The new enactment on Companies Act, 2013 (the New Act) has brought in significant changes on various aspects of financial statements to make it more contemporary and relevant, to corporates, regulators and other stakeholders in India.
Section 123(2) of the New Act states that, depreciation shall be provided in accordance with the provisions of schedule II. Schedule II Part C, provides the useful lives of tangible assets as against the minimum depreciation rates specified in Schedule XIV of Companies Act, 1956.
Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes. Depreciation is systematically allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset.
Depreciation is a non-cash item and change in depreciation charge will not result in inflow or outflow of cash. However, it can alter the shape of the Profit and Loss Account (P&L). To arrive at the true operational performance of companies in the current fiscal, attention should be given to the depreciation charge, extraordinary items and transfer to reserves done under transitional provisions of New Act.
Applicability of depreciation provisions as per New Act
All provisions with respect to financial statements shall be applicable only in respect of financial years commencing on or after 1 April 2014.
Schedule II – Part C:
- Regulatory entities – Not Applicable. Useful life and residual value shall be as notified by relevant authority.
- Intangible assets – Not Applicable. Provisions of accounting standards shall apply (except in case of toll roads created under BOT (Build, Own & Transfer) or BOOT (Build, Own, Operate & Transfer); or any road projects with public private partnership shall be amortised as per Companies Act 1956.
- Other Companies – Applicable. Useful life and residual value can be different from those specified in Schedule II, if justified in financial statements
Carrying value of Assets as on effective date:
From the effective date of the New Act, carrying value is the depreciable amount of the asset should be depreciated over the remaining useful life of the asset as per Schedule II.
The Schedule clarifies that depreciable amount of an asset is the cost of an asset or other amount substituted for cost, less its residual value. In case any asset is revalued, the new revalued value shall be considered in arriving at carrying value.
Assets Useful Life:
The useful life of an asset is the period over which an asset is expected to be available for use by an entity, or the number of production or similar units expected to be obtained from the asset by the entity.
The New Act provides useful life as the basis of systemic allocation of asset cost instead of depreciation rates. Net depreciable amount is to be amortised to P&L over the estimated useful life of the asset.
The useful lives specified in Schedule II of the New Act for different assets will result in change in depreciation charge over different period. For example, a company using the Straight-Line Method (SLM) under the New Act, the useful life has declined from 21 years to 15 years for general plant and machinery, from 15 years to 10 years for general furniture and fittings, and from 6 years to 3 years for computers. Further, the useful life of buildings other than factory buildings and other-than-RCC frame structure, prescribed under Schedule XIV, is around 58 years as compared to 30 years under the New Act.
Ordinarily, the residual value is often insignificant, but it should generally not be more than 5% of the original cost of the asset. However, it can be higher, if appropriate justification is disclosed in financial statements.
The New Act has not prescribed any specific rates/lives for depreciation of assets used under extra shifts. Rather, it states that for the period of time, an asset is used in double shift; depreciation will increase by 50%; and by 100% in case of triple shift working. Shift depreciation is primarily applicable for plant & machinery category with minimum asset life of 15 years, not marked as NESD assets in Schedule II.
For example, a company has purchased one general plant and machinery costing INR 10 Lacs three years prior to the commencement of New Act with no residual value. Under Schedule XIV for SLM basis, single, double and triple shift depreciation rates applicable to the asset are 4.75%, 7.42% and 10.34%, respectively. Under Schedule II, its life is 15 years. For all three years, the company has used the asset on a triple shift basis and therefore, depreciated 31.02% of its cost over three years i.e. INR 3.1 Lacs and carrying value of INR 6.9 Lacs.
On transition to Schedule II, the asset has a remaining useful life 12 years (15-3). From the date of transition (1-4-2014) the company will depreciate carrying amount of INR 6.9 Lacs over 12 years on SLM basis for single shift. If the company uses the asset on triple shift basis during any subsequent year, depreciation so computed will be increased by 100%. In case of double shift, depreciation will be increased by 50%.
Componentization of assets:
The New Act, mandates componentization of assets. Useful life in Schedule II is applicable to the whole of asset, however component accounting requires a company to identify and depreciate significant components with different useful lives separately.
Assets costing less than 5000:
Unlike Companies Act 1956, there is no specific requirement of 100% depreciation on assets whose actual cost does not exceed INR 5000. The Company can use a consistant company wide policy to either expense out such assets without forming part of Gross Block and Fixed Assets Register (FAR); or charge 100% depreciation in the year of acquisition in which case it will form part of the Gross Block as well as Accumulated Depreciation.
Application of AS 6 (notified):
Financial statements of company have to be prepared in congruence with AS 6 as notified by MCA. AS 6 states that depreciation rates prescribed under the statute are minimum. If management’s estimate of the useful life of an asset is shorter (or depreciation rate should be higher) than that envisaged under the statute, depreciation is computed by applying the higher rate. In other words, if useful life is lower than as prescribed by Schedule II, the companies have to use lower life for depreciation.
If company follows AS 6 useful life, there is no need to change the depreciation charge on transition, however an appropriate justification is required to be provided in the financial statements. In this case transitional provisions will not apply.
If the company follows Schedule XIV rates then transitional provisions will apply to change to Schedule II useful life or to apply AS6. With regard to the adjustment of impact arising on the first- time application, the transitional provisions to Schedule II of the New Act provides that the carrying value of the asset on the date of transition (as discussed above):
- In case asset has remaining useful life as per Schedule II – Carrying value shall be depreciated over the remaining useful life of the asset as per this schedule.
- In case asset does not have remaining useful life – after retaining the residual value, balance shall be recognized in the opening balance of retained earnings.
Depreciation under New Act has impacted companies significantly.
In conflict with AS6, Schedule II states that useful life and residual value can lower or higher that those specified, if appropriate justification can be provided in financial statements.
Additional efforts have to be put in by the management to rework each of the asset’s useful life and residual value. If useful life of asset as per management is higher than that prescribed by Schedule II, the higher rate may be applied at the option of the company, by providing a proper justification. If useful life of the asset as per the management is lower than that prescribed by Schedule II, AS 6 requires the company to mandatorily depreciate the asset using lower life only and provide with appropriate justification. This reworking may be complex for few a companies and may require system-level changes.
Componentization being mandatory is yet another important exercise for asset intensive companies to identify components having value significant to total asset value; estimate their remaining useful life and residual value to depreciate them separately.
Further, component accounting is required to be done for the entire block of assets as on April 1 2014. It cannot be restricted to only new assets acquired after 1 April 2014.
This would result in maintaining detailed records of each component of main asset resulting in increased size of FAR and maintaining independent and dependent child relationships.
It is also expected to change the measurement of depreciation and accounting for replacement costs. Currently, companies expense the replacement cost of parts in the year of incurrence. However, as per component accounting, the companies will have to capitalize these costs (significant parts) as a separate component of the asset, with consequent charging of net carrying value of the part to profit and loss account at the time of replacement.
To align themselves with New Act provisions, some companies have reassessed the useful life of assets and estimated residual value for Quarter end results (June 14 / Sep 14). While some others like IDFC have retrospectively changed the method of deprecation from WDV to SLM resulting in write back of depreciation and a major boost to the bottom line.