Calculation of depreciation for computation of net profits for the purposes of managerial remuneration Department’s memorandum on interpretation of the section - Companies Law - No. 10(1) CL VI/61,

Circular : No. 10(1) CL VI/61, dated 27-9-1961. Subject:- Calculation of depreciation for computation of net profits for the purposes of managerial remuneration Department s memorandum on interpretation of the section MEMORANDUM Enquiries have been made of this Department by some chambers of commerce and companies regarding the manner in which depreciation under the provisions of section 350 of the Companies Act, as amended by the Companies (Amendment) Act, 1960, should be calculated. The Department has given careful thought to the administrative and accounting problems connected with the implementation of the provisions of this section, in the light of intentions, underlying its recent amendment. From this point of view the Department would consider it adequate compliance with the provisions of this section, if companies and their accountants would bear in mind the principles suggested in the following paragraphs and adopt the methods of calculations broadly indicated below : In calculating the amount of depreciation to be deducted under section 350, as recently amended, in respect of the first financial year, which ends on or after the commencement of the Companies (Amendment) Act, 1960, i.e., December 28,1960, the written down value should be worked out by deducting the normal depreciation allowed for income‑tax purposes and which was deductible in accordance with the provisions of section 350 as they stood before the recent amendment of this section, in respect of financial years ending on or before December 27, 1960, from the written down value of the fixed assets [before provision of depreciation] as shown by the books of account on the date of the commencement of the Companies Act, 1956, i.e., April 1, 1956, or immediately thereafter. [In determining the notional written down value for the limited purposes of section 350, extra and multiple shift allowances need not be taken into consideration in respect of financial years which ended on or before December 27,1960]. After the notional written down value has been determined as indicated above, depreciation should be calculated by applying the rates specified in respect of the assets, in the Indian Income‑tax Act, 1922 and the rules made under it for normal depreciation and for extra and multiple shift allowances. In respect of financial years subsequent to the first financial year referred to in para 2 above, the notional written down value should be first computed in the manner indicated above. From the written down value thus computed, the amount of normal depreciation and extra and multiple shift allowances which would be deductible from year to year according to the amended section 350, should thereafter be deducted. In other words, the depreciation for the subsequent financial years should be computed by applying the rates specified in the Income‑tax Act and the rules made under it for normal depreciation and for extra and multiple shift allowances to the notional written down value determined in the manner as already indicated. EXPLANATORY NOTE Depreciation to be provided for the purpose of determining the net profits for payment of managerial remuneration ‑ The Companies (Amendment) Act, 1960 has considerably amended the provisions of section 350 regarding deduction of depreciation in determining the net profits for payment of managerial remuneration. As compared to the requirement of that section as it stood before the amendment, viz., that of deducting the normal depreciation allowable under the Indian Income‑tax Act, 1922 and the rules prescribed thereunder, it is now required that the depreciation under section 350 should be calculated according to the rates prescribed under the Indian Income‑tax Act, 1922 with reference to the written down values as mentioned in that section. From time to time, queries have been received from members of the investing public companies and their managements, chartered accountants, etc., regarding the method of computation of depreciation in accordance with the provisions of the amended section 350. The matter was carefully examined in consultation with the Advisory Committee of eminent businessmen and professional accountants, lawyers, etc., attached to the Department, and a memorandum setting out the principles to be followed for the purpose of such calculation was prepared and circulated to the chambers of commerce, professional bodies, etc. It would however appear that some company managements continue to experience difficulty in giving effect to the provisions of the section. The queries raised by them in this connection and the departmental views in regard to such problems are set out below : 1. Since section 350 provides that depreciation shall be calculated with reference to the written down value of the assets shown by the books of the company, whether it would be advisable to adopt the basis of notional written down value contemplated in the departmental memorandum? A close perusal of the wording of section 350 will make it clear that written down value as shown by the books has to be taken into account for purposes of section 350 in respect of the first financial year expiring at or immediately after the commencement of the Companies Act, 1956 and that in respect of the first subsequent financial year, the written down value for the purpose of section 350 will have to be calculated separately by applying the income‑tax rates of depreciation on the written down value mentioned above. The depreciation for the next financial year should be calculated by applying the income‑tax rates to the said written down value reduced by the amount of depreciation calculated for the previous financial year. Similar procedure should be followed for the subsequent financial years. If it was the intention of the statute that the written down value, for the purposes of section 350, should be the written down value as shown by the books of account from year to year, clearly it would have been unnecessary to include any reference to subsequent financial years. The intention could have been fully brought out by merely stipulating that the written down value of the assets as shown by the books of the company should be taken into consideration and omitting the words at the end of the financial year expiring at the commencement of this Act or immediately thereafter and at the end of each subsequent financial year . It is a well‑known principle of interpretation that every word occurring in a section has to be given a definite meaning and, in the present case, such meaning could only be that where a company does not adopt the method of calculation of depreciation, as laid down in section 350 for purposes of its books of account, for each subsequent financial year, a separate notional written down value for the purposes of section 350, in the manner stated at the beginning of this paragraph, should be worked out. This is the basis recommended in the departmental memorandum. Quite apart from the legal interpretation of the section set out above it would be necessary to ensure that a. the method of calculation is in conformity with usually accepted accounting principles; b. there is no undercharging of depreciation in future and also that companies are not required to deduct depreciation in excess of the cost of the assets concerned. The continuous application of the basis of the written down value shown in the books may, in certain circumstances, lead to results contrary to the objectives set out above. It is open to a company under the law to provide in its books for depreciation an amount higher than the minimum amount of depreciation required to be provided in accordance with section 350, before declaring dividend. In actual practice, many companies consider the income‑tax rates to be somewhat inadequate, particularly in relation to the higher replacement cost. If a company does provide for depreciation in its profit and loss account at a rate higher than what is contemplated under section 350 ( i.e., income‑tax rates of depreciation), there would be an under provision of depreciation for the purposes of section 350, as would be seen from Illustration 1 given below : ILLUSTRATION 1 Provided in the P L Account at the rate of25% (straight line method) Book written down value Provided at the rate of 20% u/s 350 on the basis of book written down value Rs. Rs. Rs. Cost : First year 2,500 1,000 2,500 2,000 Second year 2,500 7,500 1,500 2,500 Third year 2,500 5,000 2,500 1,000 Fourth year 2,500 2,500 2,500 500 Fifth year Nil Nil Nil Nil Nil Nil Total depreciation provided 10,000 5,000 Assets sold in the sixth year for 2,000 2,000 Total amount charged 8,000 3,000 It will thus be seen that if the book value basis is followed continuously depreciation to the extent of Rs. 5,000 would not be provided for the purposes of section 350, in the above circumstances. Similalry, if a company does not declare dividend it is open to it to provide no depreciation in its profit and loss account to provide for it at rate lower than those prescribed in section 350. This would distinctly result in the overcharging of depreciation ( i.e., more than 100 per cent of the cost of the assets) as will be seen from Illustration 2 given below : It will be seen that the adoption of the book value basis would result depreciation to the extent of Rs. 4,050 being charged in addition to the cost of the assets, for the purposes of section 350, in the above circumstances. ILLUSTRATION 2 Provided in the P L Account at the rate of 10% (straight line method) Book written down value Provided at the rate of 20% u/s 350 on the basis of book written down value Rs. Rs. Rs. Cost : First year 1,000 10,000 2,500 1,000 Second year 1,000 9,000 2,500 1,000 Third year 1,000 8,000 2,000 1,000 Fourth year 1,000 7,000 1,750 1,000 Fifth year 1,000 6,000 1,500 1,000 Sixth year 1,000 5,000 1,000 Book written down value after sixth year 4,000 1,250 Total depreciation provided 6,000 11,250 Assets sold in the seventh year for loss on sale 1,200 Additional charge in seventh 2,800 Year 2,800 Total amount charged 8,800 14,050 It will be seen that the departmental memorandum seeks to achieve a logical compliance with the provision of section 350, at the same time without causing much difficulty or inconvenience to company managements and professional accountants in the matter of calculation of depreciation. As it is necessary that the procedure followed under section 350 should not only conform closely to the spirit of the provisions therein, but in accordance with good company practice, it would be advisable to adopt the notional written down value basis suggested in the departmental memorandum. 2. The reasons for not deducting extra and multiple shift allowance in respect of financial years ending on or before December 27, 1960, in calculating the notional written down value in accordance with the departmental memorandum are not clear. Under the provisions of section 350, before its recent amendment, only normal depreciation, allowable under the Indian Income‑tax Act, 1922 and the rules made thereunder, were required to be deducted for determining the net profits for payment of managerial remuneration. This Department has been advised that the expression normal depreciation would not include extra and multiple shift allowance. Since the section has no retrospective application requiring the deduction of extra and multiple shift allowance, in respect of periods prior to the commencement of the Companies (Amendment) Act, 1960, i.e., before December 28, 1960, the application of the rate of depreciation including extra and multiple shift allowance in calculating the notional written down value would only create hardship to the company managements [as the arrears of extra and multiple shift allowance for previous years would require to be deducted in the very first financial year after the commencement of the Companies (Amendment) Act, 1960] and distort the profitability position of the companies concerned. It would not, therefore, be appropriate to deduct extra and multiple shift allowance in respect of financial years ending on or before December 27, 1960 in calculating the notional written down value for the purposes of section 350. 3. In the case of companies, whose fixed assets have been revalued by writing up the difference to a capital reserve account, whether the written down value should, or the purposes of section 350 , be taken as the original cost ? If any asset or assets has or have been revalued prior to the expiry of the financial year ending on April 1, 1956 or immediately thereafter, the amount added on revaluation would be a part of the book value in computing the notional written down value in accordance with the departmental memorandum on section 350. Any addition arising out of subsequent revaluation should not be taken into account for the purposes of section 350 , as it has been made clear in the memorandum that the written down value in respect of years subsequent to the financial year ending on or immediately after April 1, 1956 would be the notional written down value referred to in the said memorandum. 4. Whether depreciation should also be deducted under section 350 in respect of those assets which remained idle during the whole or a part of a financial year ? Since it has been held by accounting authorities that depreciation may arise even during the period when an asset remains idle, by the efflux of time, it would be necessary to deduct depreciation in respect of idle assets in accordance with section 349(4)( k ) read with section 350. 5. It is not clear whether depreciation of a particular year is to be calculated after taking into consideration the additions to the asset and the sale or disposal of the asset during that year. In accordance with accepted accounting procedure the additions to the assets and the sale or disposal of assets during the year have to be taken into consideration before calculating depreciation in accordance with section 350 , in respect of that financial year, but the depreciation to be adjusted in any particular year on the additions and disposals made in that year would only be on a pro rata basis with reference to the actual date of such additions/disposals. 6. Since plant and machinery which for income‑tax purposes is divided into 10 or 12 sub‑headings, each of which carries a different rate of depreciation, whether it would be in order to apply the average rates calculated with reference to the total depreciation allowed in respect of that type of fixed assets in relation to the written down values of the various items included under that asset head. Since section 350 refers to the rates specified in the Indian Income‑tax Act, 1922 and the rules framed thereunder, the relevant rates will apply to each kind of asset separately. Calculation of depreciation at the average of the rates would not be in conformity with the requirements of that section. 7. The rates of depreciation in respect of agricultural assets have not been specified in section 350 ; the procedure to be adopted in this regard may be clarified. In accordance with sound company practice, if a company desires to deduct depreciation in respect of its agricultural assets for the purposes of section 350, it may adopt the rates prescribed in the Agricultural Income‑tax Act of the State in which it is situated.