleet renewal. The actual phase out would depend upon such approval and the aircrafts would continue to be in fleet till new aircrafts are received. If the auditors’ viewpoint is accepted, the same would require reassessment of the life of aircraft on yearly basis. In such a case, the company would have to simultaneously write back and charge depreciation every year. The management of the company is, therefore, of the view that there is no need to reassess the life of A 300/B737 aircrafts.

Depreciable amount

6. The aircrafts have been depreciated upto 99% of the block value (original cost). The auditors have objected that the rate of depreciation should not be arrived at on this amount.

7. The querist has expressed his views as follows:

(a) In terms of the policy relating to depreciation, aircrafts are depreciated @ 5.6% per annum on straight-line basis. In this manner, 99% of the cost of the aircraft gets provided in 17.67 years. Apart from the Airbus A-320 aircrafts, which are relatively new, the company also has three Airbus A-300 aircrafts and eleven Boeing-737 aircrafts in its fleet which are more than 20 years old and are still in operation.

(b) In view of the aircrafts being of very high value, the company, as per its declared accounting policy, which is consistently being followed, keeps the residual value of aircrafts at 1% as writing off 95% of the original cost will result in carrying a residual value of very high amount.

Provision for obsolescence on stores and spares

8. The company acquires stores and spares for day to day maintenance of the aircrafts. Stores and spares are purchased every year based on its requirements.

9. As a consistent policy adopted by the Board, provision for obsolescence is made over a period of 18 years. The accounting policy adopted by the company in this regard is as under:

“Provision for obsolescence of Aircraft Stores and Spares is made over the depreciable life of the aircraft of 18 years. Besides, a sum equivalent to 20% of net additions during the year towards other Engineering Stores, Computer Stores, Ground Support Rotables, Simulator & Link Trainers Spares and General Tools is also provided towards obsolescence.”

10. The querist has informed that the above policy is based on the following facts:

(i) The aircrafts are depreciated over a period of 18 years.

(ii) Paragraph 8.2 of Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, issued by the Institute of Chartered Accountants of India, reads inter alia, as: “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 asset 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.” Since the life of the aircraft is 18 years, the obsolescence provision has been designed in such a way that 100% value is provided for by way of obsolescence.

(iii) As per the policy, if some spares are purchased in the 17th year of life of an aircraft, then obsolescence is provided for over the remaining life, i.e., 2 years.

11. As per the querist, the auditors of the company are of the view that the life of the fleet of aircrafts be re-assessed and excess obsolescence provided should be written back and the accounting policy should be amended accordingly. The following qualifications were made by the auditors:

(a) “Provision for obsolescence on stores and spares, though in line with significant accounting policy of the company, is not in consonance with AS 6 and AS 10.”

(b) “Recording a provision for obsolescence on spares based on the initial estimated lives of the aircrafts that is neither reviewed nor revised based on the actual usage is not reasonable. Non- adjustment of the provision by re-assessing the remaining useful lives of aircrafts by adjusting the original formula for the changed period of the lives of aircrafts including not considering residual value, is in excess of the amount necessary for making a provision and is a reserve for obsolescence rather than a provision as contemplated in Clause 7(2) of Part III of Schedule VI to the Companies Act, 1956 and remain unadjusted and unexplained.”

(c) “We were not satisfied with the formula on the basis of which provision for obsolescence is considered and could not evaluate data and consideration of assumptions on which provision is made and on which estimates have been applied for provisions could not be evaluated by us for accuracy and completeness of carrying provisions for obsolescence particularly for aircrafts which have outlived their estimated life but are still in use with 100% provisions of inventories. We were also not satisfied with the value of inventories taken.”

12. The querist has expressed his views as follows:

(a) The life of an aircraft has been worked out based on the rates prescribed in Schedule XIV to the Companies Act, 1956. If the life of the aircraft had been assessed higher than that envisaged under the statute, this would have resulted in violation of the Companies Act, 1956. Accordingly, provision for obsolescence of aircraft stores and spares is made over the depreciable life of the aircraft, i.e., 18 years.

(b) The management is of the view that since the commercial life of the aircraft is not certified by any agency, it is difficult to re-assess the life. The regulatory aviation authority, i.e., DGCA, does not prescribe any particular life span for aircrafts. Certificate of airworthiness is issued by them every year for the first 20 years and semi-annually thereafter.

(c) Reworking of the life of the aircraft would require write back of obsolescence and accounting for the same in the year of change.

(d) The Board of Directors of the company has already approved the acquisition of new aircrafts in March, 2002 to replace the ageing A 300 and B 737 aircrafts and has forwarded the proposal to the Government. It is also pertinent to mention that as per the original schedule, three B 737 aircrafts and four A 300 aircrafts were to be phased out by 31st March, 2004.

However, these aircrafts continue to be in the fleet and under operation due to delay in receipt of the Government approval for the fleet renewal. The actual phase out would depend upon such approval and the aircrafts would continue to be in the fleet till new aircrafts are received. If the auditors’ viewpoint is accepted, the lives of the aircrafts would be required to be reassessed on yearly basis. In such a case, the company would have to simultaneously write back and charge depreciation every year. The management is, therefore, of the view that there is no need to reassess the life of A 300/B 737 aircrafts.

B. Query

13. The querist has sought the opinion of the Expert Advisory Committee on the following issues arising from the above:

(a) Whether it is mandatory to re-assess the useful life of the principal asset, i.e., aircrafts.

(b) Whether the useful life of the aircrafts should be reworked and depreciation should be written back.

(c) If the answer to (a) above is in the affirmative, whether depreciation on the aircrafts should be continued to be charged at the rate provided in Schedule XIV or a lower depreciation can be charged.

(d) Whether charging-off of depreciation as per Schedule XIV to the Companies Act, 1956, as applicable to aircrafts, is wrongly done by the company.

(e) Whether providing depreciation on 99% of the cost of the aircrafts violates Schedule XIV to the Companies Act, 1956.

(f) Whether provision for obsolescence calculated on the basis of the age of the aircrafts and providing full (100%) obsolescence for fresh spares procured during the year in respect of aircrafts which have already completed their useful lives as per Schedule XIV, is in order.

C. Points considered by the Committee

14. The Committee notes that section 205(2)(a), (b) and (c) lays down the manner in which the depreciation is required to be provided by a company as below:

“(2) For the purpose of sub-section (1), depreciation shall be provided either –

(a) to the extent specified in section 350; or

 

(b) in respect of each item of depreciable asset, for such an amount as is arrived at by dividing ninety-five per cent of the original cost thereof to the company by the specified period in respect of such asset; or

(c) on any other basis approved by the Central Government which has the effect of writing off by way of depreciation ninety-five per cent of the original cost to the company of each such depreciable asset on the expiry of the specified period;

…”

 

The Committee further notes that sub-section (5)(a) of section 205 defines the term ‘specified period’ as below:

“ “Specified period” in respect of any depreciable asset shall mean the number of years at the end of which at least ninety-five per cent 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”.

15. The Committee further notes that section 350 of the Companies Act, 1956, requires that depreciation shall be calculated at the rates specified in Schedule XIV to the Act.

16. The Committee notes paragraphs 8 and 13 of AS 6 as reproduced in paragraph 5 of the ‘Facts of the Case’. The Committee also notes paragraph 11 of AS 6 reproduced below:

“11. The quantum of depreciation to be provided in an accounting period involves the exercise of judgement by management in the light of technical, commercial, accounting and legal requirements and accordingly may need periodical review. If it is considered that the original estimate of useful life of an asset requires any revision, the unamoritised depreciable amount of the asset is charged to revenue over the revised remaining useful life.”

17. The Committee also notes paragraph 9 of the Guidance Note on Accounting for Depreciation in Companies, issued by the Institute of Chartered Accountants of India, which recommends as below:

“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 asset 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.”

18. On the basis of the above, the Committee is of the view that the maximum useful life of the asset, namely, the aircraft, is the life that is worked out on the basis of the rates prescribed in Schedule XIV to the Companies Act, 1956. In other words, the rates worked out on the basis of Schedule XIV to the Companies Act, 1956 are the minimum rates of depreciation. Thus, depreciation cannot be charged at rates lower than the rates prescribed in the Schedule. Where an asset that has been fully depreciated (excluding the residual value to the extent of a maximum of five per cent), the useful life of the asset is not required to be reassessed and depreciation to be written back. This is further evident from the requirements of paragraph 11 of AS 6, according to which, it is the ‘unamortised depreciable amount’ of the asset that is charged to revenue over the revised remaining useful life. Thus, where an asset has already been written off to the extent of at least 95 per cent of its original cost as per the requirements of the Companies Act, 1956, there is no unamortised depreciable amount left to be charged off to revenue over the revised remaining useful life even if the revised life is worked out. The Committee is of the view that these considerations regarding reassessment of useful life also apply to situations where cost of modifications has been capitalised after the expiry of the useful life of the aircraft as per Schedule XIV to the Companies Act, 1956.

19. The Committee is of the view that since section 205(5)(a) defines ‘specified period’ to mean the number of years at the end of which at least 95 per cent of the original cost of the asset will have been provided for by way of depreciation, if a company provides for more than 95 per cent of the cost, it is in accordance with the requirements of the Companies Act, 1956. (Emphasis supplied by the Committee.)

20. With regard to charge-off of depreciation on the spares of the aircraft, the Committee notes that the querist has relied upon paragraph 8.2 of AS 10 reproduced in paragraph 10 above. The Committee notes that this paragraph is applicable to those types of spares which can be used only in connection with an item of fixed asset and whose use is expected to be irregular. The Committee notes that the querist has not specified the nature of the spares. The Committee, therefore, presumes that since the querist has relied upon paragraph 8.2 of AS 10, the spares are of the nature covered by that paragraph and, accordingly, the Committee has not specifically gone into the question of whether the spares are actually of that nature. The Committee has, therefore, only examined the issue whether the charging-off of the spares in the year in which the aircraft has completed its useful life as per Schedule XIV is proper.

21. The Committee notes from paragraph 8.2 of AS 10 reproduced in paragraph 10 above that in case the spares are of the nature covered in the said paragraph, it is appropriate to allocate the total cost of the spares on a systematic basis over a period not exceeding the useful life of the principal item. The Committee is of the view that since in the year of purchase of the spares, the useful life of the principal item, namely, the aircraft has already completed, it is appropriate to charge-off the total cost of the spares, i.e., 100 per cent of the cost of the spares, in the year of their acquisition.

D. Opinion

22. On the basis of the above, the opinion of the Committee on the issues raised by the querist in paragraph 13 above is as below:

(a) It is not mandatory to reassess the useful life of the principal asset, i.e., the aircraft.

(b) The useful life of the aircraft is not required to be reworked and depreciation is not required to be written back.

(c) Since the answer to (a) above is in the negative, this question does not arise.

(d) Charging-off of depreciation on the aircrafts at the rates prescribed in Schedule XIV to the Companies Act, 1956, is appropriate.

(e) Providing depreciation on 99 per cent of the original cost of the aircraft does not violate the requirements of Schedule XIV to the Companies Act, 1956.

(f) Providing depreciation on the spares on the basis of the age of the principal item, i.e., the aircraft, would be appropriate only if the spares are of the nature covered by paragraph 8.2 of AS 10. Charging-off such spares at 100 per cent of their cost in the year of their acquisition, where the useful life of the principal item, namely, the aircraft, has already expired, is in order.

¹ Opinion finalised by the Committee on 28.4.2005