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Query No. 2
Subject:
Depreciation on buildings, etc., constructed on
leasehold land.1
A. Facts of the Case
1. A government company has constructed buildings, roads, etc.,
on leasehold land, which was taken on lease from an Improvement
Trust under a lease agreement which was initially for a period of
30 years only. The land allotment letter (a copy of which has been
provided by the querist for the perusal of the Committee) indicates
that the land shall be used for office and staff colony.
2. The querist has stated that under clause 2(b) of the ‘Terms of
Transfer in Leasehold Rights of Plots in the Layout of the
Improvement Trust’ (a copy of which is provided by the querist for
the perusal of the Committee), it has been stated that “the lease
shall be renewable at the option of the lessee for further terms of
30 years”. Further, as per the allotment letter, the entire lease
premium of Rs. 21 lakh was payable upfront and annual ground
rent of 2% of lease premium, i.e, Rs. 42,000 is payable in advance
and falls due on 1st June of each year.
3. The company has been charging depreciation on the buildings,
etc., constructed on the leasehold land @ 1.63% on straight-line
method (SLM) as per the rates given in Schedule XIV to the
Companies Act, 1956 (the ‘Act’), on the basis of which the useful
life works out to be 58 years.
4. During the course of audit of accounts of the company for the
year 2005-06, the government auditors have raised provisional
comment on the issue relating to charging-off of depreciation on
buildings, roads, etc., on the leasehold land. Their contention is
that the depreciation on the buildings, etc., constructed on leasehold
land should be charged over a period of 30 years only (i.e., over
the lease period of the land) and not over a period of 58 years (i.e.
@ 1.63% on SLM) as specified in the Act and followed by the
company. According to them, the rate prescribed under the Act is
applicable in respect of assets constructed on freehold land.
5. The provisional comment and the management’s reply were
as below:
| Audit Memo |
Management’s Reply |
Provisional Comment No.1
Profit & Loss Account -
Depreciation - Rs.209.00 lakh
Buildings, roads, parks and
sheds of RJ-IV are constructed
on 7.07 hectares of leasehold
land taken from the
Improvement Trust under two
lease agreements entered in the
year 1999-2000 for a lease
period of 30 years commencing
retrospectively from 1983-84.
The lease period expires in the
year 2014.
Depreciation on buildings,
roads, parks and sheds is
charged at the rate specified
under Schedule XIV to the
Companies Act, 1956, i.e., @
1.63%. However, such rates are
applicable only in respect of
assets constructed on freehold
land. All buildings and other
structures constructed on
leasehold land are to be
charged off within the lease
period.
Due to charging-off of
depreciation at rates applicable
to assets constructed on
freehold land instead of
charging off the cost of the assets within the lease period,
depreciation for the year 2005-
06 is understated and profit for
the year is overstated by Rs.
9.09 lakh. Further, this has
resulted in understatement of
depreciation charged and
overstatement of previous
year’s profit by Rs. 60.05 lakh. |
Profit & Loss Account -
Depreciation -Rs.209.00 lakh.
Buildings of RJ-IV have been
constructed on leasehold land
taken from the Improvement
Trust under lease agreement
which is initially for a period of
30 years. Under Clause 2(b) of
the “Terms of Transfer in
Leasehold Rights of Plots in the
Layout of the Improvement
Trust” which was forwarded by
the Secretary, Improvement
Trust at the time of allotment
of land, it has been stated that
“the lease shall be renewable
at the option of the lessee for
further terms of 30 years”. As
such, the company has the
option to renew the lease for
the further period of 30 years.
Also, it is the standard practice
in case of lease made by
Government that normally it is
initially made for 30 years and
thereafter it is renewed for next
term of 30 years. Moreover, the
cost of the land, i.e., the lease
rent is being amortised
regularly over the lease period.
Further, the depreciation on
buildings constructed on the leasehold land has been
charged consistently at the rate
specified in Schedule XIV to the
Companies Act, 1956, i.e., @
1.63% on SLM (depreciable life
being 58 years).
As such, the contention that
there is understatement of
depreciation and overstatement
of profit for the year 2005-06
and for the earlier years is not
correct.
In view of the above, the memo
may kindly be dropped.
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The statutory auditors agreed with the above reply of the
management.
6. The issue was discussed in detail with the Principal Director
of Commercial Audit (the ‘PDCA’). The PDCA agreed with the
reply submitted by the company. However, while issuing a nil
comment on the accounts, he advised that the matter may be
referred to the Expert Advisory Committee of the Institute of
Chartered Accountants of India for its opinion.
B. Query
7. The querist has sought the opinion of the Expert Advisory
Committee as to whether depreciation charged by the company
on buildings, etc., constructed on leasehold land @ 1.63% on
SLM as specified in Schedule XIV to the Companies Act, 1956 is
correct or it should be charged over a period of 30 years (i.e., the
initial term of the lease).
C. Points considered by the Committee
8. The Committee, while expressing its opinion, has considered
only the issue raised in paragraph 7 above and has not touched
upon any other issue arising from the Facts of the Case, such as,
amortisation of the lease premium.
9. The Committee notes the following paragraphs from
Accounting Standard (AS) 6, ‘Depreciation Accounting’, issued by
the Institute of Chartered Accountants of India:
“5. Assessment of depreciation and the amount to be
charged in respect thereof in an accounting period are usually
based on the following three factors:
(i) historical cost or other amount substituted for the
historical cost of the depreciable asset when the
asset has been revalued;
(ii) expected useful life of the depreciable asset; and
(iii) estimated residual value of the depreciable asset.”
“7. The useful life of a depreciable asset is shorter than its
physical life and is:
(i) pre-determined by legal or contractual limits, such
as the expiry dates of related leases;
(ii) directly governed by extraction or consumption;
(iii) dependent on the extent of use and physical
deterioration on account of wear and tear which
again depends on operational factors, such as, the
number of shifts for which the asset is to be used,
repair and maintenance policy of the enterprise etc.;
and
(iv) reduced by obsolescence arising from such factors
as:
(a) technological changes;
(b) improvement in production methods;
(c) change in market demand for the product or
service output of the asset; or
(d) legal or other restrictions.
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. ...”
“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.”
10. The Committee notes the management’s observations that it
is a standard practice in case of leases made by Government that
normally they are initially made for 30 years and thereafter they
are renewed for a further period of 30 years. Having regard to the
terms of the lease and the use of the leasehold land (i.e, office
and staff colony), it seems that at the inception of the lease, the
company intends to renew the lease for a further period of 30
years at the expiry of the initial period of 30 years.
11. The Committee notes that neither Schedule XIV to the
Companies Act, 1956 (the ‘Act’) nor the main sections, viz., sections
205 and 350 of the Act state that the rates specified in Schedule
XIV are applicable only to the assets constructed on freehold land.
The Committee is of the view that the rates specified in Schedule
XIV to the Act are equally applicable for assets constructed on
leasehold land, subject to the considerations stated in paragraph
12 below.
12. From the above, the Committee is of the view that the
management should estimate the useful lives of the relevant assets
constructed on the leasehold land on the basis of considerations
mentioned in paragraph 9 above. Thus, the useful life will be the
expected period of the lease of the land, including the expected
period of extension which is reasonably certain at the inception of the lease. The depreciation rate should be worked out on that
basis. If the rate so worked out is lower than the rate specified in
Schedule XIV to the Act, the rate specified in Schedule XIV to the
Act should be adopted. A lower rate can be adopted only if permitted
by the Central Government in accordance with the provisions of
the Act.
D. Opinion
13. On the basis of the above, the Committee is of the opinion
that depreciation rate for buildings, etc., constructed on leasehold
land should be determined in the manner stated in paragraph 12
above.
1 Opinion finalised by the Committee on 23.3.2007
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