‘Useful life’ for dividends

Companies Bill 2012 permits a company to declare dividend only out of profits remaining after providing for depreciation under Schedule II.

Unlike the Companies Act, 1956, which specifies the minimum rates of depreciation to be provided by a company, the Bill requires systematic allocation of the depreciable amount of an asset over its useful life. ‘Useful life’ may be considered as the period over which an asset is available for use by the company, or as the number of production units the company expects to obtain from the asset.

While the Act also required companies to provide depreciation prior to declaration of dividends, the new requirements of the Bill may impact the profits computed by a company and the quantum of profits available for distribution to shareholders.

Useful life

The Bill specifies benchmark useful lives for several assets which are generally shorter than what is currently indicated under the Act. For example, the useful life has been reduced for general plant and machinery from 20 to 15 years; general furniture and fittings from 15 to 10 years; and computers from six to three years. This may see companies depreciating their assets over a shorter period in many instances, which, in turn, will reduce the availability of profits for distribution to shareholders.

However, the Bill will permit a specified class of companies to apply a longer or shorter useful life for depreciating assets if it is justifiable and based on technical and other indicators. This will give companies flexibility to estimate an appropriate useful life. With this flexibility, some companies may be able to justify a longer useful life and, therefore, have a lower depreciation charge in their profit or loss account. For example, a company may determine, based on technical and other indicators, that the useful life of its general plant and machinery is 25 years, which is not only higher than the benchmark 15 years but also the current maximum of 20 years.

Component accounting

The Bill also introduces the requirement for a ‘component approach’, which is in line with international practices. It requires companies to separately depreciate parts of an asset that are significant and have a useful life different from the useful life of the asset as a whole.

This may be an onerous requirement for capital-intensive companies/ industries due to the effort involved in identifying components and estimating their useful lives for depreciating separately. For example, internationally it is common for airline companies to identify separate components within an aircraft for depreciation, as the useful life of individual components such as the aircraft engine, electronic systems and the airframe may differ.

In cases where significant components are depreciated over a shorter period, there may be a significant impact on the profits available for distribution.

Impact on transition

The Bill provides that on transition to the new requirements, the carrying amount of an asset is depreciated over the remaining useful life determined under the Bill. Where the asset has no remaining useful life, the carrying value would be recognised in the opening reserves.

Thus, for assets that have a shorter useful life as compared to the current lives used for depreciation, a company would need to provide accelerated depreciation.

On the other hand, the depreciation charge will reduce where the estimated useful life is higher than currently used.

The transition provisions may have varied results depending on the new estimates of useful life.

For example, consider a company that is depreciating a 14-year-old asset over 20 years. Assuming that the company determines the revised useful life under the Bill as 15 years, the entire carrying value of the asset (representing six years of depreciation) will be charged off in one year.

On the other hand, if the asset was already 15 years old, the entire carrying value (five years of depreciation) would be charged to the reserves, and not profits.

Re-valued assets

The Bill does not clarify on the accounting treatment for depreciating re-valued assets. ‘Depreciable amount’ has been defined as cost, or other amount substituted for cost, and accordingly indicates that for re-valued assets the re-valued carrying amount should be depreciated over the remaining useful life through the profit or loss account. The Bill does not directly clarify whether the current practice for transferring amounts from the revaluation reserve to the profit-and-loss account, to offset such additional depreciation, is permitted.

In summary, the Bill introduces several changes to the manner in which depreciation should be provided by companies. The resulting impact on reported profits, and profits available for distribution of dividend, needs to be carefully analysed and monitored.

The author is Global Head of Accounting Advisory Services, KPMG in India

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