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
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
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) The following depreciation accounting procedures and policy have been 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
1846.19
2210.59
2971.82
3821.60
4974.47
39623.89
53630.39
76806.46
101418.41
104632.38
3. Furniture & Fittings & others
332.27
335.98
426.44
525.86
528.63
41802.35
56176.96
80204.72
105765.87
110135.48
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) The following depreciation accounting procedures and policy have been 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
633.08
1106.88
1123.43
1283.66
1323.44
7450.93
7930.02
8669.66
8717.43
8764.00
3. Furniture & Fittings & others
605.59
644.82
1009.24
2416.75
4243.64
8689.60
9681.72
10802.33
12417.84
14331.08
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
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
132.77
167.75
510.95
191.77
182.77
10.78
42.62
98.07
100.74
43.98
121.99
125.13
412.88
91.03
138.79
3. Furniture & Fittings etc.
17.71
44.85
55.95
28.96
18.53
1.95
8.19
21.69
1.84
37.17
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 Standard Deviation and Co-efficient of Variation of the depreciation charged by Selected Public Enterprises on Plant and Machinery during the study period between 1994-95 and 1998-99 (Rs. in lakhs)
Years
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
63644.13
8306.53
75222.31
177.96
24039.74
372.07
18130.52
83.79
37.77%
4.48%
24.10%
47.08%
Source : Annual Reports & Accounts of the selected public enterprises during the study period from 1994-95 to 1998-99.
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 Standard Deviation and Co-efficient of Variation of the depreciation charged by Selected Public Enterprises on Furniture & Fixtures during the study period between 1994-95 and 1998-99 (Rs. in lakhs)
Years
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
988.16
1784.01
429.84
19.03
2403.40
986.75
61.09
14.28
243.22%
55.31%
14.21%
75.04%
Source : Annual Reports & Accounts of the selected public enterprises during the study period from 1994-95 to 1998-99. 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 during the study period between 1994-95 and 1998-99 (Rs. in lakhs)
Years
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
72543.51
11184.49
78817.08
252.34
24718.28
2002.55
18951.70
109.11
34.07%
17.90%
24.05%
43.24%
Source : Annual Reports & Accounts of the selected public enterprises during the study period from 1994-95 to 1998-99.

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
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 during the study period between 1994-95 and 1998-99 (Base Year 1994-95 = 100)
Years
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

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