Accounting Standard (AS) 6 on Depreciation Accounting based on general principles of accounting issued by the Council of the Institute of Chartered Accountants of India. - Companies Law - CIRCULAR NO. 1/86,

CIRCULAR NO. 1/86, DATED 21-5-1986 Subject:- Dividends ‑ Declaration of ‑ Accounting Standard (AS) 6 on Depreciation Accounting based on general principles of accounting issued by the Council of the Institute of Chartered Accountants of India. 1. Introduction ‑ The Council of Institute of Chartered Accountants of India has issued Accounting Standard ( AS ) 6 on Depreciation Accounting. The standard lays down general principles of accounting for depreciation applicable to all entities. As such, the standard is applicable to companies also in all matters where there are no specific requirements under the Companies Act, 1956. As-6 also provides that the statute governing an enterprise may provide the basis for computation of depreciation. In such a situation, the requirements of the statute have to be complied with. thus, in case of companies, sections 205 and 350 of the Companies Act, which govern provisions regarding charge of depreciation for the purpose of payment of dividends and computation of managerial remuneration, respectively, provide the basis for computation of depreciation. The Companies (Amendment) Act, 1988 has amended section 350, as a consequence to which rates of depreciation prescribed in the Income‑tax Act, 1961, and the Rules made thereunder are no more relevant as the aforesaid section now provides that the rates of depreciation applicable would be those prescribed in Schedule XIV, which has been inserted in the Act. This Guidance Note on Accounting for Depreciation in Companies is issued by the Research Committee in the context of the aforesaid sections of the Act as well as the Accounting Standard. 2. The Council of the Institute and its various committees have issued, from time to time, various pronouncements on the subject of accounting for depreciation, in particular reference to the corporate sector, which are listed below : Guidance Note on Provision for Depreciation [published in Compendium of Guidance Notes, Vol. 1, 2nd edn.] Statement on Provision for Depreciation in Respect of Extra or Multiple Shift Allowance [published in Compendium of Statements and Standards on Accounting, 1st edn.] Statement on Changes in the Mode of Charging Depreciation in Accounts [published as an Appendix in the Guide to Company Audit] Guidance Note on Accounting for Depreciation Consequent to Changes in Rates for Depreciation [published in Compendium of Guidance Notes, Vol. II, 1st edn.] This Guidance Note comes into effect in respect of accounting periods commencing on or after 1st April, 1989. Accordingly, the above Guidance Notes/Statements stand withdrawn from that date. 3. Methods of charging depreciation ‑ Section 205 of the Companies Act prescribes the methods of charging depreciation. The relevant extracts thereof are as follows : (2) ... depreciation shall be provided either (a) to the extent specified in section 350; or (b) in respect of each item of depreciable asset, for such an amount as is arrived at by dividing ninety‑five per cent of the original cost thereof to the company by the specified period in respect of such asset; or (c) on any other basis approved by the Central Government which has the effect of writing off by way of depreciation ninety‑five per cent of the original cost to the company of each such depreciable asset on the expiry of the specified period; or (d) as regards any other depreciable asset for which no rate of depreciation has been laid down by this Act or Rules made thereunder, on such basis as may be approved by the Central Government by the general order published in the Official Gazette or by any special order in any particular case : Provided that where depreciation is provided for in the manner laid down in clause (b) or clause (c) then, in the event of the depreciable asset being sold, discarded, demolished or destroyed, the written down value thereof at the end of the financial year in which the asset is sold, discarded, demolished or destroyed, shall be written off in accordance with the proviso to section 350. (3) (4) ** ** ** (5) * * ** ** (a) specified period in respect of any depreciable asset shall mean the number of years at the end of which at least ninety‑five per cent of the original cost of the asset to the company will have been provided for by way of depreciation if depreciation were to be calculated in accordance with the provisions of section 350; 4. Note No. (5)(i) to Schedule XIV requires that depreciation method(s) used by the company shall be disclosed. Part II of Schedule VI requires that if no provision is made for depreciation, the fact that no provision has been made should be stated and the quantum of arrears of depreciation computed in accordance with section 205(2) of the Act shall be disclosed by way of a note. The Committee is of the view that the company should also disclose the method(s) by which the arrears of depreciation have been computed. 5. Adoption of different methods for different types of assets ‑ A company may adopt more than one method of depreciation. Thus, it is permissible to follow different methods for different types of assets provided the same methods are consistently adopted from year to year in accordance with section 205(2). Also, units in different geographical locations can follow different methods of depreciation on machinery purchased in the same year. 6. Change in the method of providing depreciation - The depreciation method selected should be applied from period to period. A change from one method of providing depreciation to another should be made only if the adoption of the new method is required by statute or for compliance with an accounting standard or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements of the enterprise. When a change in the method of depreciation is made, depreciation should be recalculated in accordance with the new method from the date of the asset coming into use. [It is hereby clarified that the relevant portion of Accounting Standard (AS) 6 on Depreciation Accounting , issued by the Institute of Chartered Accountants of India, is being revised to bring it in line with this recommendation of the Guidance Note]. The deficiency or surplus arising from retrospective recomputation of depreciation in accordance with the new method would be adjusted in the accounts in the year in which the method of depreciation is changed. In case the change in the method results in deficiency in depreciation in respect of past years, the deficiency should be charged to the profit and loss account. In case the change in the method results in surplus, it is recommended that the surplus be initially transferred to the Appropriations part of the profit and loss account and thence to General Reserve through the same part of the profit and loss account. Such a change should be treated as a change in accounting policy and its effects should be quantified and disclosed. 7. Relevant rates of depreciation for the purpose of preparation of accounts of a company ‑ Section 205 of the Companies Act requires that no dividend shall be declared or paid by a company except out of the profit of the company arrived at after providing for depreciation in accordance with the provisions of sub‑section (2) of that section. This sub‑section allows the company to provide for depreciation either in the manner specified in section 350 of the Act or in the alternative manners specified in that sub‑section itself. Part II of Schedule VI further provides that if no provision for depreciation is made, the fact that no provision has been made shall be stated and the quantum of arrears of depreciation computed in accordance with section 205(2) of the Act shall be disclosed by way of a note. 8. A question may arise as to whether it is obligatory on a company to provide for depreciation only on the basis mentioned in section 205(2) read with section 350 and Schedule XIV of the Act or whether these bases can be considered as indicating the minimum depreciation which must be provided by the company, insofar as it is required to exhibit a true and fair view of the state of affairs of the company as on a given date and of the profit or loss for the year. 9. The Committee is of the view that in arriving at the rates at which depreciation should be provided, the company must consider the true commercial depreciation, i.e., the rate which is adequate to write off the asset over its normal working life. If the rate so arrived at is higher than the rates prescribed under Schedule XIV, the company should provide depreciation at such higher rate; but if the rate so arrived at is lower than the rates prescribed in Schedule XIV, then the company should provide depreciation at the rates prescribed in Schedule XIV, since these represent the minimum rates of depreciation to be provided. Since the determination of commercial life of an asset is a technical matter, the decision of the Board of directors based on technological evaluation should be accepted by the auditor unless he has reason to believe that such decision results in a charge which does not represent true commercial depreciation. In case a company adopts the higher rates of depreciation as recommended above, the higher depreciation rates/lower lives of the assets must be disclosed as required in Note No. 5 of Schedule XIV to the Companies Act. 10. This view is supported by the Department of Company Affairs and it has clarified that the rates as contained in Schedule XIV should be viewed as the minimum rates, and, therefore, a company will not be permitted to charge depreciation at rates lower than those specified in the Schedule in relation to assets purchased after the date of applicability of the Schedule. If, however, on the basis of bona fide technological evaluation, higher rates of depreciation are justified, they may be provided with proper disclosure by way of a note forming part of annual accounts. [Circular No. 218, dated 7th March, 1989]. 11. The Committee is, however, of the view that in respect of assets existing on the date of Schedule XIV coming into force, and where the company is following the Circular of the Department of Company Affairs bearing No. 1/86 dated 21st May, 1986, whereby depreciation under straight line method was worked out based on depreciation rates in force in Income‑tax Act, 1961 and Rules made thereunder at the time of the acquisition of the asset, it would be permissible to the company to follow the Circular No. 1/86, dated 21st May, 1986. An appropriate note will be required to be given in this regard. 12. Schedule XIV requires that where the concern has worked extra shift, the multiple or extra shift depreciation will have to be provided on the plant and machinery, wherever applicable. In this regard, various units/departments/mills/factories should be taken as separate concerns. In cases where depreciation has not been provided in respect of extra or multiple shift allowance, it will be necessary for the auditor to qualify his report accordingly. An example of the qualification is given below : Depreciation in respect of extra or multiple shift allowance amounting to rupees.... has not been provided which is contrary to the provisions of Schedule XIV to the Companies Act. This has resulted in the profit being overstated by Rs.... and plant and machinery understated by Rs .... 13. It has been argued that the SLM rates (corresponding to the WDV rates as per Schedule XIV) can be different than those prescribed under Schedule XIV, provided the company continues to determine the rates as provided under section 205. For instance, against the SLM rate of 11.31 (triple shift rate for general plant and machinery) prescribed under Schedule XIV, a company can charge depreciation at the rate of 10.56 per cent. It may be mentioned that the rate of 11.31 per cent has been determined on the basis of 8 years and 6 months or so of specified period whereas 10.56 per cent is arrived as if 95 per cent of the cost of the asset is divided by 9 years. It is argued that for calculating the SLM rates complete years have to be taken into account whereas the rates under Schedule XIV also take into account fractions of years. 14. The Committee is of the view that a company should provide SLM depreciation at the rates prescribed under Schedule XIV instead of holding the contention that fractions of years can be ignored. This view is supported by Department of Company Affairs, as per its Circular No. 2/89, dated 7th March, 1989 [enclosed as Annexure I]. 15. Applicability of the rates prescribed in Schedule XIV to assets existing on which Schedule XIV came into force ‑ Applicability of the rates prescribed in Schedule XIV to existing assets would depend upon whether the company has been charging depreciation on its assets as per the written down value method or the straight line method. 16. Where a company has been following the written down value method of depreciation in respect of its assets, the WDV rates prescribed in Schedule XIV should be applied to the written down value as at the end of the previous financial year as per the books of the company. 17. Where a company has been following the straight line basis of depreciation in respect of its assets, the position prevailing at present is discussed hereunder. 18. In January 1985, the Department of Company Affairs issued a Circular No. 1/85, dated 10th January, 1985 [enclosed as Annexure II]. In this Circular, the Government recognised the need for recalculating the specified period consequent to changes in the income‑tax rates. For determining depreciation consequent upon changes in the income‑tax rates, it recommended the following method : As far as recomputation of specified period is concerned, the specified period be recomputed by applying to the original cost, the revised rate of depreciation as prescribed under Income‑tax Rules. As far as charge of depreciation is concerned, depreciation be charged by allocating the written down value as per books over the remaining part of the recomputed specified period. 19. The Department of Company Affairs issued another Circular No. 1/86, dated 21st May, 1986 [enclosed as Annexure III ] wherein it re-examined its earlier Circular of 1985. The Department accordingly expressed its view that once the specified period was determined at the time of purchase of an asset in accordance with the procedure laid down under section 205(5) read with section 350 of the Companies Act with reference to the rates of depreciation under the Income‑tax Act at that time and the amount of depreciation fixed under section 205(2)(b) of the Companies Act, the same need not be changed subsequently consequent on changes in the rates of depreciation in the Income‑tax Act. The Circular further stated that it was, therefore, open to the companies to provide for depreciation under clause (b) of section 205(2) of the Companies Act on the basis of rates of depreciation prescribed under Income‑tax Act and in force at the time of acquisition/purchase of the asset . 20. In its Circular No. 2/89, dated 7th March, 1989, the Department has reiterated that the companies which follow Circular No. 1/86 may, therefore, continue to charge depreciation at the old SLM rates in respect of the already acquired assets against which depreciation has been provided in earlier years on SLM basis . 21. The Committee is of the view that where a company is following the straight line method of depreciation in respect of its assets existing on the date of Schedule XIV coming into force, it would be permissible to apply the relevant SLM rates prescribed in the said Schedule on the original cost of the assets from the year of the change of rates. 22. The Committee is accordingly of the view that where a company has been following straight line method of depreciation in respect of its assets existing on the date of Schedule XIV coming into force, the following alternative basis may be adopted for computing the depreciation charge. 1. Where a company follows the manner of charging depreciation recommended by the Department of Company Affairs in its Circular No. 1/85, it has to change its depreciation rates as follows : The specified period should be recomputed by applying to the original cost, the revised rate as prescribed in Schedule XIV. Depreciation charge should be calculated by allocating the unamortized value as per the books of account over the remaining part of the recomputed specified period. 2. A company which follows the Circular No. 1/86, can continue to charge depreciation on straight line basis at old rates in respect of assets existing on the date on which the new provision relating to depreciation came into force. 3. SLM rates prescribed in Schedule XIV can be straightway applied to the original cost of all the assets including the existing assets from the year of change of the rates. 23. A company which changes the rates of depreciation should make an appropriate disclosure in its accounts pertaining to the year in which the change is made. 24. Pro rata depreciation ‑ Note No. 4 in Schedule XIV to the Companies Act 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. The Committee is of the view that a company may group additions and disposals in appropriate time period(s), e.g.,15 days, a month, a quarter, etc., 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. 25. Where the financial year of a company is more/less than 12 months, a question may arise as to whether the rates of depreciation prescribed in Schedule XIV are to be applied proportionately to the duration of the financial year of the company or the said rates are to be applied as flat rates irrespective of the duration of the financial year. It may be argued that since sections 205 and 350 of the Companies Act are in relation to the financial year, the rates prescribed in Schedule XIV are applicable in respect of the financial year of the company irrespective of its duration. The Committee is, however, of the opinion that in view of the true and fair consideration of preparation of accounts, the rates of depreciation as per Schedule XIV should be applied proportionately taking into consideration the duration of the financial year. 26. Depreciation on low value items ‑ Prior to the enforcement of the Companies (Amendment) Act, 1988, many companies used to follow the practice of writing off low value items in the year of acquisition since such a write off was permitted under the Income‑tax Act. The limit for such a write off was Rs. 5,000. Schedule XIV is, however, silent on this aspect. The Committee is of the view that the concept of materiality should be kept in mind while deciding the amounts to be written off in this regard. For instance, in small companies, the total write off on this basis may be a substantial figure; it may not, therefore, be proper to charge 100 per cent depreciation on low value items. However, in large companies, where the value of assets is very high, it may be proper to charge 100 per cent depreciation on low value items keeping in view the concept of materiality. The Committee recommends that the accounting policy followed by the company in this regard should be disclosed appropriately in the accounts. 27. Computation of managerial remuneration ‑ Whether SLM rates given in Schedule can be used ‑ The Department of Company Affairs, as per its Circular No. 3/19/ 88‑CL‑V dated 13th April, 1989, has stated that for the purpose of determining net profits of any financial year, the amount of depreciation required to be deducted in pursuance of clause (k) of sub‑section (4) of section 349 read with section 350 shall be the amount calculated, as per the written down value method at the rate specified in Schedule XIV, on the assets as shown by the books of the company at the end of the relevant financial year . The Committee is of the opinion that the language of section 350 as it stands at present does not permit the use of the straight line method. The aforesaid section makes reference to written down value of the assets indicating thereby that for the purposes of computation of managerial remuneration, only the WDV method can be used as the SLM rates, by definition, are applicable only to the original cost of the assets and not to the WDV of the assets. 28. Charging of depreciation in case of revaluation of assets ‑ A question may arise as to whether the additional depreciation provision required in consequence of revaluation of fixed assets can be adjusted against Revaluation Reserve created by a company by transferring the difference between the revalued figure and the book value of the fixed assets. Depreciation is required to be provided with reference to the total value of the fixed assets as appearing in the accounts after revaluation. However, for certain statutory purposes, e.g., dividends, managerial remuneration, etc., only depreciation relatable to the historical cost of the fixed asset is to be provided out of the current profits of the company. In the circumstance, the additional depreciation relatable to revaluation may be adjusted against Revaluation Reserve by transfer of Profit and Loss Account. In other words, as per the requirements of Part II of Schedule VI to the Companies Act, the company will have to provide the depreciation on the total book value of the fixed assets (including the increased amount as a result of revaluation) in the Profit and Loss Account of the relevant period, and thereafter the company can transfer an amount equivalent to the additional depreciation from the revaluation reserve. Such transfer from Revaluation Reserve should be shown in the Profit and Loss Account separately and an appropriate note by way of disclosure would be desirable. Such a disclosure would appear to be in consonance with the requirement of Part I of Schedule VI to the Companies Act, prescribing disclosure of write up in the value of fixed asset for the first five years after revaluation. 29. If a company has transferred the difference between the revalued figure and the book value of fixed assets to the Revaluation Reserve and has charged the additional depreciation related thereto to its Profit and Loss Account, it is possible to transfer an amount equivalent to accumulated additional depreciation from the revaluation reserve to the Profit and Loss Account or to the General Reserve provided suitable disclosure is made in the accounts as recommended in this Guidance Note. 30. The Revaluation Reserve is not available for payment of dividends. This view is also supported by the Companies (Declaration of Dividend out of Reserves) Rules, 1975. Similarly, accumulated losses or arrears of depreciation should not be set off against Revaluation Reserve. However, the Revaluation Reserve can be utilised for adjustment of the additional depreciation on the increased amount due to revaluation from year to year or on the retirement of the relevant fixed assets (as discussed in paragraphs 28 and 29 above respectively). 31. The revaluation of fixed assets is normally done in order to bring into books the replacement cost of such assets. This is a healthy trend as it recognises the importance of retaining sufficient funds through additional depreciation in the business for replacement of fixed assets. As such, it will be prudent not to charge the additional depreciation against revaluation reserve, though the charge of additional depreciation against revaluation reserve is not prohibited as discussed in paragraphs 28 and 29 above. The practice of not charging the additional depreciation against Revaluation Reserve would also give a more realistic appraisal of the company s operations in an inflationary situation. Source : Guidance Notes on Accounting for Depreciation in Companies issued by the Council of the Institute of Chartered Accountants of India. ANNEXURE I CIRCULAR NO. 2/89, DATED 7‑3‑1989 Certain issues arising from the provisions of section 205 as amended by the Companies (Amendment) Act, 1988 clarified - This Department has been receiving queries from different quarters on the subject mentioned above, from time to time, and, accordingly, the following clarifications are issued : (1) Date on which the new provisions relating to depreciation become effective The Companies (Amendment) Act, 1988 specifically provides that Schedule XIV shall be deemed to have come into force on 2nd April, 1987. The amended provisions of sections 205 and 350 of the Act have come into force on 15th June, 1988, by virtue of the notification issued by this Department. A question arises, therefore, whether depreciation can be charged on assets on the basis of the rates provided in Schedule XIV for accounting years ending between 2nd April, 1987 and 14th June, 1988. In view of the intention of the Legislature behind the amendments in sections 205 and 350 of the Act, the amended provisions have come into force with effect from 2nd April, 1987. (2) Recomputation of specified period ‑ It is stated that in 1986, the Department had issued a circular stating that specified period once determined may not be recomputed. Accordingly the Department had advised the companies that it was open to them not to recompute the specified period even when there is a change in the rates of depreciation later on (as against the position of the Department s earlier circular of 1985 on the subject). It is argued that as far as the existing assets are concerned, the companies can follow either of the two circulars. An option under the 1986 circular would thus be available to the companies as at present not recomputing the specified period where the Straight Line Method (SLM) is used. In other words, where a company decides to follow the 1986 circular, assets on which SLM depreciation was being charged, can continue to be depreciated at the old SLM rates. In view of this Department s Circular No. 1 of 1986 (No. 1/1/86‑CL-V), dated 21st May, 1986, specified period once determined may not be recomputed. The companies which follow this circular may, therefore, continue to charge depreciation at the old SLM rates in respect of the assets already acquired against which depreciation has been provided in earlier years on SLM basis. (3) Can higher rates of depreciation be charged ‑ It is stated that Schedule XIV clearly states that a company should disclose depreciation rates if they are different from the principal rates specified in the Schedule. On this basis, it is suggested that a company can charge depreciation at rates which are lower or higher than those specified in Schedule XIV. It may be clarified that the rates as contained in Schedule XIV should be viewed as the minimum rates, and, therefore, a company shall not be permitted to charge depreciation at rates lower than those specified in the Schedule in relation to assets purchased after the date of applicability of the Schedule. However, if on the basis of a bona fide technological evaluation, higher rates of depreciation are justified, they may be provided with proper disclosure by way of a note forming part of annual account. (4) Can SLM rates be different than those specified under Schedule XIV ‑ It is stated that SLM rates [corresponding to the Written Down Value (WDV) rates, as per Schedule XIV] can be different than those prescribed under Schedule XIV provided a company continues to determine the rates as provided under section 205. Thus, against SLM rates prescribed under Schedule XIV of 11.31 per cent (triple shift rate for general plant and machinery), a company can charge depreciation at the rate of 10.56 per cent. It may be mentioned that the rate of 11.31 per cent, has been determined on the basis of eight years and six months or so of specified period whereas if 95 per cent is divided by nine years, the corresponding SLM rate comes to 10.56 per cent. The argument is that for calculating the SLM rates, complete years have to be taken into account whereas the rates under Schedule XIV also takes into account fractions of years. It is clarified that a company must necessarily provide SLM depreciation at the rates prescribed under Schedule XIV and the interpretation that fractions of years cannot be taken into account is not correct. ANNEXURE II CIRCULAR NO. 1/85, DATED 10‑1‑1985 ‑ DETERMINATION OF DEPRECIATION UNDER SECTION 205(2)( b) OF THE COMPANIES ACT, 1956 CONSEQUENT UPON CHANGES IN INCOME‑TAX RATES INTRODUCED BY THE FINANCE ACT, 1983 I am directed to say that during the year 1983, the rates of depreciation under the Income‑tax Act has been changed on some of the assets. As the depreciation provision in the annual account of the companies under section 205/350 of the Companies Act is related to the rates of depreciation as provided in the Income‑tax Act, any change in the rates under the Income‑tax Act affects the provision of depreciation in the annual account of the companies. As a result, this Department has received several queries/ representations from companies enquiring as to what procedure they should adopt for charging depreciation on straight line method on the assets purchased earlier to the change in the rate of depreciation as provided in the Income‑tax Act. 2. This issue has been examined in this Department and it has been decided that under sub‑section (5) of section 205, specified period for providing depreciation on straight line method under clause (b) of sub-section (2) of section 205 has to be recalculated on the basis of the revised rates under the Income‑tax Act. The companies which adopt the straight line method of depreciation should provide for the depreciation in their annual accounts on the following basis : Number of years for which asset has already been depreciated, before the change in depreciation rate ‑ Say, A years Specified period calculated at revised rate by which 95 per cent of the original cost of asset would have depreciated on written down value method at revised rates ‑ Say, B years Written down value of the assets in the book at the beginning of the year in which rates have been changed under the Income‑tax Act ‑ Say, Rs. X 5 per cent of the original cost ‑ say, Rs. Y Fixed instalments of depreciation to be provided each year after the rate has been changed shall be calculated as per the formula : X Y B A If A is greater than B , then the amount (X Y) may be provided for as depreciation in the year in which rates are changed. ANNEXURE III CIRCULAR NO. 1/86, DATED 21-5-1986 ‑ DETERMINATION OF DEPRECIATION UNDER SECTION 205(2)( b) OF THE COMPANIES ACT, 1956 CONSEQUENT UPON CHANGES IN INCOME‑TAX RATES INTRODUCED BY THE FINANCE ACT, 1983 Inviting attention to Circular of even number dated 10‑1‑1985, it is stated that the question of providing depreciation under straight line method and the calculation of specified period, as suggested in the Circular referred to above, has been re‑examined. On reconsideration, the Department is of the view that once specified period is determined at the time of purchase of an asset in accordance with the procedure laid down under section 205(5) read with section 350 with reference to rates of depreciation under the Income‑tax Act at that time and amount of depreciation fixed under section 205(2)(b), the same need not be changed subsequently consequent on changes in the rates of depreciation under the Income‑tax Act. It is, therefore, open to the companies to provide for depreciation under clause (b) of section 205(2) on the basis of rates of depreciation prescribed under the Income‑tax Act and in force at the time of acquisition/purchase of the asset