Query No. 2
Subject: Depreciation on buildings, etc., constructed on leasehold land.
A. Facts of the Case
- A government company has constructed buildings, roads, etc., on leasehold land, which was taken on lease from an Improvement Trust under a lease agreement which was initially for a period of 30 years only. The land allotment letter (a copy of which has been provided by the querist for the perusal of the Committee) indicates that the land shall be used for office and staff colony.
- The querist has stated that under clause 2(b) of the ‘Terms of Transfer in Leasehold Rights of Plots in the Layout of the Improvement Trust’ (a copy of which is provided by the querist for the perusal of the Committee), it has been stated that “the lease shall be renewable at the option of the lessee for further terms of 30 years”. Further, as per the allotment letter, the entire lease premium of Rs. 21 lakh was payable upfront and annual ground rent of 2% of lease premium, i.e, Rs. 42,000 is payable in advance and falls due on 1st June of each year.
- The company has been charging depreciation on the buildings, etc., constructed on the leasehold land @ 1.63% on straight-line method (SLM) as per the rates given in Schedule XIV to the Companies Act, 1956 (the ‘Act’), on the basis of which the useful life works out to be 58 years.
- During the course of audit of accounts of the company for the year 2005-06, the government auditors have raised provisional comment on the issue relating to charging-off of depreciation on buildings, roads, etc., on the leasehold land. Their contention is that the depreciation on the buildings, etc., constructed on leasehold land should be charged over a period of 30 years only (i.e., over the lease period of the land) and not over a period of 58 years (i.e. @ 1.63% on SLM) as specified in the Act and followed by the company. According to them, the rate prescribed under the Act is applicable in respect of assets constructed on freehold land.
- The provisional comment and the management’s reply were as below:
|Audit Memo||Management’s Reply|
Provisional Comment No.1
Profit & Loss Account – Depreciation – Rs.209.00 lakh Buildings, roads, parks and sheds of RJ-IV are constructed on 7.07 hectares of leasehold land taken from the Improvement Trust under two lease agreements entered in the year 1999-2000 for a lease period of 30 years commencing retrospectively from 1983-84. The lease period expires in the year 2014. Depreciation on buildings, roads, parks and sheds is charged at the rate specified under Schedule XIV to the Companies Act, 1956, i.e., @ 1.63%. However, such rates are applicable only in respect of assets constructed on freehold land. All buildings and other structures constructed on leasehold land are to be charged off within the lease period. Due to charging-off of depreciation at rates applicable to assets constructed on freehold landinstead of charging off the cost of the assets within the lease period, depreciation for the year 2005- 06 is understated and profit for the year is overstated by Rs. 9.09 lakh. Further, this has resulted in understatement of depreciation charged and overstatement of previous year’s profit by Rs. 60.05 lakh.
Profit & Loss Account – Depreciation -Rs.209.00 lakh. Buildings of RJ-IV have been constructed on leasehold land taken from the Improvement Trust under lease agreement which is initially for a period of 30 years. Under Clause 2(b) of the “Terms of Transfer in Leasehold Rights of Plots in the Layout of the Improvement Trust” which was forwarded by the Secretary, Improvement Trust at the time of allotment of land, it has been stated that “the lease shall be renewable at the option of the lessee for further terms of 30 years”. As such, the company has the option to renew the lease for the further period of 30 years. Also, it is the standard practice in case of lease made by Government that normally it is initially made for 30 years and thereafter it is renewed for next term of 30 years. Moreover, the cost of the land, i.e., the lease rent is being amortised regularly over the lease period. Further, the depreciation onbuildings constructed on the leasehold land has been charged consistently at the rate specified in Schedule XIV to the Companies Act, 1956, i.e., @ 1.63% on SLM (depreciable life being 58 years). As such, the contention that there is understatement of depreciation and overstatement of profit for the year 2005-06 and for the earlier years is not correct. In view of the above, the memo may kindly be dropped.
The statutory auditors agreed with the above reply of the management.
- The issue was discussed in detail with the Principal Director of Commercial Audit (the ‘PDCA’). The PDCA agreed with the reply submitted by the company. However, while issuing a nil comment on the accounts, he advised that the matter may be referred to the Expert Advisory Committee of the Institute of Chartered Accountants of India for its opinion.
- The querist has sought the opinion of the Expert Advisory Committee as to whether depreciation charged by the company on buildings, etc., constructed on leasehold land @ 1.63% on SLM as specified in Schedule XIV to the Companies Act, 1956 is correct or it should be charged over a period of 30 years (i.e., the initial term of the lease).
C. Points considered by the Committee
- The Committee, while expressing its opinion, has considered only the issue raised in paragraph 7 above and has not touched upon any other issue arising from the Facts of the Case, such as, amortisation of the lease premium.
- The Committee notes the following paragraphs from Accounting Standard (AS) 6, ‘Depreciation Accounting’, issued by the Institute of Chartered Accountants of India:“5. Assessment of depreciation and the amount to be charged in respect thereof in an accounting period are usually based on the following three factors:
(i) historical cost or other amount substituted for the historical cost of the depreciable asset when the
asset has been revalued;
(ii) expected useful life of the depreciable asset; and
(iii) estimated residual value of the depreciable asset.”
“7. The useful life of a depreciable asset is shorter than its physical life and is:
(i) pre-determined by legal or contractual limits, such as the expiry dates of related leases;
(ii) directly governed by extraction or consumption;
(iii) dependent on the extent of use and physical deterioration 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,
repair and maintenance policy of the enterprise etc.; and
(iv) reduced by obsolescence arising from such factors
(a) technological changes;
(b) improvement in production methods;
(c) change in market demand for the product or service output of the asset; or
(d) legal or other restrictions.
8. 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. …”
“13. The statute governing an enterprise may provide the basis for computation of the depreciation.
For example, the Companies Act, 1956 lays down the rates of depreciation in respect of various
assets. Where the management’s estimate of the useful life of an asset of the enterprise is shorter than
that envisaged under the provisions of the relevant statute, the depreciation provision is appropriately
computed by applying a higher rate. If the management’s estimate of the useful life of the asset is
longer than that envisaged under the statute, depreciation rate lower than that envisaged by the
statute can be applied only in accordance with requirements of the statute.”
- The Committee notes the management’s observations that it is a standard practice in case of leases
made by Government that normally they are initially made for 30 years and thereafter they are
renewed for a further period of 30 years. Having regard to the terms of the lease and the use of the
leasehold land (i.e, office and staff colony), it seems that at the inception of the lease, the company
intends to renew the lease for a further period of 30 years at the expiry of the initial period of 30
- The Committee notes that neither Schedule XIV to the Companies Act, 1956 (the ‘Act’) nor the
main sections, viz., sections 205 and 350 of the Act state that the rates specified in Schedule XIV are
applicable only to the assets constructed on freehold land.
The Committee is of the view that the rates specified in Schedule XIV to the Act are equally
applicable for assets constructed on leasehold land, subject to the considerations stated in paragraph
- From the above, the Committee is of the view that the management should estimate the useful
lives of the relevant assets constructed on the leasehold land on the basis of considerations mentioned
in paragraph 9 above. Thus, the useful life will be the expected period of the lease of the land,
including the expected period of extension which is reasonably certain at the inception of the lease.
The depreciation rate should be worked out on that basis. If the rate so worked out is lower than the
rate specified in Schedule XIV to the Act, the rate specified in Schedule XIV to the Act should be
adopted. A lower rate can be adopted only if permitted by the Central Government in accordance with
the provisions of the Act.
- On the basis of the above, the Committee is of the opinion that depreciation rate for buildings,
etc., constructed on leasehold land should be determined in the manner stated in paragraph 12