Compendium of Opinions — Vol. XXVII

Query No. 2
Subject: Depreciation on buildings, etc., constructed on leasehold land.

A. Facts of the Case

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.

  1. 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.

B. Query

  1. 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

  1. 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.
  2. 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
    as:
    (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.”

  3. 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
    years.
  4. 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
    12 below.
  5. 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.

D. Opinion

  1. 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
    above.

 

Revised Schedule VI of Companies Act, 1956

Ministry of Corporate Affairs (MCA) had revised Schedule VI of Companies Act, 1956 and notified the same on March 1, 2011. The revised Schedule VI is applicable to all the  companies from April 1, 2011 except the following:

  • Insurance companies
  • Banking companies
  • Companies engaged in the generation or supply of electricity
  • Any other class of company for which a form of Balance Sheet and Profit and Loss account has been specified in or under any other Act

The revised Schedule VI introduces many new concepts and disclosure requirements and does away with several statutory disclosure requirements of the previous Schedule VI. Revised Schedule VI allows a considerable amount of flexibility compared to its predecessor, it also casts a greater responsibility on the management to exercise judgment in balancing the extent of information presented. In preparing the Financial Statements including the notes to accounts, the Revised Schedule VI, requires that a balance should be maintained between providing excessive detail that may not assist users of financial statements and not providing important information as a result of too much aggregation.

Key changes related to disclosure requirements of Balance sheet:

  1. The revised Schedule VI lays down a format for the presentation of P&L account. This format of P&L account does not list any appropriation item on its face. The classification of expenses is based on their nature and not on their function.
  2. In addition to specific disclosures prescribed in the P&L account, any item of income or expense which exceeds 1% of the revenue from operations or Rs.100,000, whichever is higher, needs to be disclosed separately.
  3. Net exchange gain/loss on foreign currency borrowings to the extent considered as an adjustment to interest cost needs to be disclosed separately as a finance cost.
  4. Details pertaining to aggregate number and class of shares allotted for consideration other than cash, bonus shares and shares bought back will be disclosed only if such an event has occurred during a period of 5 years immediately preceding the balance sheet date.
  5. Any debit balance in P&L account will be disclosed under the head “Reserves and surplus.” Earlier, any P&L debit balance carried forward after deduction from uncommitted reserves was required to be shown on the asset side of the balance sheet.
  6. Specific disclosures have been prescribed for the share application money. The application money not exceeding the issued capital and to the extent not refundable has to be shown separately on the face of the balance sheet. The amount in excess of subscription, or if the requirements of minimum subscription are not met, will be shown under “Other current liabilities”.
  7. Capital advances are now required to be presented separately under the head “Loans &
    advances” rather than as part of “capital work-in-progress” or “fixed assets”.
  8. Tangible assets under lease are required to be separately specified under each class of asset.
  9. In the earlier Schedule VI, details of capital commitments were required to be disclosed. Under the revised Schedule VI, all commitments need to be disclosed.
  10. The revised Schedule VI requires all defaults in repayment of loans and interest to be specified in each case.
  11. The revised Schedule VI introduces a number of other additional disclosures. Key examples are:
    1. Rights, preferences and restrictions attaching to each class of shares including restrictions on the distribution of dividends and the repayment of capital.
    2. Terms of repayment of loans and period.
    3. In each class of investment, details regarding names of the bodies corporate, indicating separately whether such bodies are (i) subsidiaries, (ii) associates, (iii) joint ventures, or (iv) controlled special purpose entities, in whom investments have been made and the nature and extent of the investment made in each such body corporate (showing separately partly-paid investments).
    4. Regarding investments in the capital of partnership firms, the names of the firms with the names of all their partners, total capital and the shares of each partner. Aggregate provision for diminution in value of investments (separately for current and long-term investments).

Key changes related to disclosure requirements of Profit &Loss account:

  1. The revised Schedule VI lays down a format for the presentation of P&L account. This format of P&L account does not list any appropriation item on its face. The classification of expenses is based on their nature and not on their function.
  2. In addition to specific disclosures prescribed in the P&L account, any item of income or expense which exceeds 1% of the revenue from operations or Rs.100,000, whichever is higher, needs to be disclosed separately.
  3. Net exchange gain/loss on foreign currency borrowings to the extent considered as an adjustment to interest cost needs to be disclosed separately as a finance cost.

Balance Sheet Format for Illustration

S.No. Particulars Note No. 2012 2011
I EQUITY AND LIABILITIES
 1 Shareholder’s Fund
(a) Share Capital XX XX
(b) Reserves and Surplus XX XX
(c) Money received against share warrants XX XX
 2 Share application money pending allotment XX XX
 3 Non-current liabilities
(a) Long-term borrowings XX XX
(b) Deferred tax liabilities (Net) XX XX
(c) Other Long term liabilities
(d) Long-term provisions XX XX
 4 Current liabilities
(a) Short-term borrowings XX XX
(b) Trade payables XX XX
(c) Other current liabilities XX XX
(d) Short-term provisions XX XX
XX XX
S.No. Particulars Note No. 2012 2011
II ASSETS
 1 Non Current Assets
(a) Fixed Assets XX XX
Tangible assets XX XX
Intangible assets XX XX
Capital Work in Progress XX XX
Intangible assets under development XX XX
(b) Non Current Investments XX XX
(c) Deferred Tax assets (Net) XX XX
(d) Long term loans & advances XX XX
(e) Other current Assets XX XX
 2 Current Assets
(a) Current Investments XX XX
(b) Inventories XX XX
(c) Trade receivables XX XX
(d) Cash & cash equivalents XX XX
(e) Short term loans & advances XX XX
(f) Other current assets XX XX
XX XX

Profit and Loss Account Format for Illustration

 Particulars Note No. 2012 2011
 Revenue from operations
 Other Income
 Total Revenue
 Expenses:
 Cost of material consumed
 Purchase of stock in trade
 Changes in FG, WIP and stock in trade
 Employee benefits expenses
 Depreciation and amortization expense
 Other expense
 Total Expenses
 Profit before exceptional and extraordinary items and tax
 Less: Exceptional and extraordinary items
 Profit Before Tax
 Tax expense : Current Tax
Deferred Tax
 Profit/(Loss) for the period
 Earnings per equity share
(1) Basic
(2) Diluted