Chapter 7. Depreciation – Auditing: Principles and Techniques

Chapter 7

Depreciation

CHAPTER OUTLINE
7.1 DEFINITION OF DEPRECIATION

In its broadest sense, the term ‘depreciation’ is used to describe a loss in value from any cause in contradistinction to ‘appreciation’ used in the sense of increase in value. But to an accountant, it signifies the gradual wasting away of fixed assets and a corresponding charge to the profits, to the earning of which their employment has contributed.

Accounting Standard-6 issued by the Institute of Chartered Accountants of India on “depreciation accounting” defines depreciation as “a measure of the wearing out, consumption or other loss of value of depreciable assets arising from use, effluxion of time, obsolescence through technology and market change. Depreciation is calculated so as to allocate a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortisation of assets whose usefulness is predetermined.”

The term “depreciable amount” of a depreciable asset as per the standard is its historical cost or other amount substituted for historical cost in the financial statement less the estimated residual value.

The accounting standard recommends that the depreciable amount of a depreciable asset should be allocated on a systematic basis to each accounting period during the useful life of the asset.

7.2 PURPOSES OF PROVIDING DEPRECIATION

Depreciation is provided in the books of accounts as a charge against profit in order to fulfil the following objectives:

1. To keep capital intact

One of the effects of providing for depreciation on an asset is to retain in the business out of the profits in each year, an amount equal to the proportion of the cost of the asset employed in the business that has run off, estimated on the basis of the period of its working life and its scrap value. Thus, the original capacity of the entity, assuming that all profits have been withdrawn and losses, if any, made good, will be intact. If on the contrary, depreciation had not been charged, the net income would have been overstated over the year of the life of the asset, and if the same was withdrawn or distributed as dividends, the business would have no funds for the replacement of the asset.

2. To ascertain cost accurately

It is not possible to ascertain the true cost of production of a particular product, if proper amount of depreciation is not included therein, i.e. to charge depreciation in the profit and loss account it is essential to calculate the actual cost of production. This is because depreciation, like any other expenditure, is a charge against revenue and must be included in the accounts irrespective of the fact whether the final result of a production process is profit or loss.

3. To charge initial costs against earnings

The object of depreciation accounting is to determine on a scientific basis the proportion of the cost of a machine, which must be debited in the accounts of each year during which the machine will be used. Depreciation is an expense incurred for earning profit, which is similar to the hire of an asset, the only difference being that in case of hiring, the hire charges are paid to an outsider, while in the other, it is kept in the entity itself. Hence, unless an appropriate part of the asset value is charged against profit of the business each year, the profit earned on its working will not be correctly ascertained.

4. To prepare ‘true and fair’ statements of accounts

Unless depreciation is provided, the assets will be shown at an amount higher than their true value and the profit shown will be more than the real profit. In other words, the balance sheet and the profit and loss account will not reflect true and fair financial position as well as financial result of the entity.

7.3 CAUSES OF DEPRECIATION

Decline in service potential of an asset is one aspect of depreciation, which in this sense, is a physical fact. When an asset is acquired, it is considered as the prepayment of several years’ depreciation, which is the basis of accounting for that asset during its estimated useful life. Therefore, acquisition of a fixed asset is seen as a bundle of services that will be provided by that asset to the business over time in future.

These bundles of future service benefits enable the owner of the asset to earn revenue by the following:

  1. Providing a place where products could be produced, stored and sold.
  2. Furnishing a means of converting raw materials into finished products, their designing and packaging (Machinery)
  3. Providing a mode of transporting goods to the customers (Trucks)

As an asset is used over time, the benefits decline with age. This is due to two factors:

  • Physical factors (deterioration through use)
  • Economic factors (reduction in utility through obsolescence)

Physical factors indicate the deterioration of the value of the assets due to wear and tear, time and other factors that reduce use value, and economic factors indicate the useful obsolescence arising from technological improvements and the inadequacy of the asset for the intended purpose.

From the above, it can be comprehended that the causes of depreciation arise directly through deterioration or indirectly through obsolescence.

7.4 BASIS OF CHARGING DEPRECIATION

The computation of depreciation and the amount to be charged in respect thereof in an accounting period are usually based on the following three factors:

1. Cost of the asset

Cost of an asset means the historical cost or other amount substituted for the historical cost of the depreciable asset when the asset has been revalued. Historical cost of an asset means its acquisition cost, which is the total of all costs incurred in acquiring the asset and all other incidental costs involved in bringing the asset into its working condition. When the business concern itself manufactures some assets, the cost of an asset will mean its production cost, which includes a reasonable proportion of direct costs and interest on capital borrowed to finance production.

2. Residual or scrap value of the asset

Determination of residual value of an asset is normally a difficult task. If such value is considered insignificant, it is normally regarded as nil. On the contrary, if the residual value is likely to be significant, it is estimated at the time of acquisition or at the time of subsequent revaluation of the asset. One of the bases 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.

3. Expected useful life of the asset

Determination of the useful life of a depreciable asset is a matter of estimation and is normally based on various factors including experience with similar types of assets.

Usually the useful life of a depreciable asset is shorter than its physical life.

  1. It is pre-determined by legal or contractual limits, such as the expiry dates of related leases.
  2. It is directly governed by extraction or consumption.
  3. It is dependent on the extent of use and physical determination on account of wear and tear, which again depends on operational factors, such as the number of shifts for which the asset is to be used, repairs and maintenance policy of the entity etc. and
  4. It is reduced by obsolescence arising out of.
    • technological changes
    • improvement in production process
    • change in market demand for the product or service output of the asset or
    • legal or other restrictions.
7.5 QUANTUM OF DEPRECIATION

The quantum of depreciation to be provided in an accounting period involves the exercise of judgment by management in the light of technical, commercial, accounting and legal requirements and accordingly may need periodical review. If it is considered that the original estimate of useful life of an asset requires any revision, the unamortised depreciable amount of the asset is charged to revenue over the revised remaining useful life.

In fact, the quantum of depreciation to be provided in the accounts depends on a number of factors, which include the following:

  • The cost of the asset
  • The estimated working life of the asset
  • The estimated scrap value of the asset
  • The risk of obsolescence
  • Income tax rule regarding depreciation

Prior to Companies (Amendment) Act 1960, it was not legally compulsory to provide for depreciation before distribution of dividend. Then companies could pay dividend without providing for depreciation in pursuance of judgments in the cases-Lee vs Neuchatel Asphalt Co. Ltd. (1889) and Wilmer vs Mcnamara & Co. Ltd. (1895). However, depreciation is a charge against profit. If it is ignored while paying dividend, capital erosion could not be ruled out. The financial statements of the enterprise are also unlikely to represent a true and fair view of the state of affairs of the enterprise. So, Section 205 has been included in the act requiring every company to make provision for depreciation before payment of dividend. The act has further stipulated that if a company has failed to make provision for depreciation in past year or years, it has to provide for such arrears of depreciation in addition to depreciation for current year before paying dividend. The amount of depreciation must not be less than the amount calculated at the rates specified in Schedule XIV, which has been inserted by the Companies (amendment) Act 1988.

However, the act has given the central government power to allow a company to declare dividend without providing for depreciation, where it is necessary to pay dividend in the public interest. It is important to note that absence in the Schedule XIV of any rate of depreciation on an asset or circular of the central government in this regard will not spare a company for non-provision of depreciation before payment of dividend. In this case it will be the obligation of the company to approach the central government for approval of the basis of depreciation.

However, if the book value of an asset has already been reduced to five percent or less to its original cost, it will not be statutorily necessary to make provision for depreciation.

Provisions of the Companies Act regarding quantum of depreciation are as follows:

  1. Schedule XIV of the Act specifies the rates of depreciation for various categories of assets. The schedule specifies rates for straight-line method and written-down method separately and the company is at liberty to adopt rates under any method.
  2. If there is any addition to assets during the financial year, depreciation should be calculated on pro-rata basis from the date of such addition. Similarly if any asset is sold, discarded or demolished during the financial year, depreciation should be provided up to the date on which the asset is sold, discarded or demolished.
  3. Schedule XIV also provides separate depreciation rates for double-shift and tripleshift machinery working under both straight-line method and written down value method.
  4. The Act requires a company to make provision for depreciation arrears along with current year’s depreciation if it wants to pay dividend during the year.
  5. The amount of depreciation to be calculated at the rates specified in the schedule is to be viewed as minimum. If higher amount of depreciation becomes justified on the basis of bonafide technological evaluation, such higher amount may be provided with proper disclosure by way of a note forming part of annual accounts.
  6. Shortfall or non-provision of depreciation should be properly disclosed by way of note in pursuance of Part II of Schedule VI of the Companies Act.
  7. Apart from the written-down value method and straight-line method, depreciation can be charged on any other basis approved by the central government. Such method should, however, write off at least 95 percent of the original cost of the asset on the expiry of the specified period.
7.6 DISTINCTION BETWEEN DEPRECIATION AND AMORTISATION

Depreciation is the process of allocation of cost of fixed assets to successive profit and loss account over its useful life. The purpose of such allocation is to recover gradually the amount of capital invested in the asset so that the same can be replaced at the end of its life without further infusion of capital.

On the other hand, intangible assets, such as goodwill, trade marks and patents are written off over a number of accounting periods covering their estimated useful lives. This periodic write off is called amortisation, which is similar to depreciation of tangible assets. The term amortisation is also used for writing off leasehold premises.

The distinction between depreciation and amortisation is presented in Table 7.1.

 

TABLE 7.1 Distinction between depreciation and amortisation

Points of difference Depreciation Amortisation

1. Definition

The portion of cost of fixed tangible assets written off as expired cost is called depreciation.

The portion of cost of fixed intangible assets written off as expired cost is generally known as amortisation.

2. Residual value

While calculating depreciation, residual value of fixed assets is generally considered.

No residual value is usually considered in determination of periodic amortisation, as most of the intangible assets do not have any residual value.

3. Method

There are different methods of charging depreciation like straight-line method, reducing balance method etc.

Amortisation is generally done on the basis of fixed instalment method.

4. Determination of depreciation

The benefits to be derived out of fixed tangible assets are more or less certain. So the amount of depreciation can be determined more easily and logically.

There involves a high degree of uncertainty regarding the flow of benefit out of intangibles. The value of benefit may range from zero to a substantial amount. So the estimation of amortisation becomes subjective and less logical.

7.7 DIFFERENT METHODS OF DEPRECIATION

There are different methods of depreciation. An entity may adopt any one of the methods of depreciation for its assets. Again, it may adopt different methods of depreciation for different types of assets provided the same are adopted on a consistent basis. Even a company having plants at different locations may adopt different methods of depreciation in the same accounting year. Further it may be noted that depreciation would be charged on pro-rata basis in respect of assets acquired during the financial year.

Different methods of charging depreciation are as follows:

1. Straight line method

This is the most popular method because of its simplicity and consistency. It requires allocation of an equal amount to each period. A fixed amount of the original cost is charged as depreciation every year. Thus, the asset is written down in value each year by the same amount. Under this method, the book value of the asset may be reduced to zero. The amount of depreciation under this method is calculated as:

So, depreciation under this method is the reciprocal of the estimated useful life if the scrap value is considered as nil.

2. Reducing balance method

Under this method, instead of a fixed amount, a fixed rate on the reduced balance of the asset is charged as depreciation every year. Since a constant percentage rate is being applied to the written down value, the amount of depreciation charged every year decreases over the life of the asset. This method assumes that an asset should be depreciated more in earlier years of use than later years because the maximum loss of an asset occurs in the early years of use. The fixed percentage rate, to be applied to the allocation of net costs as depreciation, can be obtained by the following formula:

where

        n = the expected useful life in years

        s = the scrap value

        c = the acquisition cost

It may be noted in this context that the Companies Act, 1956 through Section 205 gives recognition to only the above two methods as the methods of depreciation, which a company can adopt for its accounting purposes.

3. Sinking fund method

Under this method, a fund is created by the regular investment of a fixed amount to accumulate the amount required to replace an asset in the future. This method is based on the concept of present value of money. The previous two methods made no attempt to generate fund for replacement of asset at the end of its useful life, In this method, an amount equivalent to depreciation charged is invested outside the business in securities and are allowed to accumulate at compound interest so as to produce the required amount to replace the asset after a specified period of time.

4. Insurance policy method

This method is similar to sinking fund method but, instead of investing the money in securities, the amount is used in paying premium on a policy taken out with an insurance company. The policy should mature immediately after the expiry of the useful life of the asset. The money that is received from the insurance company is used to replace the asset. Though the interest received is lower than that could be obtained by investing in securities, the risk of loss on realisation of securities can be avoided under this method.

5. Sum of the years’ digit method

This method assumes that the depreciation charge should be more in the early years of the life of the asset. Under this method, the amount of depreciation is calculated by multiplying the cost by a fraction based on the sum of the number of periods of the useful economic life of the asset. Depreciation under this method is computed as follow:

where, sum of years’ digits

6. Annuity method

Under this method, the total amount of depreciation written off during the life of the asset equals the net cost of the asset plus interest calculated on the reducing balance. The basis of this method is to consider the time value of money and opportunity cost of capital locked up in the asset. When an amount is invested in acquiring an asset, the business has to forgo some amount of interest, which could have been earned if the money was employed in the purchase of an income-producing asset. This method of depreciation can be applied to an asset, the life of which will extend to a known period.

7. Revaluation method

This method is applied for the writing-off of a fixed asset to its current market value. To ascertain the real profit for an accounting period, it is necessary to value the assets each year at the end of the period and any decrease in the value as compared with the book value should be charged against profit as depreciation. If any profit is arising out of revaluation of assets, it should be credited to revaluation reserve account, where it will find a place on the liability side of the balance sheet. This revaluation method is a departure from historical cost accounting with regard to the valuation of assets.

8. Depletion method

This method is an accounting for natural resources rather than accounting for depreciation. Wasting assets, such as mines, quarries and the like are examples of such natural resources. The distinguishing feature of these types of assets is that they cannot be depreciated, but can gradually be depleted. Therefore, this method is applied to wasting assets only, where the output for each year depends on the quantity extracted. So, under this method, depreciation is calculated first by making an estimate in advance of the total quantity to be extracted over the life and then the cost of the asset is apportioned over the periods of the assets in proportion to the rate of extraction.

9. Machine hour rate method

This is a method of providing depreciation on annual machine hours in use as compared with total anticipated machine hours over the life of the machine. Under this method, it is necessary to estimate the total effective working hours of the machine during its whole life and to divide this total into the net cost of the machine and thus arriving at an hourly rate of depreciation. So, the depreciation charge per machine hour would be—

But this method ignores an important aspect i.e. depreciation also takes place when a machine is not in use.

10. Depreciation and repair fund method

Under this method, total maintenance costs are estimated for the entire life of the asset and added to its net capital cost to get a composite figure, which is divided by the number of years the asset is expected to last. The resultant amount is considered as depreciation per year. The cost of repairs and maintenance are added to calculate the amount of depreciation in this method. As a result, this method can be considered one of the best methods of equalising the burden of the cost of the assets regarding its acquisition as well as its maintenance.

7.8 DEPRECIATION ACCOUNTING AS PER AS-6

AS-6 (Depreciation Accounting) issued by the Institute of Chartered Accountants of India lays down the accounting principles regarding depreciation. AS-6 provides as follows:

1. Application

The standard is applicable to all depreciable assets except the following:

  • Forests, plantations and similar regenerative natural resources
  • Wasting assets including expenditure on the exploration for and extraction of minerals, oils, natural gas and similar non-regenerative resources
  • Expenditure on research and development
  • Goodwill
  • Livestock

2. Concept of depreciation

A measure of the wearing out, consumption or other loss of value of a depreciable asset arises from the following:

  • Use
  • Effluxion of time
  • Obsolescence.

3. Depreciable assets

The assets which have the following features are termed as depreciable assets:

  • Expected to be used for more than one accounting period
  • Have a limited useful life
  • Are held for use in production or supply of goods and services, for rental to others or for administrative purposes.

4. Useful life

As asset is considered to have a useful life under the following conditions:

  • When the period over which a depreciable asset is expected to be used by the enterprise
  • When the number of production or similar units expected to be obtained from the use of the asset by the enterprise.

5. Depreciable amount

Depreciable amount of a depreciable asset is its historical cost or other amount substituted for historical cost in the financial statements, less the estimated residual value.

6. Depreciation method

The method should be applied consistently from period to period. Any change in the method of depreciation should be made only if the new method has the following:

  • It is required by the statute
  • It is required for compliance with an accounting standard
  • It would result in a more appropriate preparation or presentation of financial statements.

7. Change in the method of depreciation

Depreciation should be recalculated in accordance with the new method from the date of the asset coming to use. The deficiency or surplus should be adjusted in the accounts in the year in which the method of depreciation is changed.

 

Example

A company purchased machinery for Rs. 1,00,000 on 1st April 2002 and followed the diminishing balance method of depreciation @ 15%. At the end of March, 2005 it was decided to follow the straight-line method of depreciation at Rs. 15,000 per year from the very beginning. How should the company give effect to this change in the method of depreciation?

Solution

Total Depreciation from 1.4.2002 to 31.3.2005 under old method

= 38,590

  [Rs. (15,000 + 12,750 + 10,840)]

 

Total Depreciation from1.4.2002 to 31.3.2005 under new method

= 45,000

  [Rs. 15,000 × 3]

Rs. 6,410

So, additional depreciation to be provided in 2004–05 is Rs. 6,410.00 debiting profit and loss account and crediting machinery account.

8. Change in useful life

Useful life of the asset should be reviewed periodically. Where there is a revision, the unamortised depreciable amount should be charged over the remaining useful life.

9. Change in the historical cost

The depreciation on the revised unamortised depreciable amount should be provided prospectively over the residual useful life of the asset.

10. Revaluation of asset

On revaluation, the provision for depreciation should be based on the following:

  • The revalued amount
  • The estimate of the remaining useful life

Example

X Ltd. acquired a building on 1st January 1988 at a cost of Rs. 3,20,000. The useful life of the building was estimated as 50 years and depreciation is provided on a straight-line basis. The building was revalued on 30th June 2005 for Rs. 8,40,000. Assuming no change in the remaining useful life, calculate the surplus on revaluation and depreciation to be charged in the profit and loss account of 2005.

Solution

Surplus on revaluation

Revaluation on 30th June 2005

  = Rs. 8,40,000

Net book value at 30th June 2005

  = Rs. 2,08,000

 

Surplus   = Rs. 6,32,000

This surplus of Rs. 6,32,000 should be credited directly to revaluation reserve as per AS-10.

Depreciation to be charged to the profit and loss account of 2005

Up to 30.06.2005, depreciation will be calculated on original value and from 1.7.2005 it is to be calculated on revalued figure.

(a) On historical cost (up to 30.6.2005)

= (Rs. 3,20,000/50) × ½ = 3,200

(b) On revalued amount [1.7.2005 to 31.12.2005]

= (Rs. 8,40,000/32.5) × 17.5 = 12,923

 

Total = 16,123

7.9 ACCOUNTING DISCLOSURE REQUIREMENT

Clause 3(iv) of Part-II of Schedule VI to the Companies Act, 1956 provides that the profit and loss account must disclose the amount of depreciation, renewals and diminution in the value of fixed assets. If no provision has been made for depreciation in respect of a particular asset, the fact that no provision has been made should be stated and the quantum of arrears depreciation computed in accordance with Section 205(2) should be disclosed by way of a note.

The form of the balance sheet prescribed under the Companies Act, 1956 (Schedule VI Part (I)) further requires that total depreciation written off or provided in respect of each asset should be disclosed.

AS-6 requires the following information to be disclosed in the financial statements:

  • The historical cost or other amount substituted for historical cost of each class of depreciable assets
  • Total depreciation for the period for each class of assets, and
  • The related accumulated depreciation

It also requires disclosure of information in the financial statements along with the disclosure of other accounting policies— the depreciation methods used, and depreciation rates or the useful life of the assets, if they are different from the principal rates specified in the schedule governing the enterprise.

7.10 LEGAL NECESSITY OF PROVISION FOR DEPRECIATION

On account of the provision under Section 205 that no dividend shall be declared except out of profit arrived at after providing for depreciation in accordance with the provisions of the Act, it becomes obligatory for every company distributing dividend to make a provision for depreciation.

Sub-section (2) of Section 205 prescribes different methods that may be adopted for computing the amount of depreciation. These can be summarised as follows:

1. Method as per Income Tax Act

The charge on account of depreciation may be calculated in the manner required by Section 350, i.e. at the rates prescribed for different assets by the Income-Tax Act, 1961 and the rules framed there on in respect of depreciation.

2. Amount to be depreciated

It may be calculated at a rate arrived at by dividing 95% of the original cost of the asset to the company, by the number of years at the end of which 95% of its original cost has been provided for as depreciation.

3. Other methods as approved by central government

The provision for depreciation may be made on any other method approved by the central government, which has the effect of writing off by way of depreciation 95% of the original cost to the company of each depreciable asset at the expiry of the specified period.

4. Where no rate is available

If a company possesses a depreciable asset for which no rate for depreciation has been prescribed by the Income Tax Act, 1961 or the rules framed there on, the amount of depreciation should be computed on such basis as the central government may approve, either by any general order published in the official gazette or any special order in particular case.

7.11 PROVISION FOR DEPRECIATION FOR PAST YEARS

The provisions as contained in Section 205(1) prescribes that if a company has not provided for depreciation for any previous financial year or years ending after 28.12.1961 (the date when the Companies (Amendment) Act came into force), it shall, before declaring or paying dividend, provide for such depreciation

  • either out of that financial years’ profit, or
  • out of the profits of any other previous financial year or years.

There are, however, two exceptions to this rule.

  1. The profits of financial year or years ended before 28.12.1960 may be distributed even though in arriving at these profits, no depreciation in respect of past years had been provided.
  2. A company may be permitted by the central government, if it is thought necessary, to pay dividend for any financial year without first providing for depreciation for that year or for any earlier years. The central government, would, however, exempt a company only if it finds that such a distribution is necessary in the public interest [Section 205(1)(c)].
7.12 DEPRECIATION ON LOW VALUE ITEMS

The Department of Company Affairs, Ministry of Law, Justice and Company Affairs, Government of India, issued a notification during December, 1993, which has been inserted as Notes No. 8 in Schedule XIV to the Companies Act, 1956 that “Notwithstanding anything contained in the schedule, depreciation on assets, whose actual costs does not exceed Rs. 5,000 shall be provided @100%. However, in respect of the fixed assets acquired prior to December, 1993 alternative basis of computation of depreciation is permitted.”

But Note 4 to the Schedule XIV requires that, where during any financial year any addition has been made to any asset, the depreciation on such asset should be calculated on a pro-rata basis from the date of such additions. As Note 8 to Schedule XIV prescribes the rate of depreciation of 100%, pro-rata depreciation should be charged on addition of the said low value items of fixed assets also. However, the company can write off fully low value items on the consideration of materiality. Where, such an accounting policy is followed by a company, the same should be properly disclosed in the accounts.

7.13 DEPRECIATION ON WASTING ASSETS

In terms of the decision in the case Lee vs Neuchatel Asphalte Co. Ltd. (1889), there does not appear any necessity to provide depreciation on wasting assets like mines, quarries etc. In the present day context, however, it is highly doubtful whether the principle propounded in the above case would hold good.

Wasting assets exhaust by working and necessarily involve depletion of the capital employed on such assets. It is, therefore, necessary with a view to maintain the capital employed, a charge for such depletion for ascertaining a true and fair view of the financial statements. Also according to the opinion of the company law board, depreciation on wasting assets is a necessary charge for arriving at the true and fair picture of the profit and loss account and balance sheet.

7.14 CHANGE IN THE METHOD OF DEPRECIATION

According to Sec. 205(2) and 350 of the Companies Act, 1956, two methods of charging depreciation namely straight-line method and reducing balance method have been recognised. However, a company is also allowed to follow any other method of charging depreciation duly approved by the central government. Whatever method of depreciation is followed by a company, it should be followed consistently. Consistency in the method is necessary to ensure comparability of the results of the operations of the enterprise from period to period. It is to be noted that Companies Act, 1956 does not restrain a company to change the method of depreciation.

However, AS-6 issued by the Institute of Chartered Accountants of India has suggested the change in the method of depreciation only when any of the following hold:

  1. The change is required by the statute or for compliance with an accounting standard.
  2. The change in the method of depreciation will ensure more appropriate presentation of financial statements.

If the change in the method of depreciation has to be effected due to any of the above reasons, following procedures should be observed:

  1. The change in the method should be implemented with retrospective effect. In other words, depreciation should be recalculated in accordance with the new method from the date of the asset coming into use.
  2. The adjustment for excess or short depreciation should be treated as prior period and extra ordinary item and should be reflected in income statement accordingly.
  3. The change in the method of depreciation should be treated as change in accounting policy and should be disclosed accordingly.
7.15 AUDITOR’S DUTY AS REGARDS DEPRECIATION

Apart from fixed assets in respect of which depreciation must be provided, it also has to be provided on semi-permanent assets, e.g. patents, trade marks etc. Since the auditor is not in a position to estimate the working life of a majority of them, for this he has to rely on the opinion of persons who have a technical knowledge of the assets. He must, however, satisfy himself that an honest attempt has been made to estimate the working life of each asset, that the total provision for depreciation is adequate and that the method adopted for determining the amount to be written off is properly disclosed in the profit and loss account and the balance sheet.

In part III of Schedule VI of the Companies Act, it is provided that any amount written off as depreciation is to be regarded as a provision, but any amount so written off, which is in excess of the amount, to which in the opinion of the directors is reasonably necessary for the purpose, to be regarded as a ‘reserve’. The amount should be shown as a reserve under the head “reserves and surplus” on the liabilities side of the balance sheet. It is the duty of the auditor to ensure himself that the above provisions are being followed in maintaining depreciation accounting.

So, the duties of an auditor in connection with depreciation can be stated as follows:

  1. The auditor should ensure which method of depreciation, i.e. whether straight-line, method or reducing balance method as stipulated in Schedule XIV to the Companies (Amendment) Act 1988 is being followed by the company.
  2. The auditor should check that depreciation has been provided at the rates not less than the rates specified in Schedule XIV to the Companies (Amendment) Act 1988.
  3. He should see that if any other method of depreciation is in use, it has got the approval of the Central Government.
  4. He should also make sure that the method of depreciation and the rate of depreciation, which are not in accordance with Schedule XIV, have been duly disclosed.
  5. The auditor should ensure that if an asset is sold, discarded, demolished or destroyed, the excess of written down value over its sale proceeds or its scrap value has been written off in the financial year in which it is sold, discarded, demolished or destroyed.
  6. The auditor should ensure that the provision for depreciation on additions, deletions etc. during the accounting year have been made on pro rata basis.
  7. He should check the extra shift depreciation for double shift or triple shift, working has been computed in respect of plant and machineries in proportion of the number of days the company worked double shift or triple shift, as the case may be, bears to the total number of normal working days during the year.
  8. The auditor should see that dividend has been declared only out of profits arrived at after provision for depreciation.
  9. He should ensure that the amount of depreciation written off has been clearly disclosed in the profit and loss account.
  10. He should see that the accounting policy of the company has clearly stated the method of depreciation in use.
  11. The auditor should satisfy himself that adequate amount of depreciation has been provided. If he is not satisfied with the adequacy of amount of depreciation, he will persuade the management to make further provision for depreciation.
  12. He should see the same method of charging depreciation is being followed year after year. If there is any change in the method of depreciation he will enquire into the reason and satisfy himself with its justification.
  13. He will see that excess depreciation provided so far has been transferred to reserve and shown under the head ‘reserves and surplus’ on the liabilities side of the balance sheet.
  14. The auditor should check that the following information has been disclosed in the financial statements:
    1. The historical cost or other amount substituted for historical cost of each class of depreciable assets
    2. Total depreciation for the period for each class of assets
    3. The related accumulated depreciation
7.16 LEGAL VIEWS AS REGARDS DEPRECIATION

Decisions taken in different legal cases reflect the legal view regarding depreciation. Some such cases are summarised below.

Case Study

  1. Case: Wilmer vs McNamara Co. Ltd. (1895)

    Legal view: A company could not be restrained from declaring a dividend out of current profits merely because no provision had been made for the depreciation on fixed assets.

     

  2. Case: Verner vs General Commercial Investment Trust Ltd. (1894)

    Legal view: A Trust company may not make good the loss of capital. Fixed capital may be sunk and lost, yet the excess of current receipt must be kept up.

     

  3. Case: Bolton vs Natal Land Colonisation Co. Ltd. (1891)

    Legal view: A company may declare a dividend out of current profits without necessarily making good the loss of capital.

     

  4. Case: Lee vs Neuchatel Asphalte Co. Ltd. (1889)

    Legal view: Subject to the provisions in the articles of association, a company may distribute dividend without providing for depreciation on its wasting assets.

POINTS TO PONDER
  • “Depreciation is a measure of the wearing out, consumption or other loss of value of depreciable assets arising from use, effluxion of time, obsolescence through technology and market change”: AS-6.
  • Depreciable amount of a depreciable asset is its historical cost or other amount substituted for historical cost in the financial statement less the estimated residual value.
  • The purposes for which depreciation is provided include keeping the capital intact, ascertaining the cost accurately, charging the initial costs against earnings and preparing true and fair statements of accounts.
  • Depreciation is caused basically for two factors: physical factors and economical factors i. e. directly through deterioration and indirectly through obsolescence.
  • Cost of the assets, its scrap value and the expected useful life are the bases of charging depreciation.
  • The quantum of depreciation depends on a number of factors, which include the cost of the asset, the estimated working life of the asset, the estimated scrap value, the risk of obsolescence and the income tax rule regarding depreciation.
  • Prior to the Companies Act, 1960 it was not legally compulsory to provide for depreciation before distribution of dividend. At present, according to Section 205 of the Companies Act requires that every company should make provision for depreciation before payment of dividend.
  • Different methods of charging depreciation include straight-line method, reducing balance method, sinking fund method, insurance policy method, sum of year’s digits method, annuity method, revaluation method, depletion method, machine hour rate method, and depreciation and repair fund method.
  • The historical cost or the amount substituted for historical cost, total depreciation for the period and accumulated depreciation of each class of assets should be disclosed in the financial statements.
  • Whatever method of depreciation is followed by a company, it should be followed consistently. The change in the method of depreciation is permissible if it is required by the statute or will ensure better presentation of financial statements.
  • The auditor should ensure that the company is following the method of depreciation as stipulated in Schedule XIV of the Companies Act.
  • He should also make sure that the method and the rate of depreciation have been duly disclosed.
  • The auditor should ensure that the provision for depreciation on additions, deletions etc. during the accounting year have been made on pro-rata basis.
  • He should see the same method of charging depreciation is being followed year after year.
  • He should also ensure that excess depreciation provided has been transferred to reserve and shown under the head ‘reserves and surplus’ on the liabilities side of the balance sheet.
REVIEW QUESTIONS

Short-answer Questions

  1. What do you mean by the term ‘depreciation’?
  2. Is it necessary to make provision for depreciation?
  3. State the main factors to be considered for determining the amount of depreciation?
  4. Is it legally compulsory to charge depreciation on assets?
  5. Discuss the provisions of the Companies Act regarding arrears depreciation.
  6. Is there any statutory necessity to make disclosures of depreciation in company accounts?
  7. What are the provisions of the Companies Act regarding depreciation on low value items?
  8. Is depreciation on wasting assets a necessary charge for arriving at the true and fair picture of the financial statements of a company?

Essay-type Questions

  1. Is it absolutely necessary that depreciation should be provided for before profits are distributed as dividend? What are the provisions of the Companies Act, 1956 regarding the quantum of depreciation to be provided for in the annual accounts?
  2. A limited company wants to change its method of providing for depreciation from reducing balance method to fixed instalment method. Can the company do so? If so, explain as to how? In this context, discuss the view of AS-6 of ICAI and auditor’s duties in regard to depreciation.
  3. An enterprise purchases an item of machinery on 1.4.2002 for Rs. 1,00,000. It depreciates this item at the rate of 10% per annum on straight-line basis. On 1.4.2005, the enterprise decides to change the method of depreciation from straight-line to written down value. The applicable rate under the new method is 15%. How should the enterprise give effect to this change in the method of depreciation?
  4. Discuss the accounting treatment of the following:
    1. Change in the method of depreciation
    2. Change in the value of the asset
  5. A limited company wishes to change over from the written down value method of providing depreciation which it has hitherto been following to the straight-line method. The company seeks your opinion on this proposed action. Advise.