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MET INSTITUTE
BANDRA, MUMBAI
The main goal of this project is to present the scope and the objective of
depreciation accounting, the different methods employed in the process of
depreciation and to illustrate how to determine depreciation with the assistance
of various cases.
We would first and foremost thank our professor Prof. L.N. Chopde for his able
guidance and being our mentor through out the semester and we also wish to
thank all those who have immensely contributed to the project and enhanced our
knowledge and understanding of the subject along the way.
This project has commenced with the definition of depreciation, extending to the
scope and objective, the determination of depreciation, the method to be
employed for calculating depreciation, determination of useful life,
determination of residual value, queries and responses, balance sheet, schedule
to the balance sheet and instances of calculation of depreciation in one particular
organisation. A neat form of contents follows which acquaints all the readers
with the flow of the project.
Determination of Depreciation
Assessment of depreciation and the amount to be charged in respect thereof in
an accounting period are usually based on the following three factors:
• Historical cost or other amount substituted for the historical cost of the
depreciable asset when the asset has been revalued.
• Expected useful life of the depreciable asset; and
• Estimated residual value of the depreciable asset.
Depreciable amount of a depreciable asset is its historical cost, or other amount
substituted for historical cost in the financial statements, less the estimated
residual value. In case the depreciable assets are revalued, the provision for
depreciation is based on the revalued amount on the estimated of the remaining
useful life of such assets. Depreciation is charged in each accounting period by
reference to the extent of the depreciable amount, irrespective of an increase in
the market value of the assets. This is based on the concept of historical cost.
Historical cost of a depreciable asset represents its money outlay or its equivalent
in connection with its acquisition, installation and commissioning as well as for
additions to or improvement thereof. The historical cost of a depreciable asset
may undergo subsequent changes arising as a result of increase of decrease in
long term liability on account of exchange fluctuations; price adjustments
changes in duties or similar factors. In case the depreciable assets are revalued,
the provision for depreciation is based on the revalued amount on the estimate of
the remaining useful life of such assets.
Depreciation Method
There are several methods of allocating depreciation over the useful life of the
assets. Those most commonly employed in industrial and commercial enterprises
are the straightline method and the reducing balance method. The straightline
method of depreciation is appropriated when the use of the asset is expected to
be relatively even over its estimated useful life or there is not discernible pattern
of decline in service potential. However, if the expected productivity or revenue-
The useful life of a depreciable asset is shorter than its physical life and is:
1. Pre-determined by legal or contractual limits, such as the expiry dates of
related leases
2. Directly governed by extraction or consumption
3. Dependant 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
4. 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
Query
Whether adoption of block concept of charging depreciation in accounts, as per
the Income-tax Act, is justified in the case of a company? If so, whether the
concept of true and fair view of accounts is affected when the profit on sale of
assets is not credited to profit and loss account but to the concerned block of
assets?
Response
After Schedule XIV coming into force, rates higher than those under that
Schedule can only be adopted on the basis of a bonafide determination of the
commercial life of an asset, which is a technical matter. Also, in such a case,
proper disclosure has to be made. Therefore, a company can follow rates
prescribed under the Income-tax Act/Rules only if these rates represent bona fide
commercial depreciation and are higher than Schedule XIV rates. Also Note No.4
to Schedule XIV to the Companies Act, 1956 requires “where, during any
financial year, any addition has been made to any asset, or where any asset has
been sold, discarded, demolished or destroyed, the depreciation on such assets
shall be calculated on a pro-rata basis from that date of such addition or, as the
case may be , up to the date on which such asset has been sold, discarded,
demolished or destroyed. Therefore for purposes of companies Act, it is not
appropriate to determine depreciation, after crediting profit on sale of assets
against the concerned block of assets. In fact profit on sale of assets needs
separate recognition and disclosure under the Companies Act.
Minimum Depreciation
The statue 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 by the statute, depreciation rate
lower than that envisaged under the stature, depreciation rate lower than that
envisaged by the statute can be applied only in accordance with requirements of
the statute. In a large number of cases, the rates of depreciation under Schedule
Rates higher than Schedule XIV should be used provided such rates are based on
sound commercial and technical considerations. For example, higher
depreciation rates are used where technological obsolescence is prevalent, eg.
Computers. In such a case, the auditor should broadly satisfy himself that the
rates are determined in an appropriate manner. Since the determination of
commercial life of an asset is a technical matter, the decision of the Board of
Directors is normally accepted by the auditor unless he has reason to believe that
such decision is grossly incorrect.
Query
The company had set up a factory on coastal land. In view of the corrosive
climate, the machine life was reducing faster and, therefore, it wanted to charge a
higher rate of depreciation than those prescribed under Schedule XIV.
Response
The statute governing an enterprise may provide that basis for computation of
the depreciation. For example, the Companies Act, 1956, lays down the rates of
depreciation in respect of various assets. In accordance with AS-6, ‘Depreciation
Accounting’, 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 is lower than that
envisaged by the statute can be applied only in accordance with requirements of
the statue. It is important for financial statements to be true and fair that
management estimate the useful lies of assets and determines depreciation at
higher rates if the useful lives are lower than the one set out in schedule XIV.
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.
However, since 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 plans to
declare any dividend. It may be possible due to assets lying idle the remaining
usable life is extended, in which case a reassessment of useful life can be made.
On this basis the unamortized depreciable amount should be charged over the
revised remaining useful life, which would result in a lower annual charge of
depreciation in the future years. However, as cautioned above, depreciation
amount should not be lower than that determined under Schedule XIV for the
purposes of Section 205(2) of the CompaniesAct. Full depreciation is provided
for even if the asset is kept in the best working condition or its market price has
gone up since depreciation is also a factor of efflux of time.
If the company was using the written down value method the computation gets
slightly complicated. In the above case the straight line depreciation rate is 20%
which translates to roughly 60% on the reducing balance method. Now if the
straight line method it works out to 25%, which under WDV would work out to
roughly 75%. Thus depreciation on the original amount would be provided at
60% and on the addition at 75%. To make the computations easier, a weighted
average can be worked out.
The company procured ocean going dredgers which were cleared by the customs
without levy of custom duty in the year 2000. However in 2003 the custom
authorities alleged willful misstatement and suppression of facts. The company
disputed the allegations but believes that the liability will fructify. Therefore, the
amount of customs duty sought to be levied on the respective dredgers has been
capitalised and a provision for customs duty was made in the books. We check
the method on how to charge depreciation on the addition to fixed asset in 2003
caused by capitalisation of the customs duty.
Response
As per AS-6, where the historical cost of a depreciable asset has undergone a
change due to increase or decrease in long term liability on account of exchange
fluctuations, price adjustments, changes in duties or similar factors, the
depreciation on the revised depreciable amount should be provided
prospectively over the useful life of the asset. In the given case, the nature of
change in historical cost of the fixed asset is different i.e. it is not a situation of a
change in the duty as such, but it is a case of an asset escaping payment of duty.
Accordingly, the depreciation should be worked out on restrospective basis i.e.
the depreciation in respect of the past years since the acquisition of the dredgers
should be charged in the profit and loss account of the current year and should
be disclosed as a prior period item.
Query
In the scenario where the useful life is 25 years, the entire building is depreciated
on SLM basis over 25 years. In the scenario where the useful life is 75 years, the
minimum statutory depreciation should be provided the following alternatives
may be permissible:
(a) 3.34% SLM depreciation is provided on the entire building since one building
can only have one rate of depreciation or one useful life and therefore the higher
rate is applied
(b) 1.63% can be applied on office portion and 3.34% can be applied on factory
portion- this could be justified on the grounds that it should achieve proper
allocation of deprecation to future years based on Schedule XIV requirement.
The view in (a) is the preferred view and the one in (b) is an alternative view.
Note no. 4 in Schedule XIV to the Companies Act, 1956, prescribes that “Where
during any financial year, any addition has been made to any asset, or where any
asset has been sold, discarded, demolished or destroyed, the depreciation on
such assets shall be calculated on a pro rata basis from the date of such addition
or, as the case may be, up to the date on which such asset has been sold,
discarded, demolished or destroyed”. A company may group additions and
disposals in appropriate time period (s), eg. 15 days or a month, for the purpose
of charging pro rata depreciation in respect of additions and disposals of its
assets keeping in view the materiality of the amounts involved”.
Disclosure
(1) The historical cost or other amount substituted for historical cost of each
class of depreciable assets
(2) Total depreciation for the period for each class of assets
(3) The related accumulated depreciation
In case the depreciable assets are revalued, the provision for depreciation is
based on the revalued amount on the estimate of the remaining useful life of
such assets. In case the revaluation has material effect on the amount of
depreciation, the same is disclosed separately in the year in which revaluation is
carried out.
Depreciation Calculation
(Working Example I)
Elucidation
(Example 3)
Tangible Assets
Fixed Assets are stated at cost less accumulated depreciation and impairment
losses, if any. Cost comprises the purchase price and any other directly
attributable costs of bringing the asset to its working condition for its intended
use.
Intangible Assets
Depreciation
Depreciation is provided using Straight Line Method as per the useful lives of
the assets estimated by the management or at the rates prescribed under
Schedule XIV of the Companies Act, 1956, whichever is higher.
Tangible assets and intangible assets costing Rs. 5,000 or less individually are
fully depreciated/amortized in the year of purchase.
At Future Capital Real Estate, employees can avail of a benefit termed as ‘Hard
Furnishing’, details on the policy are stated as under:
1. Objective
2. Applicability
• All the confirmed employees in Band 3, 4 & 5 with effect from 1st July
2005 (Revised on 1st July 2006).
3. Guidelines
Value (Rs.)
Position
(for block of 3 years)
Head 3,00,000/-
Chief 2,25,000/-
Manager 1,20,000/-
Manager 90,000/-
• The employee may select hard furnishing items of his / her choice;
however, the items should purely be capital items as defined under the
Income Tax Act.
6. Purchase Of Items
8. Income Tax
• The hard furnishing items will be given as assets to the employee for
his/her use and treated as perquisites under income Tax Act. The
taxable value of this perquisite will be calculated as mentioned in the
below attached document.
Camera Electronics 10% of the cost of assets 7.50% of the cost of assets
The above perquisite value will be added to the employee’s annual taxable income.
Attached is the full & final settlement statement of one of the ex-employees who
has left us within three years of purchase of the asset. The amount of
depreciation is mentioned and the working given:
Date of
Employee no : xxx Joining: 17-Jul-07
Date of
Employee Name : xxx Resignation: 01-Aug-08
Date of
Designation xxx Leaving 31-Oct-08
Department: xxx
Band: xxx
A) Amount Due to Employee Amount Rs Amount Rs
3 Exgratia (Comments) -
xxxxx xxxxxx