Query No. 25

Subject:           Creation of Depreciation Reserve Fund.[1]

A. Facts of the Case

1.         A company is a Government company within the meaning of section 617 of the Companies Act, 1956 and is working under the administrative control of the Ministry of Railways (MOR). The company is engaged in the business of handling and transportation of containerised cargo. The transportation of the containers is done through road, rail and air and the customers for these services are shipping lines, clearing and forwarding agents and other customers. The company operates container terminals across the country to cater to the needs of the trade, whether it is export-import or domestic business. Accordingly, the activities of the company have been divided into international traffic (Export and Import) and domestic traffic. The operating activities of the company are mainly carried out at its Inland Container Depots (ICDs), Container Freight Stations (CFSs) and PSCTs (Port Side Container Terminals) spread all over the country.

2.         The main sources of incomes of the company are freight, handling, transportation and terminal service charges (TSC), etc. A brief description of these incomes is as under:

• Freight and transportation incomes are the rail and road haulage charges respectively charged from the customers
• Handling income is the amount received for handling of containers.
• TSC income is the parking charges taken by the company for the time period during which a container remains parked in its ICD after the expiry of permissible free time limit. In fact, it also includes charges for safety and security of containers/cargo.

Similarly, major expenditures are on freight payment to Railways for rail movement and payments made to contractors for handling and transportation of containers.

3.         The querist has stated that the company believes in highest standards of corporate governance and recognises that financial statements are an important source of information for all its stakeholders. The company is committed to prepare its financial statements as per the applicable law(s), regulations, accounting standards/guidance notes issued by the Institute of Chartered Accountants of India (ICAI), and to make complete disclosures so as to enable its stakeholders to make informed decisions. Keeping this legal framework in mind, the company intends to create a Depreciation Reserve Fund (DRF). The procedure, which will be followed for its smooth operation and at the same time ensuring that all legal compliances are met has been detailed below:

(i)         The company wishes to continue with its existing method of charging depreciation on fixed assets, i.e., written down value (WDV).

(ii)         Once DRF is created, it will be recouped on annual basis by appropriation of profits equivalent to the amount of depreciation charged on ‘Plant & Equipment’ less adjustments during the preceding financial year. The querist has separately explained that adjustments here refer to:

(a)  Depreciation on items of plant and equipment sold during the preceding financial year; and

(b)  Depreciation on items of plant and equipment, which have become obsolete during the preceding financial year.

The querist has also explained with the help of an example. Let us assume that DRF is created during financial year (F.Y.) 2012-13, then in such a scenario, it will be recouped by appropriation of profits equivalent to an amount of Rs. 108.33 crore worked out as follows:

The intention behind creation of DRF by an amount equivalent to depreciation on ‘plant & equipment’ less ‘adjustments during the preceding financial year’ is that by following this method, at any stage of time, DRF and the corresponding investments will equate with the cumulative depreciation under the head ‘plant and equipment’.

The querist has stated that under such circumstances, one more line ‘Less: Transfer to Fund’ will be inserted under the sub-heading ‘Balance in Statement of Profit and Loss’ in Note 2 to Balance Sheet (Refer Annual Report for the F.Y. 2011-12).

(iii)         DRF will be backed by an equal amount of investment in earmarked securities. Investment in such securities will be made as per the existing guidelines of Department of Public Enterprises (DPE), which at present are being followed for investing the surplus funds of the company. Such investments will be made once a year within 15 days from the date of adoption of annual accounts by the Board of Directors (BOD) for the preceding financial year. For smooth operation, ___% (to be decided by management) of the funds will be parked in flexi-deposits, which can be utilised for meeting the urgent requirements related to replacement of small items of plant and equipment.

(iv)         For operation of DRF, a separate bank account will be opened, which will have main account at corporate office and sub-accounts at eight regional offices {Northern Region, North Central Region, Western Region, Central Region, Southern Region, South Central Region, Eastern Region and North West Region}, all linked with the main account. The modus operandi for operation of such bank account would be as follows:

⇒ Funding to sub-accounts will be made from the main account.

⇒ Replacement of items related to plant and equipment at corporate office will be made out of the main account.

⇒ For replacement of items related to plant and equipment at regional level, cheques will be issued directly by the region from the dedicated sub-account.

⇒ Sub-accounts will have zero balance and funds will be transferred to these sub-accounts from the main account on receipt of actual requirement from the regions.

⇒ Main account will be linked to flexi-deposits, so that procurement needs of small items of plant and equipment can be easily met out.

(v)        Interest earned on earmarked investments will be credited to the ‘statement of profit and loss’.

(vi)       Accounting entries to be performed at each step of DRF would be as follows:

(vii)       Accounting policy for DRF and related investments, which the company would be required to disclose in its annual financial statements, will be as follows:

“Depreciation Reserve Fund
For replacement of existing items of plant and equipment, Depreciation Reserve fund (DRF) is created. DRF is recouped from the surplus in the statement of profit and loss by an amount equivalent to depreciation charged on plant and equipment less adjustments during the preceding financial year. DRF is represented by an equal amount of investments in earmarked securities. Such investments are made in accordance with the DPE guidelines and ___% (to be decided by management) of these investments are made in flexi-deposits. Interest earned on earmarked investments is credited to the statement of profit and loss.”

(viii)       On creation of DRF, disclosure in the notes to annual accounts would be as follows:

“During the year, the company framed a new policy for creation of Deprecation Reserve Fund (DRF). Consequent upon adoption of such policy, there is no impact on the profitability of the company during the year. ”

(ix)       During transition period, DRF will be created out of the opening surplus in the statement of profit and loss. For example, if DRF is created during F.Y. 2012-13, surplus in the statement of profit and loss will get reduced by Rs. 644.72 crore, which is equivalent to the accumulated depreciation for plant and equipment as on 01.04.2011. In such a scenario, Note 2: ‘Reserves and Surplus’ to balance sheet will appear as follows:

(x)        At any point of time, DRF will be represented by the equal amount invested in specified securities. During transition period, some of the existing securities (fixed deposits/flexi deposits etc.) will be earmarked for replacement of items related to plant and equipment. In such a scenario, ‘Cash & Bank Balances’ in Note 9: ‘Current Assets’ will appear as follows (Refer Annual Report for F.Y. 2011-12):

B. Qury

4.         The Expert Advisory Committee of the ICAI is requested to advice on the methodology, which the company intends to follow for creation and operation of DRF and whether such procedure falls within the ambit of rules/regulation and procedures laid down in the Indian Companies Act, 1956, Revised Schedule VI, Accounting Standards issued by the ICAI and any other applicable laws.

C.        Points considered by the Committee

5.         The Committee notes that the company in the extant case wishes to create a depreciation reserve fund (DRF) for replacement of existing items of plant and equipment by appropriating a portion of the profit for a period equivalent to the amount of depreciation charged as per the WDV method after certain adjustments for sale/obsolescence of plant and equipment. Also, while creating depreciation reserve fund for the first time, an amount equivalent to the accumulated depreciation will be transferred from the opening surplus in the statement of profit and loss under the head ‘reserves and surplus’. Further, an amount equivalent to depreciation reserve fund will be invested in earmarked securities as per the DPE Guidelines, which would be called as DRF Investments. The interest earned on such investments will be recognised in the statement of profit and loss. Similarly, when the investments will be disposed off for replacement of plant and equipment, bank account will be debited with a credit to DRF Investments and the DRF will be debited with a credit to P&L Appropriation Account. On this basis, the querist has sought the opinion of the Committee as to whether the aforesaid accounting methodology and procedures of the company are correct or not. Accordingly, the Committee has restricted itself to such issues and has not considered any other issue that may arise from the Facts of the Case, such as, the amount that should be appropriated to DRF, etc. The Committee has also not considered accounting entries to be passed by the company as the same may vary depending on the situation, for example, accounting entry for receipt of interest income on investment may vary depending on whether the interest is received periodically or at the maturity of investments. At the outset, the Committee wishes to point out that its opinion is purely from accounting view point and not from the perspective of interpreting provisions of any law since as per Rule 2 of its Advisory Service Rules, the Committee is prohibited from doing so. The Committee also notes from paragraph 3(ii) above that while creating DRF, depreciation for plant and equipment for the preceding financial year, has been adjusted for depreciation on plant and equipment sold or which became obsolete during the preceding financial year. The Committee wishes to mention that whether DRF should have been created for depreciation of the preceding financial year or of the current year and whether such adjustments should have been made in respect of the current financial year or preceding financial year, has not been examined as it does not affect the opinion of the Committee expressed hereinafter. The Committee has also not examined the implication of creation of depreciation reserve fund on creation of statutory reserve/fund.

6.         The Committee notes that over and above the charging of depreciation as per the requirements of the Standard and Companies Act, 1956 in the statement of profit and loss, creation of a depreciation reserve fund for replacement of fixed assets is an appropriation of profits in respect of which there is no specific legal requirement. The Committee is of the view that from the accounting perspective, there is no bar on the company for transfer of profits to such fund. In this context, the Committee also notes Note 6 B (ii) of the General Instructions for Preparation of Balance Sheet of the Revised Schedule VI to the Companies Act, 1956, which provides as follows:

“(ii)      A reserve specifically represented by earmarked investments shall be termed as a ‘fund’.”

From the above, the Committee notes that the expression ‘Fund’ should be used only if the said account is “specifically represented by earmarked investments” otherwise the term ‘Reserve’ should be used. The Committee notes from the Facts of the Case that while providing accounting entries in respect of creation and utilisation of DRF, the term ‘Profit and Loss Appropriation Account’ has been used. In this context, the Committee notes that after Revised Schedule VI coming into effect with effect from 1.4.2011, appropriations to the profit for the year (including carried forward balance) are to be presented under the main head ‘Reserves and Surplus’ (Refer paragraph 8.1.2.9 of the Guidance Note on the Revised Schedule VI to the Companies Act, 1956, issued by the ICAI) and any appropriation item should not be shown on the face of the statement of profit and loss. Further, depreciation reserve fund should be shown separately alongwith a proper disclosure of the nature, purpose and amount of such fund. The movements in such fund and other balances of reserves/surplus while transferring to/ from such fund since the last balance sheet is also required to be disclosed as per the requirements of the Revised Schedule VI to the Companies Act, 1956.  Accordingly, the Committee is of the view that the accounting treatment explained by the querist is not in contradiction to the aforesaid requirements of Revised Schedule VI to the Companies Act, 1956.

D.       Opinion

7.         On the basis of the above, the Committee is of the opinion that the methodology of the company for creation and operation of DRF is not in contradiction to the Accounting Standards and the Revised Schedule VI to the Companies Act, 1956, as discussed in paragraph 6 above.

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