Gaps in GAAP

Background In the 1956 Act, Schedule XIV prescribed depreciation rates for various assets, both under the SLM method and WDV method. The purpose of prescribing minimum rates was to ensure that dividends are declared out of profits determined after providing for minimum depreciation. AS-6 on Depreciation Accounting laid out principles for depreciation for the purposes of financial statements. Under this standard, depreciation under Schedule XIV is counted as minimum. Higher depreciation was required to be provided for, if based on management’s assessment, the useful life of asset was lower than that laid out in Schedule XIV.

Initially, Schedule II of the 2013 Act laid out useful lives for assets, which were to be compulsorily used as minimum rates except by Ind-AS companies. Pursuant to an amendment to Schedule II this requirement was removed. Rather, the provision now reads as under:

“(i) The useful life of an asset shall not be longer than the useful life specified in Part ‘C’ and the residual value of an asset shall not be more than five per cent of the original cost of the asset:

Provided that where a company uses a useful life or residual value of the asset which is different from the above limits, justification for the difference shall be disclosed in its financial statement.”

From the use of word “different”, it seems clear that both higher and lower useful life and residual value are allowed. However, a company needs to disclose in the financial statements justification for using higher/lower life and/ or residual value.

Transitional provisions
With regard to the adjustment of impact arising on the first-time application, the transitional provisions to Schedule II state as below:

“From the date Schedule II comes into effect, the carrying amount of the asset as on that date:
(a) Will be depreciated over the remaining useful life of the asset as per this Schedule,
(b) A fter retaining the residual value, will be recognised in the opening balance of retained earnings where the remaining useful life of an asset is nil.”

Proviso to Schedule II states that if a company uses a useful life or residual value of the asset which is different from limit given in the Schedule II, justification for the difference is disclosed in its financial statements. How is this proviso applied if notified accounting standards, particularly, AS 6 is also to be complied with?

AS 6 states that depreciation rates prescribed under the statute are minimum. If management’s estimate of the useful life of an asset is shorter than that envisaged under the statute, depreciation is computed by applying the higher rate. The interaction of the above proviso and AS 6 is explained with simple examples:

(i) T he management has estimated the useful life of an asset to be 10 years. The life envisaged under the Schedule II is 12 years. In this case, AS 6 requires the company to depreciate the asset using 10 year life only. In addition, Schedule II requires disclosure of justification for using the lower life. The company cannot use 12 year life for depreciation.

(ii) T he management has estimated the useful life of an asset to be 12 years. The life envisaged under the Schedule II is 10 years. In this case, the company has an option to depreciate the asset using either 10 year life prescribed in the Schedule II or the estimated useful life, i.e., 12 years. If the company depreciates the asset over the 12 years, it needs to disclose the justification for using the higher life. The company should apply the option selected consistently.

Similar logic will apply for the residual value.

Whether revenue based amortisation under Schedule II can be applied to intangible assets other than toll roads?

Amended Schedule II reads as follows “For intangible assets, the provisions of the accounting standards applicable for the time being in force shall apply except in case of intangible assets (Toll roads) created under BOT, BOOT or any other form of public private partnership route in case of road projects.” The amendment clearly suggests that revenue-based amortisation applies to toll roads. The same method cannot be used for other intangible assets even if they are created under PPP schemes, such as airport infrastructure.

Is component accounting under Schedule II mandatory? Is it applied retrospectively or prospectively? How are transitional provisions applied in the case of component accounting?

Component accounting requires a company to identify and depreciate significant components with different useful lives separately. For example, in the case of a building, the base structure or elevators or chiller plant may be identified as separate components. The application of component accounting is likely to cause significant change in the measurement of depreciation and accounting for replacement costs. Currently, companies need to expense replacement costs in the year of incurrence. This was causing a volatility. Under component accounting, companies will capitalise these costs as a separate component of the asset, with consequent expensing of net carrying value of the replaced part. Component accounting would comparatively result in a more stable P&L account.

Schedule II clarifies that the useful life is given for whole of the asset. If the cost of a part of the asset is significant to the total cost of the asset and the useful life of that part is different from the useful life of the remaining asset, the useful life of that significant part will be determined separately. This implies that component accounting is mandatory under Schedule II. In contrast, AS 10 gives companies an option to follow the component accounting; it does not mandate the same.

Materiality in the context of component accounting is decided on an asset by asset basis, and how significant the cost of component is, compared to cost of the total asset. This will call for judgement to be exercised. Component accounting is required to be done for the entire block of assets as at 1st April, 2014. It cannot be restricted to only new assets acquired after 1st April 2014.

If a component has zero remaining useful life on the date of Schedule II becoming effective, i.e., 1st April 2014, its carrying amount, after retaining any residual value, will be charged to the opening balance of retained earnings. The carrying amount of other components, i.e., components whose remaining useful life is not nil on 1st April 2014, is depreciated over their remaining useful life.

In case of revaluation of fixed assets, companies are currently allowed to transfer an amount equivalent to the additional depreciation on account of the upward revaluation of fixed assets from the revaluation reserve to P&L. What is the position under Schedule II?

Under Schedule XIV, depreciation was to be provided on the original cost of an asset. Considering this, the ICAI Guidance Note on Treatment of Reserve Created on Revaluation of Fixed Assets allowed an amount equivalent to the additional depreciation on account of the upward revaluation of fixed assets to be transferred from the revaluation reserve to the P&L.

In contrast, schedule II to the 2013 Act requires depreciation to be provided on historical cost or the amount substituted for the historical cost. therefore, in case of revaluation, a company needs to charge depreciation based on the revalued amount. Consequently, the ICAI Guidance note, which allows an amount equivalent to the additional depreciation on account of upward revaluation to be recouped from the revaluation reserve, will not apply.

Schedule II to the 2013 Act is applicable from 1 April 2014. Section 123, which is effective from 1 April 2014, among other matters, states that a company cannot declare dividend for any financial year except out of (i) profit for the year arrived at after providing for depreciation in accordance with Schedule II, or
(ii)    … Given this background, is the applicability of Schedule II preponed to financial statements for even earlier periods if they are authorised for issuance post 1st April 2014?

As per MCA announcement, Schedule II is applicable from 1st april 2014.

Schedule II contains depreciation rates in the context of Section 123 dealing with “Declaration and payment of dividend” and companies use the same rate for the preparation of financial statements as well. Additional depreciation may be provided, based on assessment of useful life as per AS 6.

One view is that for declaring any dividend after 1st April 2014, a company needs to determine profit in accordance with Section 123. this is irrespective of the financial year-end of a company. Hence, a company uses Schedule ii principles and rates for charging depreciation in all financial statements finalised on or after 1st April 2014, even if these financial statements relate to earlier periods.

The second view is that based on the General Circular 8/2014, depreciation rates and principles prescribed in Schedule II are relevant only for the financial years commencing on or after 1st  april 2014. the language used in the General Circular 8/2014, including reference to depreciation rates in its first paragraph, seems to suggest that second view should be applied. For financial years beginning prior to 1st april 2014, depreciation rates prescribed under the Schedule XiV to the 1956 act will continue to be used.

In the author’s view, based on the clear intent of the regulator, second view is the preferred approach for charging depreciation in the financial statements.

How do the transitional provisions apply in different situations? In situation 1, earlier Schedule XIV and now Schedule II provide a useful life, which is much higher than AS 6 useful life. In situation 2, earlier Schedule XIV and now Schedule II provide a useful life, which is much shorter than AS 6 useful life.

In situation 1, the company follows aS 6 useful life under the 1956 as well as the 2013 Act. In other words, a status quo is maintained and there is no change in depreciation. hence, the transitional provisions become irrelevant. in situation 2, when the company changes from Schedule XiV to Schedule ii useful life, the transitional provisions would apply. for example, let’s assume the useful life of an asset under Schedule XiV, Schedule ii and as 6 is 12, 8 and 16 years respectively. the company changes the useful life from 12 to 8 years and the asset has already completed 8 years of useful life, i.e., its remaining useful life on the transition date is nil. in this case, the transitional provisions would apply and the company will adjust the carrying amount of the asset as on that date, after retaining residual value, in the opening balance of retained earnings. if, on the other hand, the company changes the useful life from 12 years to 16 years, the company will depreciate the carrying amount of the asset as on 1st April 2014 prospectively over the remaining useful life of the asset. this  treatment  is  required  both  under  the  transitional provisions to Schedule ii and AS 6.

How are tax effects accounted for adjustments made to retained earnings required by transitional provisions?

Attention is invited to the ICAI announcement titled, “Tax effect of expenses/income adjusted directly against the reserves  and/or  Securities  Premium  Account.”  the announcement, among other matters, states as below:

“… Any expense charged directly to reserves and/or Securities Premium Account should be net of tax benefits expected to arise from the admissibility of such expenses for tax purposes. Similarly, any income credited directly to a reserve account or a similar account should be net of its tax effect.”

Considering the above, it seems clear that the amount adjusted to reserves should be the net of tax benefit, if any.