1.2       Query

Provision for depreciation on assets not used due to strike

1. The following note (no. 7) appeared in the Balance Sheet of a public limited company, for the year 1982-83:

“Due to textile strike and the assets having remained idle for sizable period of the year, depreciation has been provided in the accounts on pro-rata basis with reference to percentage of loom production on all assets. Similar working has been made for previous year’s depreciation and the difference between depreciation charged in previous year and amount calculated on this basis has been adjusted in the current year’s depreciation and only balance amount has been provided in the accounts. This has resulted in the charge of depreciation being lower by Rs. 112.48 lacs and has reduced the loss to the corresponding extent.”

2. The auditors of the company qualified their report in respect of the above note. The auditors also wrote to the company on this matter as below:

3.In the year 1983-84, the company provided full depreciation in the normal way as it was working throughout the year. The company however did not make good the short-fall of depreciation because it felt that there was no short-fall and in any case, the company had sufficient reserves to take care of such short-fall. The auditors again wrote to the company; the relevant extracts of their letter are reproduced below:

“Your attention is drawn to Note No. 7 appearing in the accounts in the previous year. In the said note there was a charge regarding provision of depreciation in that year as well as in earlier year whereby the depreciation was provided less to the extent of Rs. 112.48 lacs. We had stated in the previous year that this amounts to short provision of depreciation as per circular of the Company Law Board. This is also not an accepted method of depreciation provision. We had qualified our report in the previous year drawing attention to this note and we stated that there is a short provision of depreciation in the current year. We find, while the company has made certain changes in the method of providing for depreciation, the method followed in the previous year is abandoned in the current year. In our opinion, the short provision of depreciation of the previous years amounting to Rs. 112.48 lacs should be made good from the profit of this year or earlier years. In this connection, we draw your attention to the fact that in the opinion of the Company Law Board, depreciation has to be provided fully on all assets which are installed although they may lie idle for whole or a part of year as depreciation arises on the efflux of time and not on actual use so far as normal depreciation is concerned. We may also draw your attention to the fact that Section 205 has laid down that no dividend can be paid unless full depreciation (including all arrears) is provided for out of the current year’s profit or earlier years profit. You may please consider this and inform us about your views on the above matter.”  

4. The company did not agree with the auditors to make good the said short-fall and was of the view that no qualification on the matter was called for in the auditors’ report.

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

(i)         Whether depreciation provided in the year 1982-83 was adequate insofar as section 205 of the Companies Act, 1956, is concerned or there was a short-fall?

(ii)        Whether the company is obliged to make good such short-fall if the answer to (i) above is in the affirmative?

(iii)            Whether the observations of the auditors are correct or those of the company?

(iv)       Whether the company can declare dividend without making good the said short-fall on the ground that it was not so obliged or that the reserves of the company are adequate to take care of the short-fall?

(v)        Whether any qualification on the accounts is necessary in case the company declares any dividend and if yes, in what manner?

                                                   Opinion                                                             December 28, 1984

1. The Committee notes that Section 205(2) of the Companies Act, 1956, does not deal with the manner of provision for depreciation on assets remaining idle owing to labour trouble etc. The Committee is therefore of the view that the matter has to be considered in the light of accounting, legal, and commercial practices prevailing in the country.

2. The Committee notes the following opinion of the Company Law Board on the matter which has also been referred to by the querist:

“Since according to accepted accounting principles, depreciation also arises out of efflux of time, it would be necessary for the purpose of section 205 to provide for depreciation even in respect of assets which are not in use during any financial year, if it purposes to declare to pay dividend.”

3. The Committee also notes that it has been decided by courts in certain cases [1]that as soon as an item of asset is installed and is ready for use, depreciation can be provided even though the said asset is not actually used for the whole or part of the relevant financial year.

4.Regarding the adequacy of provision for depreciation for the purpose of preparation of annual accounts, the Committee notes that it has been recommended by, the Research Committee of the Institute of Chartered Accountants of India that “……the company should provide depreciation at the rates mentioned in those sections [i.e. Sections 205 (2) and 350 of the Companies Act, 1956] since these represent the minimum rates of depreciation to be provided”.[2].

5. The Committee is therefore of the view that the practice followed by the company, in the preparation of accounts for the year 1982-83 as well as for the earlier year, to provide depreciation on pro-rata basis with reference to percentage of loom production on all assets owing to these remaining idle due to textile strike, is not correct. Therefore, the depreciation was short-provided to that extent in those years. The Committee is further of the view that this short-fall should by made good in 1983-84 as a prior-period item by making a separate disclosure in the current statement of profit and loss together with its nature and amount in a manner that its impact on current profit or loss can be perceived. [3]In case the company does not do so the auditors will be justified in qualifying their report.

6.Regarding the argument advanced by the company that it had sufficient reserves to take care of the short-fall in depreciation and therefore there was no need to make good the short-fall in the accounts, the Committee is of the view that this argument is not defensible since Section 205 (1) of the Companies Act specifically requires that full depreciation for the year, as well as the arrears of depreciation of earlier years, must be provided before the company can declare dividend.

7.On the basis of the above considerations, the opinion of the Committee on the issues raised by the querist in para 5 above, is as below:

(i)         Depreciation provided by the company in the year 1982-83 was not adequate insofar as Section 205 of the Companies Act, 1956, is concerned; consequently the depreciation was short provided.

(ii)             The company is obliged to make good this short-fall.

(iii)       The observations made by the auditors are correct.

(iv)       The company cannot declare dividend without making good the said short-fall either on the ground that it is not so obliged to do so or that the reserves of the company are adequate to take care of the short-fall.

(v)        In case the company declares any dividend without making good the said short-fall, the auditors should qualify their report. An illustration of the manner of making the qualification is given below:

“The company has declared dividend without making good the shortfall of depreciation relevant to the years 1981-82 and 1982-83, amounting to Rs. …….. In our opinion this is contrary to the requirements of Section 205 of the Companies Act, 1956.”

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  [1] For example, see Whittle Anderson Ltd. V. CIT (79 ITR 613) and CIT V. Vayithri plantations (128 ITR 675)
[2] ‘Provision for depreciation’ P. 1. of Compendium of Notes.

[3] Para 9 of Accounting standard 5 (AS-5) on ‘Prior Period and Extraordinary Items and Changes in Accounting Policies’ issued by the Institute of Chartered Accountants of India