Depreciation accounting

CHAPTER – 6 Dr Alaa M Malo-Alain 187

Chapter 6

Depreciation Accounting

6.1 MEANING AND CONCEPT

A proper management of the value of an asset is essential for depiction of

its real value in the statement of financial position. This involves measurement of

depreciation in case of long-lived assets. Usually, the fixed assets are shown on the

balance sheet at original cost less depreciation. It is, therefore, essential that the

amount of depreciation to be charged periodically as expense, is determined

rationally and systematically.

The old view of depreciation was that it was meant to be a provision to

replace depreciable assets. Therefore, it was left to the discretion of the

management to provide or not to provide for depreciation. They used to provide for

depreciation when the firm made good profits and dispense with it during the years

the firm suffered from losses. Even under the Companies Act, 1956, it is

interesting to note, that provision of depreciation becomes necessary only if the

company wants to declare dividends. Even the accounting practices of showing

profits before depreciation and profits after depreciation tend to confirm the view

that most companies / enterprises regard it as an appropriation of profits. But the

modern view of depreciation is different. All the fixed assets can be imagined as a

bundle of future services to be used by the enterprise over the period of the

economic life of such assets. Therefore, the cost of investment in such assets must

be equitably allocated to different periods of their economic life in a systematic

and rational manner. The amount charged to each period is called depreciation and

represents the cost of expiration of such assets.

In this connection American Institute of Certified Public Accountants

(AICPA) defines Depreciation Accounting in its Accounting Research Bulletin, as

"a system of accounting which aims to distribute the cost or other basic values of


tangible capital assets, less salvage, if any, over the estimated useful life of the unit

(which may be a group of assets) in a systematic and rationale manner. It is a

process of allocation, not of valuation."1 A closely identical view is maintained by

the International Accounting Standard Committee, IAS-4, on Depreciation

Accounting defining it as "the allocation of the depreciable amount of an asset over

its estimated useful life."2

Hendriksen says that the most commonly accepted definition of

depreciation is that "it is a systematic and rational method of allocating costs to

periods in which benefits are received."3

Anthony and Reece, have defined the term depreciation as follow, they

said, "with the exception of land, most items of plant and equipment have a limited

useful life; that is, they will provide service to the entity over a limited number of

future accounting periods. A fraction of the cost of the asset is therefore properly

chargeable as an expense in each of the accounting periods in which the asset

provides service to the entity. The accounting process for this gradual conversion

of plant and equipment capitalised cost into expense is called depreciation."4

In the words of Maheshwari S.N., he said depreciation is nothing but "that

portion of the cost of the assets that is deducted from revenue for assets services

used in the operation of a business."5 Further, depreciation has been defined as "the

allocation of total cost of the asset as a business expense of the various years of its

useful life."6

Depreciation can, therefore, be regarded as "the expiry of fixed asset

through time, regardless of cause."7 It can be expressed mathematically as :

D = C – S

Where :

D = Depreciation over the useful life of an asset.

C = Cost

S = Salvage value if any

The amount „D‟ is charged to different periods in different ways.


6.2 DEPRECIATION, DEPLETION, AMORTIZATION

AND DILAPIDATION

Usually the term Depreciation Accounting is associated with the allocation

of cost of any kind of fixed assets. Different terms have been developed in

accounting usage for describing this process for different types of assets. These

terms are :

(a) Depreciation : The term depreciation is used when expired utility of a

physical asset (building, machinery or equipment) is to be recorded.

(b) Depletion : The term 'depletion' is applied to the process of measuring and

recording the exhaustion of natural resources such as ore deposits, oil wells,

timber stands, quarries etc. Depletion differs from depreciation in that

depletion implies removal of a natural resource i.e. a physical shrinkage or

lessening of an estimated available quantity while depreciation implies a

reduction in the service capacity of an asset. E.L. Grant, explains the term

'Depletion' thus :

"A writing-off of the cost of exhaustible natural resources is

usually referred to as depletion rather than as depreciation."8

(c) Amortization : The term amortization refers to the process of writing off

the long term investments in intangibles such as leaseholds, patents,

copyrights, trademarks, goodwill and heavy organisation cost.

(d) Obsolescence : The term obsolescence refers to the reduction in the useful

life of the asset arising from the following factors :

(i) technological changes,

(ii) improvement in production method,

(iii) change in market demand for the product or service output of the

asset,

(iv) legal or other restrictions.

Obsolescence is distinguished from exhaustion, wear and tear and

deterioration in that these terms refer to functional loss arising out of a change in

physical condition. Whereas, "Obsolescence refers to the loss of usefulness


because of the development of improved equipment or processes, changes in style,

or other causes not related to the physical condition of the asset."9

(e) Dilapidation : When a property is returned to the landlord after the expiry

of lease period, the landlord is entitled to demand that it be in as good

condition as when it was leased out. For this purpose, leaseholders often set

aside some amount each year to provide for any dilapidation that may need

to be put right when the property is returned. For accounting purposes the

expected amount of dilapidation is added to the cost of leased property. The

depreciation is provided on the total cost thus arrived at.

6.3 DEPRECIATION V/S MAINTENANCE

Maintenance expenses are necessary for keeping a fixed asset in a state of

efficiency. But this does not mean that fixed assets, if properly maintained, will not

reach a stage of scrap. In spite of the highest degree of care, a fixed asset must

reach a point when it has to be discarded. Thus the cost of a fixed asset must be

spread over a period of its use and maintenance cost should not be allowed to

substitute the depreciation cost.

6.4 FACTORS INFLUENCING THE TOTAL AMOUNT

OF DEPRECIATION

Depreciation should be charged to the profit and loss account every year,

but how much depreciation should be charged or written off, it is difficult to

answer as it is a problem to measure the depreciation in terms of money or to fix a

rate at which it should be charged. There are a number of factors which affects the

quantum of depreciation to be charged every year. Some of the factors which

should be kept in view while determining the yearly amount of depreciation are as

follows :

(1) Original Cost of the Asset : The original cost of the asset should be

ascertained. This will include all capital expenses which are incurred till the

asset is put in operation such as carriage inward, insurance, installation

charges etc.

(2) The useful or economic life of asset : The economic life of the asset is

measured in terms of the units of service expected to be derived from the


asset. It is defined as “the period of time over which it is expected to

provide service (i.e. benefits) to the entity that controls it.”10

The selection

of an appropriate unit of economic life of an asset must be determined after

considering the factors affecting depreciation. When the cause of

depreciation is wear and tear, it is undoubtedly proper to choose a physical

unit.

It is, however, difficult to estimate the economic life of an asset. The

starting point is the physical life of the asset and it should be reduced after

taking into account the expected use of the asset, factors of obsolescence

and also previous experience with similar types of assets. Such estimation

is more difficult for an asset based on new technology or used in the

production of a new product or in the provision of a new service, but it is

nevertheless required on some reasonable basis.

(3) Additions made to the asset : The additions or extensions made to the

assets during the year, taking into consideration the dates on which these

additions were made for the purpose of correct computation of the amount

of depreciation, should also be ascertained.

(4) The estimated residual value : Residual value is the realisable value of

the asset at the end of its economic life. This value should be calculated

after deducting the disposal and removal costs from the sale value of the

asset. Cost minus net realisable value is called the depreciation base or

depreciable amount or depreciable cost and it is the amount that has to be

charged over the economic life of the asset.

One of the basis for determining the residual value would be the realisable

value of similar assets which have reached the end of their useful lives and

have operated under conditions similar to those in which the asset will be

used.

(5) Interest on Invested Capital : Interest that could have been earned if the

amount invested in the fixed asset had been invested outside the business,

should also be considered.


(6) Repairs and Renewals and Maintenance : In case there are appropriate

arrangements for repairs, renewals and proper maintenance of the asset, the

life of asset will automatically increase leading to lesser amount of yearly

depreciation.

(7) Obsolescence : The owners of the business should keep full knowledge of

any technological changes or new inventions which may come in the

market in the near future, which are likely to affect the position of the asset.

In case there is a possibility of any such new invention, the old asset will

have to be replaced before the end of its useful life and in that case the

amount of depreciation will be increased.

(8) Working Hours of the asset : If the asset is used excessively in two or

three shifts, its wear and tear will be rapid. The depreciation will then be

charged at a higher rate.

(9) Skill of operators : If the asset is handled properly which depends on the

skill of operators, the life of asset will automatically increase. The

depreciation will then be charged at a reduced rate.

(10) Legal provisions : In case there are any statutory rules which have been

framed by the Government for purposes of charging depreciation, they

must be complied with. For example rates of depreciation to be charged on

certain assets are given in Section 32 of Income Tax Act, 1961, and in

schedule XIV section (205) and (350) of Indian Companies Act, 1956.

6.5 OBJECTS OF PROVIDING DEPRECIATION

The primary objective of Depreciation Accounting is the allocation of

depreciable amount of an asset over its estimated useful life. But, there are also

some secondary objectives which are attached to Depreciation Accounting. These

objectives are as follows :

(1) To ascertain correct cost of production : The object of providing

depreciation is to find out the correct cost of production. The asset loses its

value due to its use in the business. Decrease in value is likely any other

expense which must be debited to Profit and Loss account before profits are


arrived at. It is like a factory expense which must be added to the cost of

production. If it is not provided, the cost of production will not be correct.

(2) To present true and fair view : If the depreciation is not provided, the

assets will be shown at the higher value in the Balance Sheet than their real

value. They will thus be overvalued. This will not show a true and fair view

of the state of affairs of the business concern.

(3) To keep the Capital intact : The purpose of providing depreciation is to

set aside a certain sum of money every year to replace that asset later on

when it is discarded and thus to keep the capital intact.

(4) Correct determination of profits : Maheshwari S.N. has rightly remarked

that, "the objective of Depreciation Accounting is to absorb the cost of

using the assets to different accounting periods in a way so as to give the

true figures of profit or loss made by the business."11

That means if the

depreciation is not provided, the profits will be inflated as in this case a

necessary business expense will remain undebited to Profit and Loss

account. In this way the profit and loss account will not show correct and

true profit for the period. Depreciation is a kind of expenditure, it should,

therefore, be debited to the Profit & Loss Account to determine correct

amount of profit or loss.

(5) To Comply legal provisions : Legally it is also necessary to make

provision for depreciation according to section 205 of the Companies Act,

1956 before distribution of dividend or for ascertaining divisible profits as

no dividend can be distributed without providing for depreciation.

(6) To avoid distribution of dividend out of Capital : If the depreciation is

not provided, the Profit and Loss account will show higher profit than the

real one and this will result in the return of the part of capital by way of

dividend which is legally prohibited and also commercially unsound. It is,

therefore, necessary to provide depreciation to arrive at the correct amount

of profit so that dividend may not be paid out of capital.

(7) Replacement of asset : When depreciation is provided it reduces the profit

after depreciation figure and this saves the cash resources of the enterprise

(to the extent of depreciation) from being distributed by way of dividend.


The amount so saved, if set aside every year, is able to produce at the end

of the life of the asset the amount required to replace it.

(8) Saving in Taxes : Though depreciation is not a cash cost, it is permitted to

be deducted from profits for tax purposes. This is the main advantage

having regard to the fact that for certain types of companies the tax rate is

as high as 55 per cent.

(9) Complete accounting of production expenses : The depreciation is a

factory overhead in manufacturing concerns and thus forms part of

production expenses. If it is not provided, the cost accounts of the concern

will remain incomplete. It is, therefore, necessary to account for the

depreciation also so that costing record may be complete and correct.

(10) Evaluation of an asset : At the end of each year all the fixed assets should

be properly valued. Their value decreases every year due to constant use.

Hence to ascertain the correct value of asset providing of depreciation is

necessary.

(11) Matching Cost against revenues : It is essential to provide means of

allocating the Cost of fixed assets to the Cost of Operations.

All the above objectives are interconnected. Accounting for depreciation is

essential for the preparation of financial statements on a true and fair basis.

Companies and other business organisations, subject to taxation, adopt the

concept of spreading the original cost over the effective life of the asset and not on

the replacement concept. An enterprise may reserve out of its profits any amount to

build up a fund for replacing the asset at the end of their effective life, but this is a

separate matter at the discretion of the management.

6.6 REQUIREMENT OF COMPANIES ACT, 1956 –

LEGAL PROVISIONS RELATING TO DEPRECIATION

In the case of companies which are governed by the Companies Act 1956

the act provides that provision of depreciation, unless permission to the contrary is

obtained from the central government, should either be based on the reducing

balance method at the rates specified in the rules or on the corresponding straight


line depreciation rates which would write off 95% of the original cost over the

specified period. If the useful life of the asset as determined by the management is

shorter or longer than envisaged in the statute, the rates must accordingly be

manipulated. The standard requires the method to be followed consistently in order

to adhere to fundamental accounting assumptions. The change from one method of

providing depreciation to another should be made only if the adoption of the new

method is regained 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 financial statements of the enterprise. When a change in the method

of depreciation is made the unammortized depreciable amount of the asset should

be charged to revenue over the remaining useful life by applying the new method.

Change in method is applicable to future and has no net retrospective effect. Such a

change should be treated as a change in the accounting policy and its effect should

be quantified and disclosed. IAS-4 is silent about change in method of

depreciation.

However, Section 205 of the Companies Act has not brought the legal and

accountancy position quite close. Previously, it was possible to declare dividend

without writing off depreciation on fixed assets. Arrears of depreciation in respect

of financial years falling before the commencement of the Companies

(Amendment) Act, 1960, need not be provided still. But for financial years falling

after the commencement of the Companies (Amendment) Act 1960, dividend can

not be declared unless :

(a) depreciation for the fixed assets has been written off in respect of the

financial year for which dividend is to be declared according to section

205(2);

(b) arrears of depreciation on fixed assets in respect of the previous year

(falling after the commencement of companies (Amendment) Act 1960

have been deducted from the profits.

Distinction has to be made between depreciation provided for (that is

recorded in books) and not provided for. In respect of financial years falling after

28th December, 1960 depreciation not provided for (arrears) must first be deducted

before paying dividend out of profits of the year for which dividend is to be paid.

But in the case of depreciation provided for the year in which there is a loss, it is


sufficient if the amount of depreciation or the amount of the loss is deducted out of

subsequent profits before payment of divdend.

Section 205(2) lays down how depreciation is to be calculated. According

to it, depreciation should be provided either :

(a) to the extent specified in section 350 i.e. to the extent of the amount

calculated with reference to the written down value of the assets as shown

by the books of the company 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 at the specified rates mentioned in scheduled

XIV; or

(b) in respect of each item of depreciable asset for such an amount as is arrived

at by dividing 95 percent of the original cost thereof to the company by the

specified period in respect of such assets; or

(c) on any other basis approved by the central government which has the effect

of writing off by way of depreciation 95 percent 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 assets for which no rate of depreciation

has been laid down by this act or any rule made thereunder, on such basis

as may be approved by the central government by any general order

published in the Official Gazette or any special order in any particular case.

(e) According to Section 350, if any asset is sold, discarded, demolished or

destroyed for any reason before depreciation of such an asset has been

provided for in full, the excess, if any, of the written down value of such

asset over its sale proceeds, or as the case may be, its scrap value, shall be

written off in the financial year in which the asset is sold, discarded,

demolished or destroyed.

(f) The amount of depreciation charged on the fixed assets every year is

debited to the profit and loss account and credited to the provision for

depreciation account which is allowed to accumulate from year to year. The

amount of depreciation may be debited to depreciation account and credited


to provision for depreciation account. Depreciation account is transferred to

the profit and loss account. In the balance sheet the balance of provision for

depreciation account is shown by way of a deduction from the cost of the

fixed asset.

(g) If any asset is purchased during an accounting period, depreciation may be

provided for the full year giving a note of this effect but according to sound

principles of accountancy, depreciation should be provided only for that

part of the year for which the asset has been in use. If there, is any change

in an accounting year in the method of providing for depreciation the fact

must be disclosed alongwith the quantum of effect on the profit/loss of the

company. If depreciation is provided for any previous year or years, it is to

be treated as an appropriation of profit and not a charge against profits.

Part II of Schedule VI of the Companies Act requires that the Profit and

Loss Account must disclose the amount provided for depreciation, renewals or

deminution in value of fixed assets. If such a provision is not made by means of a

depreciation charge, the method adopted for making such a provision shall be

stated. 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.

The law does not make it compulsory for a company to provide for

depreciation on fixed assets. All that is required is that dividends must not be

declared without providing for depreciation.

6.7 REVISION OF ESTIMATE OF USEFUL LIFE

The quantum of depreciation to be provided in an accounting period

involves the exercise of judgement by the management in the light of technical,

commercial, accounting and legal requirement and accordingly may need

periodical review. If it is considered that the original estimate of useful life of an

asset requires any revision, the unamortized depreciable amount of the asset is

charged to revenue over the revised remaining useful life. Alternatively, the

aggregate depreciation charged to date is recomputed on the basis of the revised

useful life and excess or short depreciation so determined is adjusted in the


accounting period of revision. This should be disclosed as an extraordinary item in

the accounts of the said period.

6.8 DEPRECIATION ON REVALUATION OR

REVISION OF HISTORICAL COST

Where the depreciable assets are revalued, the provision for depreciation

should be based on the revalued amount and on the estimate of the remaining

useful lives of assets. In case the revaluation has a material effect on the amount of

depreciation, the same should be disclosed separately in the year in which the

revision is carried out.

Even where the historical cost is revised consequent to changes in the long

term liability on account of exchange fluctuation, price adjustments, changes in

duties or similar duties, the depreciation on the revised unamortized depreciable

amount should be provided prospectively over the residual life of the asset.

6.9 ADDITIONS OR EXTENSIONS TO AN EXISTING ASSET

Any addition or extension to an existing asset which is of a capital nature

and which becomes an integral part of the existing asset is depreciated over the

remaining useful life of that asset. As a practical measure, however, depreciation is

sometimes provided on such additions or extension at the rate which is applied to

an existing asset. If this suggestion of Accounting Standard-6 (AS-6) is followed

the amount spent on such additions may not be fully allocated over the remaining

useful life of the original asset.

Any addition or extension which remains a separate entity and is capable of

being used after the existing asset is disposed of, is depreciated independently on

the estimates of its own useful life.

Scrapping of an asset : If any depreciable asset is disposed of, discarded,

demolished or destroyed the net surplus or deficiency, if material, should be

disclosed separately.


6.10 DISCLOSURE OF DEPRECIATION IN

FINANCIAL STATEMENTS

Regarding depreciation accounting, the AS-6 requires disclosure of the

following information in the financial statements :

(i) The historical cost or other amount substituted for historical cost of each

class of depreciable assets;

(ii) total depreciation for the period for each class of assets; and

(iii) the related accumulated depreciation.

Alongwith other accounting policies the following in relation to

depreciation should also be mentioned :

(i) Depreciation methods used; and

(ii) depreciation rates of the useful lives of the assets, if they are different from

the principle rates specified in the statute governing the enterprise.

Sometimes changes in accounting policies will have material effect on

financial statements and hence the following must also be disclosed :

(i) Where assets are revalued and such revaluation has a material effect on the

amount of depreciation, the same should be disclosed separately in the year

in which the revaluation is carried out.

(ii) Any change in the method of depreciation is treated as a change in the

accounting policy and its effect should be quantified and disclosed.

(iii) Any adjustment for excess or short depreciation made in any accounting

period due to the revision in estimate of the useful lives of depreciable asset

is treated as an extraordinary item and disclosed accordingly.

6.11 DEPRECIATION POLICY

Every policy is framed by top level of management. As such the policy

regarding depreciation is also decided at the top level. But the question is, What

policy is involved as regards depreciation? The primary object of providing


depreciation has been clearly spelt out already, but a decision regarding the method

to be followed has far-reaching consenquences. These consequences are those

which make the problem complex. It is for the management accountant to analyse

the implications of following particular method of depreciation and appraise the

management of its implications. The final decision is left to the management, the

matter being a policy decision.

A decision regarding depreciation method becomes complex due to the

below-stated considerations which are equally important. Further, a decision on a

method once taken has to be consistently followed and cannot undergo frequent

changes.

(i) Tax implications : In India, the income-tax law prescribes a method of

depreciation namely the diminishing balance method. If a company adopts

the straight line method then it will have to declare a different income for

taxation purposes as opposed to the income reckoned for accounting

purposes. Thus, it would be a duplication of work in maintaining fixed

assets ledgers, computing depreciation and preserving the records by both

the methods. The trouble undertaken, however, may be worthwhile when

cash flow implications and dividend payment implications of tax are taken

into account.

(ii) Impact on dividend distribution : The company cannot pay dividends

except out of profits "Profits" mean the surplus left after providing for

depreciation under any of the recognised methods. If the management

chooses the straight line method, the distributable surplus in the earlier

years would be larger. This would enable the management to declare

dividends more easily than if they follow the diminishing balance method

when the surplus will be comparatively less. The management must give

adequate thought to this matter as the image of the company in the minds of

the investing public is based on the return that the company offers to them.

(iii) The cash flow implications : It has already been stated that the quantum of

cash flow from operations cannot be affected by a change in the method of

depreciation. Afterall, cash flow is the difference between sales revenue

and cash cost. If the depreciation figure is less, the quantum of profit would

be more and vice-versa. Thus, profit plus depreciation would remain


constant other things remaining the same. But the method of depreciation

followed has its influence on the quantum of distributable profit and hence

on the quantum of dividend. With a given cash flow, if a greater amount is

paid out as dividend the cash flow which is left for replacing the assets is

less. If this happens in the earlier years of an asset, the interest of such cash

flow will be available, plus the interest thereon, plus the sale proceeds

should provide adequate funds to replace the asset on expiry of its complete

service potential. With the ensuing costs these funds cannot meet the full

costs. Hence it is essential to minimise the generation of funds from this

source. One of the ways of maximising the funds is to earn the maximum

return on the depreciation funds. Hence if we change a higher quantum of

funds over longer years it will generate a higher quantum of return on those

funds. This aspect has to be brought to the notice of the management in

simple and unambiguous terms.

(iv) Depreciation and changing price levels : Depreciation is regarded as a

process of allocation of historical cost over the estimated useful life of the

asset and the profit of any year is known as the difference between current

revenue and current cost. The current cost means operating cost which

includes depreciation also is calculated on the basis of historical cost. In

this context, the concept of profit through matching of current revenue and

current cost does not hold true. Further, the object of providing depreciation

is to build up adequate funds to replace the assets at the end of its service

life. But this object is not achieved if depreciation is provided on historical

cost. This object could be met only when depreciation is provided on the

basis of the estimated replacement cost of asset but it will again lead to

arbitrary and highly volatile depreciation charges in each year. Particularly

because no one can exactly predict the replacement cost of an asset. Further

the estimate will go on changing from year to year. Thus, there will not be a

steady base for calculations and this drawback in reckoning depreciation on

the basis of historical cost should be conceded. A via media that could be

suggested is to reckon depreciation on the basis of accepted methods (based

on historical costs) with a view point to make an extra appropriation out of

distributable profits to meet the rising cost of replacement. But, this extra

appropriation will not confer any tax advantage on the company and hence

the management may not look upon this suggestion for a policy favourably,

since it has to meet the problem of rising cost of replacement.


6.12 FORMULATION OF DEPRECIATION POLICY

While analysing the depreciation policy of public enterprises under study, it

was found that all the units have framed their depreciation policy based on the

following factors :

(a) Rate of depreciation

(b) Method of depreciation

(c) Additions and betterments

(d) Service life

(e) Wear and tear of assets

(f) Savings in tax

During the period of study SAIL, BHEL and IOC did not consider tax

saving but MMTC gave consideration to it as well.

6.13 METHOD OF DEPRECIATION

In the present study while examining the depreciation method adopted by

the companies, I have observed that the statutory provisions regarding the selection

of depreciation method were on one hand controversial, and sailent on the other,

therefore, the following are the view point for all of them.

6.13.1 Method of Depreciation under the Indian Income Tax Act, 1961

As per section 32 of Income Tax Act of 1961 of India. The approved

method of charging depreciation is the written down value method WDV

and thus an assessee has no option to choose a depreciation method for

Income-Tax purposes.

At this point, conflict arises because the Companies Act 1956 of India

recognise the SLM and WDV method, and mainly entertains the SLM for

the purpose of submitting the Annual Reports and Accounts to the Registrar

of Companies (ROCs). On the other hand, the Income Tax Act of 1961 of

India, clearly rejects the SLM and approves only the WDV method, that

means an enterprise has to prepare two Annual Reports and Accounts being

one for the submission to the (ROCs) and the other for Income Tax

Authorities.


6.13.2 Method of Depreciation under the Companies Act of 1956 of India.

According to Schedule XIV section 205(3) and 350 of the Indian

Companies Act, 1956, the companies have their own choice to follow either

the WDV method or the SLM. Thus, the adoption of depreciation method

has been made discretionary at the level of directors. In practice, it has been

found that the directors of the companies prefer to adopt SLM with respect

to recover the cost over the estimated useful life (EUL) of the asset.

Whereas, this purpose can not be achieved by following the WDV method.

Furthermore, by charging depreciation according to SLM the amount of

distributable profits becomes less and the company can keep the deducted

amount of depreciation as a reserve for the purpose of any contingencies.

Furthermore, its worth mentioning that, the Companies Act does not

require disclosure of the method of depreciation adopted by the company

except when the method of depreciation adopted for financial accounting

purposes is different from the method permitted under Income-Tax Act, i.e

WDV method. This fact may be disclosed in the published accounts of the

company together with the amount of depreciation claimed under Income-

Tax Act.

6.13.3 Method of Depreciation under the Institute of Chartered Accountants of

India (ICAI).

According to AS-6 Depreciation Accounting, there are several methods of

allocating depreciation over the useful life of all the assets such as straight

line method (SLM), reducing balance or written down value method

(WDV), and depletion method etc. The accounting standards do not

recommend any particular method. Those most commonly employed in

industrial and commercial organization are the straight line (SLM) and

written down value method (WDV). The management of the business

selects the most appropriate method(s) based on various factors eg. (a) type

of assets, (ii) nature of the use of such assets, and (iii) circumstances

prevailing in the business. A business may also use a combination of the

methods. In case of depreciable assets having insignificant value the entire

depreciation may be charged off to the year of purchase.


In deciding on a depreciation method for financial reporting purposes,

income tax considerations have been kept entirely separate. For tax purposes, the

public enterprises have used the tax code's accelerated depreciation rules thereby

receiving as quickly as possible the tax savings related to depreciation.

In the present study all the public enterprises have adopted the straight line

method for providing depreciation in their financial statements. But for the purpose

of computation of tax liability the written down value method has been used.

6.14 CHANGE IN DEPRECIATION METHOD

It should be noted that the method of providing depreciation on a particular

asset should be consistent from year to year. If no depreciation has been charged in

a particular year, the fact should be stated in the Balance Sheet and the profit and

loss account. If the method of charging depreciation is changed, the fact should be

disclosed, together with the amount of the depreciation that should have been

charged, had the old system been followed. Further, if adjustment is made for

previous years also, the amount involved should be debited or credited (as the case

may be) separately in the Profit and Loss Account, preferably in the appropriation

section.

In the present study it has been found that all the units of the selected public

enterprises under study were yearly following the same method i.e. straight line

method during the period of the study from 1994-95 to 1998-99 and in all of the

public enterprises the method of depreciation i.e. SLM was not changed during the

period of study.

6.15 SELECTION OF UNIT OF DEPRECIATION

For an efficient and systematic depreciation procedure, the selection of an

appropriate unit of depreciation is a must. There can be two methods of selection

of the unit of depreciation which are as follows :

(a) Output basis : This unit is used in the case when the service life of

an asset is limited largely due to wear and tear.


(b) Time basis : When functional cause of depreciation predominates, it

is an accepted view that a unit of time i.e. months or years will give

the best results.

In the present study, it has been observed that all the four public enterprises

under study selected the unit of depreciation based upon time. The same unit has

been adopted by these companies for financial and cost accounting purposes as

well.

6.16 GROUP BASES OR ITEM BASES

At the time of formulating depreciation policy the management has to

decide whether depreciation should be provide on group basis or item basis.

Making a comparative study of both the methods it was observed that group basis

of charging depreciation is more easier to follow in comparison to item basis. In

the present study, it has been found that all the units of the selected public

enterprises are following group bases of depreciation for all types of fixed assets

i.e. land and building, plant and machinery, furnitures and fittings. It should be

noted that the depreciation whether charged on group basis or item basis will not

different. But, the group basis reduces the accounting work because under group

basis depreciation is calculated on the consolidated value of the assets of the

concerning group whereas, in the case of item basis, the depreciation is calculated

on individual items of every part of the assets which increases the accounting work

despite of the fast that the total amount of chargeable depreciation remains

unchanged. It is the only reason that Accountants would prefer the group basis of

depreciation than item basis.

6.17 BASIS OF DEPRECIATION CHARGE

All the units of public enterprises under study viz. SAIL, BHEL, IOC and

MMTC have taken the original cost as the basis of charging depreciation.

Adjustments for increase or decrease in foreign liability in respect of fixed assets

due to devaluation or revaluation has been made by all the public enterprises under

study in conformity with the requirements of the Companies Act of India.


6.18 RATES OF DEPRECIATION

In the present study, it has been observed that SAIL, BHEL, IOC and

MMTC, except for some assets, provided depreciation as per the rates specified in

schedule XIV of the Companies Act, 1956. Regarding some assets these

enterprises have charged excess depreciation which was debited to Profit & Loss

Account in place of transferring it to a reserve account as required by the

Companies Act, 1956.

6.19 DEPRECIATION ACCOUNTING IN THE SELECTED

PUBLIC ENTERPRISES

In the case of fixed assets, the original cost, the additions thereto and

deductions therefrom, made during the year and the total depreciation provided

must be given. The amount of depreciation applicable to the fixed assets sold,

transferred or discarded during the year should be deducted from the total

depreciation provided in respect of relevant fixed assets upto the beginning of the

year. Any amount set aside as depreciation in respect of fixed assets which is in

excess of the amount which in the opinion of the directors is reasonable, must be

treated as reserve and not as provisions and such excess amount should appear

under the heading 'Reserves and Surplus' on the liabilities side of the balance sheet.

This provision is intended to prevent the creation of secret resume by providing

excessive provision. Where any buildings are acquired under the house building

schemes of co-operative housing societies or companies by purchasing shares they

should be included in the cost of the buildings with the note disclosing the number

of shares or debentures held.

Fixed assets no longer in use should be stated separately and be

characteristically valued at liquidation value in as much as they are no longer an

element of the on going concern and are to be disposed off as soon as that can be

done advantageously.

In the present study it has been observed that the excess depreciation has

been transferred to Profit & Loss Account. However, in the Companies Act there is

a provision that excess depreciation may be transferred to a reserve account. This

practice has not been followed by public enterprises under study. All the units

under study have shown assets according to schedule VI Part-I. The capital work-

in-progress has been disclosed separately as fixed assets. The units under study

have divided the fixed assets into certain parts which for the analysis have been


divided into three parts viz. - Land and Buildings, Plant and Machinery and

Furniture and Fittings.

All the units have disclosed the information about each fixed asset‟s

original cost, the addition thereto and deduction therefrom during the year. The

units under study disclosed information about total depreciation on discarded or

sold fixed assets. There is no public enterprise which discloses profit or loss

separately on each discarded or sold fixed assets in their accounts. It is suggested

that every unit must also disclose this information.

6.19.1 Steel Authority of India Limited (SAIL)

The following depreciation accounting procedures and policy have been

adopted by BHEL (as enlisted in its Annual Report & Accounts).

(a) Depreciation has been provided on the straight line method at the rates

specified in schedule - XIV to the Companies Act, 1956.

(b) Depreciation on some specific assets is based on the management‟s

estimates of the useful life of the assets, at the rates which are higher than

schedule XIV rates. These are as follows:

Earth moving equipment ...................... 15%

Miscellaneous equipment ..................... 10%

Motor cars ....................................... 20%

Motor Buses, Trucks........................... 15%

Furniture and Fittings.......................... 10%

Library books.................................... 20%

Aircrafts.......................................... 16%

Except for the above assets the depreciation on other assets is provided as

per the rates and in the manner specified in Schedule XIV of the

Companies Act 1956.

(c) Depreciation on buildings, roads, bridges, and culverts capitalised upto 31-

3-1987 has been charged at the rates derived from those specified in the


Income Tax Rules, as applicable in the year of their addition. Depreciation

on such assets, capitalised since 1-4-87 has been provided in accordance

with the rates and manner specified in Schedule XIV of the Companies Act

1956 on straight line method.

(d) Depreciation is charged on roads, bridges and culverts from

1-4-1983.

(e) Cost of acquiring mining rights is amortised over the lease period.

(f) Depreciation on assets installed/disposed of during the year is provided

with respect to the month of addition or disposal thereof.

(g) The land of the company has been categorised separately as freehold and

leasehold.

(h) The cost of the fixed assets owned by government/semi government

authorities are written off in five years.

(i) The cost of the shares/debentures acquired form the co-operating housing

societies have been shown separately.

(j) Plant and machinery has been divided into two parts on their continuous

and non-continuous basis. This classification has been done on a technical

basis and depreciation thereon is provided accordingly.

(k) Fixed assets retired from active use, quantum not fully ascertained,

continue to be exhibited under fixed assets at their book value. Since the

net realisable value of such asset is not ascertainable, loss, if any on such

item is accounted for on acceptance of disposal proposals according to

Accounting Standard-10.

The year wise depreciation charged by SAIL on various parts of fixed

assets has been shown in the following table, 6.1.


Table 6.1

Depreciation on Block of Assets charged by SAIL during the period of

study between 1994-95 and 1998-99

(Rs. in lakhs)

Particulars 1994-95 1995-96 1996-97 1997-98 1998-99

1. Land and Building

Depreciation 7010.89 7923.24 7758.00 7605.00 8665.00

+ Depreciation on transferred values 6.43 35.84 1.00 1.00 1437.00

7017.32 7959.08 7759.00 7606.00 10102.00

– Depreciation on discarded &

transferred assets

76.07 615.21 66.00 77.00 53.00

Depreciation charged during year 6941.25 7343.87 7693.00 7529.00 10049.00

2. Plant and Machinery

Depreciation 43660.80 48657.15 59337.00 75717.00 100400.00

+ Depreciation on transferred values – – – – 9390.00

43660.80 48657.15 59337.00 75717.00 109790.00

– Depreciation of assets sold or

transferred

2670.44 3197.87 5547.00 4943.00 2583.00

Depreciation charged during year 40990.36 45459.28 53790.00 70774.00 107207.00

3. Furniture & Fittings etc.

Depreciation 2306.77 2539.52 2366.00 18.00 1806.00

+ Depreciation on transferred assets – – – – 187.00

2306.77 2539.52 2366.00 18.00 1993.00

– Depreciation of asset sold or

transferred

69.29 100.19 191.00 3824.00 98.00

Depreciation charged during year 2237.48 2439.33 2175.00 -3806.00 1895.00

Total Depreciation charged (1+2+3) 50169.09 55242.48 63658.00 74497.00 119151.00

Source : Annual Reports & Accounts of SAIL for study period during 1994-95 to

1998-99

From the table (6.1) it is clear that the depreciation has been shown

separately on the assets i.e. charged depreciation added by the depreciation on the

addition of assets and deducted by the depreciation on the discarded/disposed

assets. It is clear from the previous table that the depreciation charged by SAIL has

shown an increasing trend on all the blocks of assets except for the block of Land

and Buildings during the year 1997-98 where the depreciation decreased.


In the case of Land and Building the depreciation charged during 1994-95

was Rs. 6941.25 lakhs which increased to Rs. 7343.87 lakhs during 1995-96

despite reduction in the depreciation due to disposed/discarded land and building

which included the amortization of the assets owned by state or semi government

authorities and was to be written off fully after 5 years. The depreciation charged

on land and buildings was Rs. 7693 lakhs during 1996-97 which decreased to Rs.

7529 lakhs during 1997-98 mainly because of deducting the depreciation on

discarded assets. During 1998-99 the depreciation on land and buildings increased

to Rs. 10049 lakhs.

In the block of plant and machinery the depreciation showed an increasing

trend. It is to be noted here that there was no depreciation on the addition of assets

till 1997-98 and even then the amount of yearly depreciation was increasing which

shows that the company was acquiring assets in the beginning of the year. The

company has deducted the depreciation on that part of plant and machinery which

was put out of use. The depreciation charged during 1994-95 on the block of plant

and machinery was Rs. 40990.36 lakhs which increased to Rs. 107207 lakhs during

1998-99. There was a continuous deduction from depreciation on account of

disposal of assets.

In the case of depreciation on the block of furniture and fittings the

depreciation showed a decreasing trend because of discarding of furniture and

fittings. The depreciation charged on furniture and fittings during

1994-95 was Rs. 2237.48 lakhs, which reduced to Rs. 2175 lakhs in

1996-97. During 1997-98 the depreciation on the discarded furniture and fittings

was higher than the current year‟s depreciation which was adjusted in the total

depreciation through Profit and Loss Account.

It has been observed that the excess depreciation charged by the company

was debited to Profit and Loss Account against the statute of the Companies Act

1956 that the excess depreciation should be kept in a reserve account.

6.19.2 Indian Oil Corporation (IOC)


adopted by IOC (as enlisted in its Annual Reports & Accounts).


(a) The fixed assets have been classified into 9 units. Land has been

categorised into three parts viz. freehold, leasehold and right of way.

(b) Furniture and fixtures have been shown as one unit while railway sidings,

drainage and sewerage have been shown as separate units.

(c) Land acquired on lease for over 99 years (perpetual lease) is treated as

freehold land. Cost of right-of-way for lying pipe lines has been capitalised.

(d) The construction period expenses including crop compensation for laying

pipelines, administration and supervision expenses exclusively attributable

to projects are capitalised. However, such expenses in respect of capital

facilities being executed alongwith the production / operations

simaltaneously are charged to revenue. Financing cost during the

construction period on loans raised for/allocated to project has been

capitalised.

(e) Cost of leasehold for 99 years or less has been amortized during the lease

period.

(f) Assets costing upto Rs. 5000 are depreciated fully in the year of

capitalisation.

(g) Capital expenditure on items like electricity transmission lines, railway

sidings, etc. the ownership of which is not with the corporation, are charged

to revenue.

(h) Depreciation on fixed assets other than the above is provided in accordance

with the rates as specified in schedule XIV of the Companies Act 1956 on

straight line method upto 95% of the cost of the assets. Depreciation is

charged pro-rata on quarterly basis on assets sold, disposed and dismantled

during the year from/upto the quarter of capitalisation/sale.

(i) In case of depreciable assets the cost of the asset is shown at gross value

and grant therein is taken to capital resume which is recognised as income

in the Profit and Loss Account over the period and in proportion in which

depreciation is charged.


(j) The company has not shown separately the depreciation on the additions

made during the year as well as the depreciation deducted on the assets

sold/discarded.

(k) No depreciation has been charged on freehold land owned by the

corporation during the period of study.

(l) No revaluation of fixed assets was made during the period of study.

(m) Depreciation for the purpose of tax liability has been calculated separately

as per the rates specified in Income Tax Act and such depreciation was

based on written down value method.

(n) Method of providing depreciation remained intact during the period of

study.

The depreciation provided by the corporation on various blocks of fixed

assets has been presented in the following table, 6.2.

Table 6.2

Depreciation Charged by IOC on the Assets during the period

of study between 1994-95 and 1998-99

Rs. in lakhs

Particulars 1994-95 1995-96 1996-97 1997-98 1998-99

1. Land and Building 1846.19 2210.59 2971.82 3821.60 4974.47

2. Plant and Machinery 39623.89 53630.39 76806.46 101418.41 104632.38

3. Furniture & Fittings & others 332.27 335.98 426.44 525.86 528.63


Source : Annual Reports & Accounts of the IOC during the study period from

1994-95 to 1998-99.

From the table (6.2) it can be observed that the amount of depreciation

charged by the corporation showed an increasing trend during the period of study.

The total depreciation charged by the corporation during 1994-95 was Rs.

41802.35 lakhs which increased to Rs. 80204.72 lakhs during 1996-97 which was


almost double of the depreciation charged during 1994-95 which further increased

to Rs. 110135.48 lakhs in the year 1998-99.

The increase in the amount of depreciation shows that the company has

acquired the fixed assets during these years in a big way. The increase in the

amount of depreciation was not the same in the case of land and building as

compared to the total amount of depreciation. The depreciation on land and

building during 1994-95 was Rs. 1846.19 lakhs which reached Rs. 3821.60 lakhs

during 1997-98. Because of acquiring the leasehold land and right-of-way during

the year 1998-99 the amount of depreciation charges increased to Rs. 4974.47

lakhs.

The total amount of depreciation charged by IOC was prominently

dominated by the depreciation charged on plant and machinery. Out of the total

depreciation of Rs. 41802.35 lakhs charged in 1994-95, Rs. 39623.89 were related

to the depreciation charged on plant and machinery. The corporation had to acquire

more plant and machinery due to improved technology as well as there were

additions from capital work-in-progress. The amount of depreciation increased to

Rs. 76806.46 lakhs during 1996-97 which further increased to Rs. 104632.38 lakhs

in the year 1998-99. The depreciation on plant and machinery was keeping pace

with the total depreciation charged by the corporation.

The depreciation charged on furniture and fixtures has also shown an

increasing trend but the rate of increase in depreciation was not as balanced as it

was for plant and machinery and land and buildings. The amount invested in

furniture and fixtures was comparatively very less and the depreciation increased

in the same proportion of the investment. The depreciation charged on furniture

and fixtures was Rs. 332.07 lakhs during 1994-95, which increased to Rs. 426.44

lakhs during 1996-97 which proportionately increased to Rs. 528.63 lakhs during

1998-99.

It has been observed that the corporation did not show separately the profit

or loss made on account of disposing off of assets.

6.19.3 Bharat Heavy Electricals Limited (BHEL)


adopted by BHEL (as enlisted in its Annual Reports & Accounts) :


(i) Fixed assets (other than land acquired free from the State Government) are

carried over at the cost of acquisition or construction or book value less

depreciation.

(ii) Land acquired free of cost from the State Government is valued at Rs. 1

except for that acquired after 16th

July 1969 in which case the same is

valued at the acquisition price of the State Government concerned by

corresponding credit and capital reserve.

(iii) Cost includes value of internal transfers for capital works, taken at actual /

estimated factory cost of market price whichever is lower. Effect of

extraordinary events such as devaluation / revaluation in respect of long

term liabilities / loans utilised for acquisition of fixed assets is added to /

reduced from cost.

(iv) Depreciation on fixed assets (other than those used abroad under contract)

is charged on the straight line method as per the rates prescribed in

Schedule XIV of the Companies Act 1956 except where depreciation is

charged at rates shown hereunder :

Table (6.3)

Rates of Depreciation as charged by the Board of Directors

during the period of study, 1994-95 to 1998-99

Item of Fixed Assets Single

Shift

Double

Shift

Triple

Shift

General Plant and Machinery 8% 12% 16%

Automatic / Semi Automatic Machines 10% 15% 20%

Erection Equipment, Tools and Tackles 20% – –

Township Building

(i) Second Class

(ii) Third Class

2.5%

3.5%

– –

Railway Sidings 8% – –

Locomotives & Wagons 8% – –

Electrical Installations 8% – –

Office and other equipment 8% – –

Source : Annual Reports and Accounts of BHEL during the period of study,

1994-95 to 1998-99.


(v) In respect of additions to / deductions from the fixed assets, depreciation

has been charged on pro-rata monthly basis.

(vi) Fixed assets used outside and persuant to long term contracts are

depreciated over the duration of the initial contract.

(vii) At erection / project sites the cost of roads, bridges and culverts is fully

amortised over the tenure of the contract, while sheds, railway sidings,

electrical installations and other enabling works (other than purely

temporary erections, wooden structures) are depreciated after retaining ten

percent as residual value.

(viii) Purely temporary erections such as wooden structures are fully depreciated

in the year of construction.

(ix) Leasehold land and buildings are amortised over the period of lease.

Buildings constructed on land taken on lease are depreciated over their

useful life or the lease period whichever is earlier.

(x) When the carrying amount on any fixed assets has undergone a change in

accordance with the policy for foreign currency transactions, the

depreciation on the unamortised depreciation assets is spread over the

residual useful life of the asset.

(xi) The company‟s contribution or expenditure towards construction and

development of assets not owned by the company has been capitalised

under the general head, capital expenditure, and written off to revenue in

five years.

(xii) Grants related to fixed depreciable assets have been adjusted against the

gross cost of the relevant assets.

(xiii) Depreciation on the fixed assets acquired for the purpose of research and

development have also been calculated as per the specified rates.

(xiv) In respect of the assets manufactured and given on finance lease, the

normal sale price / fair value / contracted price is accounted for as the cost

of „Fixed Asset on Lease‟ with corresponding credit to Profit and Loss

Account treating it as turnover.


Lease rentals are recognised as accrual finance income which is part of

lease rentals recognised by applying implicit interest rate on the value of

net investment in lease. Against lease rentals, matching annual charge

representing recovery of net investment over the primary lease is made by

the operation of Lease Equalisation Account, net of depreciation.

Depreciation on the same is charged at the rate applicable to similar types

of fixed assets. Depreciation as also Lease Equalisation Account have been

taken to Profit and Loss Account with corresponding adjustment in the net

book value of lease asset. It has increased the profits of the company.

(xv) The fixed assets upto the cost of Rs. 10,000 have been fully depreciated in

the year when acquired.

(xvi) The impact of providing 100 percent depreciation on fixed assets as well as

charging off loose tools upto Rs. 10,000 each have resulted in excess

depreciation which has been charged to Profit & Loss Account. The excess

depreciation charged by the company during the period of study is shown

in the following table (6.4) :

Table - 6.4

Excess Depreciation Charged by BHEL during

the period of study, 1994-95 to 1998-99

(Rs. in lakhs)

Years Amount Charged

1994-95 697.00

1995-96 683.27

1996-97 771.23

1997-98 828.64

1998-99 1118.40

Source : Annual Reports and Accounts of BHEL during the period of study, 1994-

95 to 1998-99


The above amount of excess depreciation should have been transferred to

the reserve account.

(xvii) Depreciation has been charged separately for the assets meant for

factory/office complex as well as the township/residential complex.

(xviii) Depreciation on the additions made to the assets has not been given in the

schedule. Similarly, the depreciation charged on the asset sold/discarded

has not been shown separately.

(xix) The profits or loss on the asset sold/discarded has not been shown by the

company.

The depreciation charged by BHEL during the period under study on the

various blocks of fixed assets has been presented in the following table.

Table 6.5

Depreciation charged by BHEL on Block of Assets during study period

between 1994-95 and 1998-99.

(Rs. in lakhs)

Particulars 1994-95 1995-96 1996-97 1997-98 1998-99

1. Land and Building 633.08 1106.88 1123.43 1283.66 1323.44

2. Plant and Machinery 7450.93 7930.02 8669.66 8717.43 8764.00

3. Furniture & Fittings & others 605.59 644.82 1009.24 2416.75 4243.64


Source : Annual Report & Accounts of BHEL during the study period from

1994-95 to 1998-99

The table (6.5) shows that during 1994-95 and 1995-96 the total

depreciation charged by BHEL mainly included the depreciation charged on plant

and machinery. During 1994-95 the total depreciation was Rs. 8689.60 lakhs

which included Rs. 633.08 for the depreciation on land and buildings, Rs. 7450.93

lakhs for the depreciation on plant and machinery and Rs. 605.59 lakhs for the

depreciation on furniture and fixtures. The depreciation charged by the company

continuously showed an increasing trend because of additions in the fixed assets.


The accumulated depreciation on the assets discarded had been adjusted in the

same year.

The depreciation charged during 1994-95 on land and buildings was Rs.

633.08 lakhs which increased to Rs. 1323.44 lakhs during the year 1998-99

denoting that the company had acquired more leasehold land, constructed roads,

bridges, culverts, railway sidings etc. The block of plant and machinery mainly

included plant, machinery, equipment, electronic data processing equipments,

vehicles etc. The depreciation charged on this block during 1994-95 was Rs.

7450.93 lakhs, since the rate of depreciation was uniform based on SLM, the

chargeable amount of depreciation every year increased and reached upto Rs.

8764.00 lakhs during 1998-99. It implies that the company had acquired more

plant & machinery of improved technology as per the requirement and also taken

them on lease.

The depreciation on furniture and fittings during 1994-95 was

Rs. 605.59 lakhs which increased to Rs. 1009.24 lakhs during 1996-97. During

1997-98 and 1998-99 the company had acquired and got transferred a considerable

part of furniture & fittings from capital work-in-progress which increased the cost

and accordingly the amount of chargeable depreciation increased to Rs. 2416.75

lakhs in 1997-98 and to Rs. 4243.64 lakhs during 1998-99.

It was observed that the company did not show the depreciation on the

additions made to the assets and the depreciation deducted on account of the assets

sold or discarded.

6.19.4 Mineral and Metal Trading Company (MMTC)

The following depreciation accounting and policy have been adopted by

MMTC (as enlisted in its Annual Reports & Accounts) :

(a) All fixed assets are stated at historical cost less accumulated depreciation.

(b) Depreciation has been provided on straight line method at the rates

approved by the Board of Directors which are equal to or higher than those

provided under schedule XIV of the Companies Act, 1956. The rates of

depreciation charged on the various assets by the Board of Directors has

been presented in the following table (6.6) :


Table 6.6

Rates of Depreciation Charged on various assets by the Board of Directors

during the period of study, 1994-95 to 1998-99

Name of Asset

Rate of Depreciation

as adopted by

company

Rate of Depreciation

as provided in

Schedule XIV

(A) General Assets

Furniture and Fitting 10% 6.33%

Weigh Bridges 10% 4.75%

Typewriter, Machinery, Fans and office

equipment & AC

12.5% 4.75%

Vehicles 20% 9.50%

Computers 20% 16.21%

Leasehold land As per lease agreement

Electric Installation (excluding fans) 10% 1.63%

Water supply, Sewerage and Drainage 10% 1.63%

Road and Culverts 2.5% 1.63%

Building and Flats 2.5% 1.63%

Residential Flats (ready built) 5% 1.63%

(B) Manufacturing units Assets

Factory, Building 3.34% 3.34%

Electrical Installation 4.75% 4.75%

Water Supply 4.75% 4.75%

Plant and Machinery(general)

Single Shift 4.75% 4.75%

Double Shift 7.42% 7.42%

Triple Shift 10.34% 10.34%

Plant and Machinery-continuous process 5.28% 5.28%

(c) All Movable Assets upto Rs. 10,000 100% for Movable

assets costing Rs.

10,000 or less each

100% for assets costing

Rs. 5000 or less each

Source : Annual Reports and Accounts of MMTC during the period of study,

1994-95 to 1998-99


Depreciation has been charged from the month of acquiring the fixed

assets.

(c) Depreciation includes amortisation of leasehold.

(d) Wooden partitions and temporary structures are fully depreciated in the

year of purchase and erection.

(e) For movable assets, where the written down value at the beginning of the

year and/or purchases made during the year is Rs. 10,000 or less, in each

case 100% depreciation is provided except retaining a nominal value of

Rs.1.

(f) No depreciation has been charged on freehold land.

(g) Depreciation on the additions of assets and the depreciation on the assets

sold/discarded have been adjusted and shown separately.

(h) Assets have been shown separately for office and staff.

(i) Excess depreciation has been charged to Profit and Loss Account.

(j) Profit or Loss on account of sales of the discarded assets has not been

presented in the schedule.

The depreciation charged by the company on different blocks of assets

during the study period has been presented in the following table 6.7.


Table 6.7

Depreciation charged by MMTC on Assets during the period

of study between 1994-95 and 1998-99.

(Rs. in lakhs)

Particulars 1994-95 1995-96 1996-97 1997-98 1998-99

1. Land and Building

Depreciation on opening assets &

additions

36.42 35.25 112.93 48.33 44.87

36.42 35.25 112.93 48.33 44.87

– Depreciation on assets sold or

transferred

0.23 – – 0.27 0.60

Depreciation during the year 36.19 35.25 112.93 48.06 44.27

2. Plant and Machinery


additions

132.77 167.75 510.95 191.77 182.77


transferred

10.78 42.62 98.07 100.74 43.98

Depreciation during the year 121.99 125.13 412.88 91.03 138.79

3. Furniture & Fittings etc.


additions

17.71 44.85 55.95 28.96 18.53


transferred

1.95 8.19 21.69 1.84 37.17

Depreciation during the year 15.76 36.66 34.26 27.12 - 18.64

Total Depreciation charged

during the year (1+2+3)

173.94 197.04 560.07 166.21 164.42

Source : Annual Report & Accounts of MMTC during the study period from

1994-95 to 1998-99.

From the table (6.7) it can be observed that the depreciation charged by the

company during the first three years of study i.e. 1994-95 to 1996-97 showed an

increasing trend and after that it decreased significantly. The total depreciation

charged by MMTC during 1994-95 was Rs. 173.94 lakhs which increased to Rs,

560.07 lakhs during 1996-97 and suddenly decreased to Rs. 166.21 lakhs in 1997-

98 and to Rs. 164.42 lakhs during 1998-99. The main reason for the decrease was

that during 1997-98 the company adopted modern technology and accordingly

discarded the old assets or transferred them to other heads which reduced the

yearly depreciation.


The depreciation charged by the company on land and building during

1994-95 was Rs. 36.19 lakhs which increased to Rs. 112.93 lakhs but again

decreased to Rs. 48.06 lakhs during1997-98 and to Rs. 44.27 lakhs in 1998-99. The

reason behind it was the fully writing off of the leasehold land and buildings.

Similarily on plant and machimery the depreciation charged by the company

during 1994-95 was Rs. 121.99 lakhs which increased to Rs. 412.88 lakhs but

reduced to Rs. 91.03 lakhs in 1997-98 because of discarding of a major part of the

plant and machinery. But again the company acquired plant and machinery of

improved technology including electronic data processors and computers. The

yearly depreciation charged by the company during 1998-99 increased to Rs.

138.79 lakhs.

On furniture and fixtures the depreciation charged by the company during

1994-95 amounted to Rs. 15.76 lakhs which increased to Rs. 36.66 lakhs during

1995-96 but after that the depreciation continuously decreased and was reduced to

Rs. 27.12 lakhs during 1997-98. Again the cause of it was found to be the sale of

furniture and fixtures which were put out of use. During 1998-99 the yearly

depreciation was Rs. –18.64 lakhs but the depreciation charged on discarded assets

was higher than the chargeable depreciation which resulted in negative

depreciation which was fully adjusted with the total depreciation.

6.20 USE OF STATISTICAL TECHNIQUE TO JUDGE THE

CONSISTENCY OF DEPRECIATION

To judge whether there is consistency or not while charging depreciation on

various assets by the selected public enterprises the following techniques have

been used :

(a) Standard deviation (b) Coefficient of variation

(c) 'f' test

6.20.1 Depreciation on Land and Buildings

A comparative study of the depreciation charged by the selected public

enterprises on land and buildings during the study period has been

presented in the following table (6.8) :


Table 6.8

Standard Deviation and Co-efficient of Variation of the depreciation

charged by Selected Public Enterprises on Land and Building

during the study period between 1994-95 and 1998-99

(Rs. in lakhs)

Years SELECTED PUBLIC ENTERPRISES

SAIL BHEL IOC MMTC

1994-95

1995-96

1996-97

1997-98

1998-99

6941.25

7343.87

7693.00

7529.00

10049.00

633.08

1106.88

1123.43

1283.66

1323.44

1846.19

2210.59

2971.82

3821.60

4974.47

36.19

35.25

112.93

48.06

44.27

Total 39556.12 5470.49 15824.67 276.70

Average Depreciation (X) 7911.22 1094.10 3164.93 55.34

Standard Deviation () 776.31 173.81 799.55 20.65

Coefficient of Variation

( / X x 100)

9.81% 15.89% 25.26% 37.31%

Source : Annual Reports & Accounts of the selected Public Enterprises during the

study period from 1994-95 to 1998-99.

From the table (6.8) it is clear that SAIL has provided the maximum

depreciation on land and buildings as compared to other public enterprises under

study. The charging of depreciation of course depends upon the cost of the asset

possessed by the company. Higher amount of depreciation does not mean that the

depreciation was charged at higher rates than other concerns. The other concerns

i.e. the BHEL, IOC and MMTC also provided depreciation at uniform rates.

The average depreciation for SAIL was Rs. 7911.12 lakhs. It is to be noted

that during the first four years of the study, the depreciation provided by SAIL was

less than the average depreciation but depreciation provided during 98-99 was

above the average. Infact, the average was high because of higher amount of

depreciation provided in 1998-99. The average amount of depreciation provided by

BHEL was Rs. 1094.10 lakhs. In the case of BHEL the depreciation provided in


1994-95 was less than the average depreciation otherwise provided. In the

remaining years the amount of depreciation was above the average depreciation. In

the case of IOC the depreciation on land and building varied between the range of

Rs. 1846.19 lakhs to Rs. 4974.47 lakhs, the lowest being in the year 1994-95 and

the highest during 1998-99. The average depreciation provided by IOC on land and

building was Rs. 3164.93 lakhs.

The MMTC has provided the minimum amount as depreciation on land and

building. During 1994-95 the depreciation on land and building was Rs. 36.19

lakhs which increased suddenly to Rs. 112.93 lakhs during 1996-97 because of

acquiring further assets. Because of this the average of the depreciation charged by

MMTC on land and building came to Rs. 55.34 lakhs. During the whole period

under study the yearly depreciation remained less than the average except for the

year 1996-97.

Fluctuation in the amount of depreciation provided on land and building

does not give an idea regarding consistency of depreciation policy. For the

purpose, the coefficient of variation has been calculated. Analysing the coefficient

of variation it can be concluded that SAIL followed a consistent policy as regards

the depreciation on land and building because it has variation equal to 9.81 percent.

MMTC showed a more fluctuating depreciation policy for providing depreciation

on land and building because the coefficient of variation was 37.31 percent. IOC

followed a comparatively consistent policy for depreciation on land and building

but BHEL can be regarded consistent in charging depreciation on land and

building during the period of study.

6.20.2 Depreciation on Plant and Machinery

An overall view of the depreciation provided by SAIL, BHEL, IOC and

MMTC for plant and machinery during the study period has been presented

in the following table with a view to compare the consistency followed by

these concerns as regards the depreciation on plant and machinery.


Table 6.9


charged by Selected Public Enterprises on Plant and Machinery


(Rs. in lakhs)


SAIL BHEL IOC MMTC

1994-95

1995-96

1996-97

1997-98

1998-99

40990.36

45459.28

53790.00

70774.00

107207.00

7450.93

7930.02

8669.66

8717.43

8764.60

39623.89

53630.39

76806.46

101418.41

104632.38

121.99

125.13

412.88

91.03

138.79

Total 318220.64 41532.64 376111.53 889.82




( / X x 100)

37.77% 4.48% 24.10% 47.08%

Source : Annual Reports & Accounts of the selected public enterprises during the


It is evident from the table (6.9) that average depreciation provided by

SAIL on plant and machinery was Rs. 63644.13 lakhs with a standard deviation of

Rs. 24039.74 lakhs. The depreciation varied between Rs. 40990.36 lakhs and Rs.

107207 lakhs implying greater variability. BHEL seems to be more consistent

regarding providing depreciation as the average depreciation was Rs. 8306.53

lakhs during 1994-95 and in 1995-96 the depreciation charged was less than the

average depreciation but for the remaining three years the yearly depreciation was

above the average depreciation. There was an increasing trend of depreciation

charged by IOC on the block of plant and machinery. The average depreciation


provided by IOC was Rs. 75222.31 lakhs with a standard deviation of Rs.

18130.52 lakhs. During 1994-95 and 1995-96 the yearly depreciation was less than

the average depreciation but for 1996-97, 1997-98 and 1998-99 the depreciation

was higher than the average depreciation especially during the last two years when

the amount of depreciation was considerably higher than the average depreciation.

The depreciation provided by MMTC seems to be consistent during the whole

period of study except for the year 1996-97 when the depreciation was abnormally

high. During 1994-95 the company provided Rs. 121.99 lakhs as depreciation

which increased to Rs. 412.88 lakhs during 1996-97. The depreciation again

decreased to Rs. 91.03 lakhs during 1997-98. The average depreciation charged by

MMTC on plant and machinery amounted to Rs. 177.96 lakhs with standard

deviation of Rs. 83.79 lakhs.

Making an inter-firm comparison regarding the depreciation on plant and

machinery the MMTC can be regarded as having the greatest variability followed

by SAIL. The coefficient of variation of MMTC was 47.08 percent which denotes

an inconsistency in the amount of depreciation provided by it. The inconsistency

was less in the case of SAIL. The depreciation provided on plant and machinery

was moderately consistent for IOC as the coefficient of variation for IOC was

24.10 percent. As a whole, the depreciation policy for providing depreciation on

plant and machinery was highly consistent for BHEL as the coefficient of variation

was 4.48 percent only being the lowest among all the enterprises under study.

6.20.3 Depreciation on Furnitures and Fixtures

A comparative view of the depreciation provided on furniture and fittings

by the selected public enterprises during the period of study has been

presented in the following table (6.10) alongwith their average, standard

deviation and coefficient of variation.


Table 6.10


charged by Selected Public Enterprises on Furniture & Fixtures


(Rs. in lakhs)


SAIL BHEL IOC MMTC

1994-95

1995-96

1996-97

1997-98

1998-99

2237.48

2439.33

2175.00

- 3806.00

1895.00

605.59

644.82

1009.24

2416.75

4243.64

332.27

335.98

426.44

525.86

528.63

15.76

36.66

34.26

27.12

- 18.64

Total 4940.81 8920.04 2149.18 95.16




( / X x 100)

243.22% 55.31% 14.21% 75.04%



It is evident from the table (6.10) that among all the public enterprises

under study BHEL has provided the maximum depreciation on furniture and

fixtures while the MMTC has provided the minimum depreciation. The average,

depreciation provided on furniture and fixtures was highest, at Rs. 1784.01 lakhs

for BHEL followed by SAIL at Rs. 988.16 lakhs. The minimum average

depreciation provided on furniture & fixtures was Rs. 19.03 lakhs for MMTC. The

IOC had an average depreciation of Rs. 429.84 lakhs.

It is clear from the above table that SAIL was highly inconsistent in respect

of providing depreciation on furniture and fixtures as the coefficient of variation

was 243.22 percent followed by MMTC which had the coefficient of variation

equal to 75.04 percent that means it was consistent by 24.96 percent. The

depreciation on furniture and fittings provided by BHEL was also variable because


of the coefficient of variation was 55.31 percent. But the depreciation provided by

IOC on furniture and fixtures can be regarded consistent because there was only

14.21 percent variation.

It can be concluded that IOC was more consistent in providing depreciation

on furniture and fixtures while SAIL was highly inconsistent and instable for

providing depreciation on furniture and fixtures. On the basis of depreciation

provided by these selected public enterprises on various blocks of assets, an overall

view of total depreciation provided by these enterprises has been presented in the

following table (6.11) which has been analysed to determine the consistency or

stability in the amount of depreciation provided by these enterprises.

Table 6.11

Standard Deviation and Co-efficient of Variation of the

total depreciation charged by Selected Public Enterprises


(Rs. in lakhs)


SAIL BHEL IOC MMTC

1994-95

1995-96

1996-97

1997-98

1998-99

50169.09

55242.48

63658.00

74497.00

119151.00

8689.60

9681.72

10802.33

12417.84

14331.08

41802.35

56176.96

80204.72

105765.87

110135.48

173.94

197.04

560.07

166.21

164.42

Total 362717.57 55922.47 394085.38 1261.68




( / X x 100)

34.07% 17.90% 24.05% 43.24%




From the above table it can be observed that as regards the average

depreciation provided by the selected public enterprises on total fixed assets IOC

stands first and followed by SAIL, BHEL and MMTC. But the standard deviation

was highest for SAIL followed by IOC, BHEL and MMTC. SAIL can not be

regarded consistent as compared with IOC and BHEL because the coefficient of

variation of depreciation charged was 34.07 percent which seems to be high.

Comparing the overall consistency/variability in the amount of total

depreciation on fixed assets, it can be said that BHEL was more consistent with a

coefficient of variation of 17.90 percent. IOC can be regarded as consistent as

regards the total depreciation provided by IOC on total assets because the

coefficient of variation was 24.05 percent. The preceding table depicts that MMTC

was comparatively the most variable / inconsistent in providing the amount of

depreciable because its coefficient of variation was 43.24 percent being the highest

among all the public enterprises selected for study.

The consistency or variability in the amount of depreciation provided by

the selected public enterprises on various assets as well as a whole can be viewed

from the following table (6.12) :

Table 6.12

Consistency or Variability in the amount of Depreciation

by Selected Public Enterprises

PARTICULARS

SELECTED PUBLIC ENTERPRISES

SAIL BHEL IOC MMTC

1. Block of Land and Building Consistent Consistent Consistent Variable

2. Block of Plant & Machinery Variable Consistent Consistent Variable

3. Block of Furniture & Fixtures Highly

Inconsistent

Inconsistent Consistent Variable

4. On Total Fixed Assets Moderately

Consistent

Consistent Consistent Variable


ANALYSIS OF VARIANCE

In the present study, an attempt has been made to judge whether -

(i) There was a significant difference in the amount of depreciation charged by

the selected public enterprises during the period of study;

(ii) There was a significant difference in the year-wise depreciation.

To judge the above, we have used the technique of analysis of variance for

which the total depreciation charged by the selected public enterprises have been

indexed with 1994-95 as base year. The index number of the total depreciation

charged by these public enterprises has been presented in the following table

(6.13):

Table 6.13

Index of the total depreciation charged by Selected Public Enterprises


(Base Year 1994-95 = 100)


SAIL BHEL IOC MMTC

1994-95

1995-96

1996-97

1997-98

1998-99

100.00

110.11

126.89

148.69

237.50

100.00

111.42

124.31

142.90

164.93

100.00

134.39

191.87

253.01

263.47

100.00

113.28

322.00

95.56

94.53

Source : Annual Reports & Accounts of the selected companies during the period

of study from 1994-95 to 1998-99.

To apply the technique of analysis of variance, a two way classification has

been used with the following Null Hypothesis.

(a) There is no significant difference in the amount of depreciation charged by

the selected public enterprises, and

(b) The year-wise depreciation does not differ significantly.


Table 6.14

Analysis of Variance

Source of Variation Sum of

Squares

Degree of

Freedom

Mean

Square

1. Between Columns (Enterprises) 9899.96 3 3299.99

2. Between Rows (Years) 27866.09 4 6966.52

3. Residual 45834.42 12 3819.54

83600.47 19

(a) Comparison of Depreciation charged by the enterprises

The critical value of 'f' for 12 and 3 degrees of freedom at 5 percent level of

significance is 8.74. The calculated value is less than this, so it can be concluded

that the depreciation charged by enterprises does not differ significantly and our

hypothesis is accepted.

(b) Comparison of year wise depreciation

The critical value of 'f' for 4 and 12 degrees of freedom at 5 percent level of

significance is 3.26. The calculated value is less than this, hence the null

hypothesis is accepted and concluded that year wise depreciation does not differ

significantly.

Thus, the test shows that the selected public enterprises and year-wise

amount are almost alike so far as the depreciation is concerned.

f = 3819.54

3299.99 = 1.16

f = 6966.52

3819.54 = 1.82


6.21 IMPACT OF CHANGING PRICE LEVEL ON

DEPRECIATION

The existing accounting practices of preparing financial statements are

based on an important accounting assumption namely, the monetary postulate

which, states that the value of the monetary unit is stable and that fluctuations in it

may be ignored in the preparation of accounts. So long as prices and costs remain

stable, no accounting problem arises. But with the movement-upwards or

downwards-in the price-level, the assumption of a stable monetary unit does not

hold good. Consequently, a host of problems begin to creep into the accounts.

There is now a near unanimity that historical cost accounts suffer from

many serious limitations during the period of rapidly changing prices. The high

rate of inflation that gripped almost all the economies of the world during seventies

and eighties forced different users, e.g., corporate managers, accountants,

academics, investors, government, etc. to consider anew whether the corporate

accounts prepared on historical cost basis serve the purpose they are supposed to,

and whether some change in the accounting system is warranted. With a view to

overcoming the problems associated with historical cost accounts, a number of

proposals were made to incorporate the effects of inflation in accounts. In some

countries, notably UK, USA and Canada, the proposals took a definitive form and

were implemented.

Partly influenced by these developments and partly compelled by their own

circumstances, some developing economies of the world have shown considerable

amount of interest in inflation accounting. In India also, loud thinking was going

on about the usefulness and suitability of the historical cost accounting in the

context of a high rate of inflation. It is obvious that any such move is likely to

provoke mixed reactions. Although a great majority of the business enterprises in

India do not seem to have made any worth-mentioning attempt, some of the large

business enterprises have tried to keep themselves abreast of the development

taking place outside the country, and a few of them have even attempted to

incorporate the effect of inflation in their accounts.

By and large, the situation has been quite fluid. The opinion on the subject

seemed to be divided between the two extremes-one in favour of introducing


changes in the existing system of accounting so as to take care of changing prices

into accounts, and the other of maintaining that the historical cost accounting is

still useful and no change is warranted in the existing system.

Let us take a look at the following assumed figures.

(i) Fixed Assets at Costs 60,00,000

Less : Depreciation on straight line basis for 6 years @10% 36,00,000

Net Block 24,00,000

Add : Working Capital 16,00,000

Capital Employed 40,00,000

(ii) Profit after tax @ 50% 5,00,000

The post-tax profit, by looking at the figures given above, comes to 12.5%

i.e. 500000 x 100 / 40,00,000. It may appear to be quite satisfactory. But for

assumption, if fixed assets acquired now, would have cost double the amount the

real profit on fixed assets will be different as indicated below :

Fixed assets at current cost 12,00,0000

Less : Depreciation for 6 years 72,00,000

Net Block 48,00,000

Add : Working Capital 16,00,000

Capital Employed 64,00,000

Profit earned

Profit after tax as shown 5,00,000

Add :

Tax @ 50% of total 5,00,000

Depreciation p.a. actual 6,00,000

Profit before depreciation and tax 16,00,000

Less :

Depreciation on the basis of present day cost 12,00,000

Profit before tax 4,00,000

Less : Tax @ 50% 2,00,000

Profit after tax 2,00,000

This shows that the return on the assets value is barely 3% i.e. 2,00,000 x

100 / 64,00,000. and not 12.5 percent. Thus, in time of inflation the profit and loss


account and balance sheet drawn up on historical cost basis may not be a proper or

reliable basis for judging the well being of an enterprise. It is said that the profit

shown by the firm in an inflationary period are illusory or just paper profits. In any

case, the depreciation charges are inadequate to permit replacement when it is due.

Depreciation charges on the basis of replacement cost will mean collection of

sufficient funds for an asset when its life is over.

6.21.1 Distortion in Accounting Results

As pointed out above, the monetary postulate underlying historical cost

based account (HCBA) does not hold good during the period of changing prices.

Consequently, a host of problems begin to creep into the accounts with the

movement-upwards or downwards-in prices. Such problems have the effect of

distorting the accounting results in various ways. These distortions are manifested

in the form, among other of an overstatement of profits and an understatement of

assets during inflation. Conversely, there is an understatement of profit and an

overstatement of assets when there is deflation.

There are two primary factors which contribute to distortions in the

reported results. They are : depreciation on fixed assets, and purchasing power

gains (losses) on monetary assets/liabilities held by the firm during the period of

changing prices. Thus, being depreciation on fixed assets is one of the important

aspect of the present research work. Therefore, I shall discuss this factor in a brief

way.

6.21.2 Depreciation on Fixed Assets

The point at which rising prices are apt to have the greatest impact upon

historical cost accounts is the depreciation on fixed assets. As per the historical

cost convention, fixed assets of an enterprise are taken, for depreciation purposes,

to have been purchased at uniform prices, though in practice they are purchased at

various prices in the past. The total amount of depreciation provided over the

working life of the asset is equal to the original money cost of the asset (assuming

that the scarp value is nil). Obviously, there would be no difficulty in financing the

replacement of the used-up asset if the prices have not changed. But with the

changes in prices, replacement of assets becomes difficult. It is so because the

depreciation provision, based as it is, on the original money investment in fixed


assets, represents an amalgam of costs incurred at various points of time, and does

not represent the same amount of purchasing power as was originally invested in

the assets exhausted during the operations. It will thus be seen that as the level of

prices goes up, the historical cost basis of depreciation provision causes a gap

between the annual depreciation provision and the cost of the used-up portion of

the asset, both measured in terms of purchasing power. Over a long period, such a

difference, being cumulative in nature, tends to widen and leads the firm into a

critical financial position; the firm faces difficulties in replacing its fixed assets.

Such a deficiency in depreciation provision has a bearing on the reported

profit figure as well. In the profit and loss statement, the depreciation provision

(based on the original money cost of investment in fixed assets) is matched with

sale proceeds at current prices (measured in terms of the monetary unit having

lesser purchasing power). Hence, the reported profit is swollen by a capital element

representing short provision of depreciation. Further, on the balance sheet the

assets are represented at lower amounts because fixed assets are recorded at the

original monetary costs invested at the time of their acquisition.

6.21.3 Purchasing Power Gains and Losses

Purchasing power gains (losses) occur simply because the firm is holding

some monetary liabilities and assets which gain or lose purchasing power during

inflation. These gains and losses are in the nature of costs of holding monetary

assets and liabilities and should be taken into account while considering the effects

of price changes on historical cost accounts.

6.21.4 Limitations of Historical Cost Based Accounts

Historical Cost Based Accounting (HCBA), however, suffers from a major

limitation. It is well known that the purchasing power of rupee has been

persistently shrinking since late fifties, and more alarmingly since early seventies,

as is clear from the Table 6.15 But HCBA fails to recognise the impact of this

shrinkage. It records transactions represented by rupees of varying purchasing

power.


Table 6.15

Annual Rates of Inflation in India

Year CPI WPI

1968 3.0% (-) 0.4%

1969 0.6% 2.1%

1970 5.1% 6.2%

1971 3.1% 5.0%

1972 6.5% 8.8%

1973 16.9% 16.4%

1974 28.6% 28.6%

1975 5.7% 3.9%

1976 (-) 7.6% (-) 2.0%

1977 8.3% 7.6%

1978 2.5% (-) 0.2%

1979 6.3% 11.6%

1980 11.4% 20.1%

1981 13.1% 12.2%

1982 7.9% 2.4%

1983 11.9% 7.9%

1984 8.3% 6.9%

1985 5.6% 4.6%

1986 8.7% 5.6%

1987 8.8% 7.0%

1988 9.4% 8.7%

1989 6.2% 6.8%

1990 9.0% 9.0%

1991 13.9% 13.5%

1992 11.8% 11.9%

1993 6.4% 7.5%

1994 10.2% 10.5%

1995 10.2% 9.3%

1996 9.0% 5.9%

1997 7.2% 5.2%

1997-98 6.9% 4.8%

1998-99 13.1% 6.9%

1999-2000 (expected) 5.5% 3.5%

Sources :

1. Upto 1997 : IMF, “International Financial Statistics Yearbook, Vol. LI, 1998”, Washington.

2. 1997-98 onwards : CMIE, “Monthly Review of Indian Economy”, New Delhi. Various Issues.


Thus, HCBA overstates the profit by undercharging depreciation and

materials cost. Depreciation is undercharged since it is based on the historical cost

of fixed assets instead of their current cost. Similar is the case of materials cost as

the stocks purchased at historical costs are matched against revenues expressed at

current prices. Again, HCBA reflects assets at their historical cost instead of

current cost. It results in understatement of the net worth of an enterprise. HCBA

thus fails to serve the primary purpose of the financial statements. It presents a

distorted view of the profitability by overstating it and of intrinsic worth by

understating it.

However, the following are the main problems created by price changes in

Historical Cost Accounts.

(i) Non-recovery of Costs

It is an accepted principle that the exhaustion of fixed assets and the

consumption of current assets involved in the operation of the business should be

considered in the nature of cost and that sufficient provision out of current

revenues should be made so as to recover fully the purchasing power equivalent of

the used-up portion of the assets. As pointed out earlier, a short provision of

depreciation means that the costs of carrying on the business have not been fully

recovered. This causes a financial strain, and ultimately the firm finds itself

without adequate wherewithal to support its operations.

(ii) Problem of Replacement

The firms finds it gradually more difficult to replace business assets

because of the non-recovery, as costs, of the exhaustion of fixed assets. This

problem is quite serious in respect of fixed assets. As discussed earlier that under

historical cost accounting, the total amount of depreciation provision over the

useful life of the asset does not represent the same amount of purchasing power as

was originally invested in the asset in use. This deficiency in depreciation

provision turns out to be a financial problem in the replacement of assets, whether

by a similar asset or an entirely new asset. It is felt that such a deficiency in the

depreciation provision should ordinarily be met out of the net retained profit which

is subject to tax. However, the following example will make the idea more clear.

For example, if a machine is purchased for Rs. 50,000/- and if it is to be replaced


after a few years, a new machine of the same type will have to be purchased to

continue the operation of the enterprise. If the cost of this new machine is Rs.

90,000/- then Rs. 90,000/- instead of 50,000/- will be needed for its replacement. It

means that the capital represented by this fixed asset must be recovered out of the

gross proceeds from the business before that business can be said to have made a

profit.

(iii) Financial Strain on Business

The historical cost accounting treatment of depreciation creates a financial

strain on the business. The shortage of annual depreciation provisions leads to the

shortage of fixed working capital so urgently needed to finance replacement and

growth activities during inflation. With the passage of an inflationary period, the

firm finds that it has exhausted a substantial part of its capital by way of taxes

bonuses and dividend payments.

(iv) Problem of Capital Levy and Capital Distribution

It is clear from the earlier discussions that the historical cost treatment of

depreciation on fixed assets leads to an overstatement of profits. The taxation of

such overstated profits amounts to „capital levy‟ and the distribution of such profits

to „distribution out of capital‟. This simply means „living on capital‟. Hence, there

is further erosion of working capital and a consequent financial strain on the

business.

(v) Interpretative Value of Financial Statements

The effect of inflation on the interpretative value of financial statements is

quite crucial, and it is very often put forward as an argument in favour of a

deviation from the existing historical cost accounting system. There are at least two

important aspects of this problem which need to be emphasized: (a) during the

period of prolonged inflation, various items of the balance sheet are based on

different levels of costs and prices, and hence, they are not comparable in any real

sense, and (b) profits and similar capital gains get inextricably mixed up with

operating profit in the income statement, thus making a proper assessment of the

earning capacity of the firm difficult, if not impossible. In a nutshell, it is very

difficult to interpret and make proper use of financial statements as a tool of

managerial decision making, since such financial statements no longer provide a


basis for appreciation of the true financial position and operating results of the

firm.

Secondly, such financial statements tend to mislead shareholders and other

users. The concepts of „profit‟ and „maintenance of capital‟ based on monetary

postulate make the shareholders believe that so long as their capital (monetary) is

maintained, their interests in the company are fully protected. It is quite obvious

that this is not the truth if prices are changing. The real interest of the shareholders

lies in the yield from business as a going concern and, in the eventuality of its

winding up, in its actual break-up value as opposed to the apparent book value. It

is, thus, clear that shareholders and other investors are not provided with

information which enables them to accurately interpret the operating results and to

judge the relative effect of inflation upon a particular enterprises.

It is here to be noted that historical cost accounts fail during the period of

inflation to serve the purpose-for which they are designed. The reported profits the

major source of cash flow of an enterprise-are overstated and the assets are

understated. The income statement does not indicate the true earnings of the

enterprise and the balance sheet does not show the true financial position. The

cycle of overstated profits, capital levy and capital distribution leads to erosion of

capital which is reflected in a reduction of the operating capability of the

enterprises. Overstated profits based on the conventional accounting system lead to

a higher tax burden, more bonus and an inaccurate measure of the efficiency of

management. Higher profits may also lead to the distribution of a bigger dividend.

Needless to add, this affects the ability of an enterprise to generate favourable cash

flows, and finally to survive and grow.

6.22 ROLE OF THE INSTITUTE OF CHARTERED

ACCOUNTANTS OF INDIA

The Institute of Chartered Accountants of India (ICAI) realised the

importance of the subject of Inflation Accounting very late. It was only in February

1982, that it issued a discussion paper :Treatment of Changing Prices in Financial

statements” to generate discussion and to create awareness about the subject. The

main aim of the paper was “to examine how and to what extent the techniques of

Inflation Accounting designed in western countries are applicable to the Indian

situation.”


The paper discussed the different approaches to Inflation Accounting based

on SSAP-7 (ACPP), SSAP-16 (CCA) and “Periodical Revaluation of Fixed Assets

alongwith the adoption of LIFO” and then raised a few issues for discussion such

as the choice of the method, selection of the general and specific indices, status of

the information reflecting the price changes, the needs for reforms in tax laws,

social implications of Inflation Accounting and above all, possible improvement in

the two methods-ACPP & CCA.

In December 1982, the ICAI issued a guidance note “Accounting for

changing Prices”. The guidance note retained the main structure of the earlier

discussion paper and attempted to give recommendations on the issues raised

earlier for discussion. The guidance note recommends Current Cost Accounting

method as it in its view is a “rational and comprehensive system”. The guidance

note issued by ICAI has been included in Chapter VII of the thesis.

The ICAI also admits, “Introduction of a full-fledged system of Current

Cost Accounting on a wide scale in India will inevitably take some time.” It has,

however, been silent since 1982.

6.23 PRICE LEVEL CHANGES AND THE SELECTED

PUBLIC ENTERPRISES UNDER STUDY

In the present study of the Selected Public Enterprises, it has been observed

that all the units were preparing their annual account by historical cost method and

were not supplying additional inflation adjusted information in their annual reports

and accounts.

On personal perusal of the reasons, of not following changing price level.

The management of the public enterprises under study gave the following reasons :

1. The government would not allow adjusted income for tax purpose.

2. Practical difficulties in the field out-way the benefit derived. The practical

difficulties is regarding the suitable guidelines as well as daily increasing

the rate of inflation.


3. The annual reports and accounts are meant for the external users but it has

been felt that the external users will not understand and make use of the

inflation adjusted account.

4. The use of inflation adjusted information for computing ratio don't seem to

be popular for the purpose of comparison.

However, the management of the said enterprises show their preference to

consider the presentation of inflation adjusted information on a supplementary

basis. They could be stated as footnotes or by way of mentioning it in the chairman

speech.


NOTES & REFERENCES

1. American Institute of Certified Public Accountants, AICPA, “Accounting

Research Bulletin”, No. 1, 1953.

2. International Accounting Standard Committee, IAS-4, “Guidance Note on

Depreciation Accounting issued by the Institute of Chartered

Accountants of India,” ICAI, New Delhi, para 2, 1989.

3. Hendrinksen, E.S. and Breda, M.F., “Accounting Theory,” Richard D.

Irwin, Inc., 1992, p. 369.

4. Robert, N. Anthony, James S. Reece, “Accounting Principles”, Sixth

Edition, Richard, D. Irwin, Inc., Homewood, Illinois 60430, p. 169, 1994.

5. Maheshwari, S.N., “An Introduction to Accountancy”, 4th

edition, Vikas

Publishing House Pvt. Ltd., p. 224, 1999.

6. Jain, Khandelwal, “Auditing (Theory and Practice)”, Shivam Book

House (P) Ltd., Jaipur, p. 444, New edition, 2000.

7. L.S. Porwal, “Accounting Theory”, 3rd

edition, Tata McGraw-Hill

Publishing Company Limited, New Delhi, p. 320, 2001.

8. Grant, E.L., “Basic Accounting for Cost Accounting”, New York :

McGraw-Hill Book Company, p. 321, 1956.

9. Robert, N. Anthony, James S. Reece, op. Cit., p. 170.

10. Ibid., p. 170.

11. Maheshwari, S.N., op. cit., p. 226.

Documents

Depreciation accounting