Our first learning in financial accounting is that profit is an estimate. Profit is an estimate because estimation is at the heart of accrual accounting. Even, in the regime of transaction-based accounting system, profit was an estimate. For example, when an entity recognises revenue from a transaction, it estimates the realisability of the sale proceeds. The accounting system is moving slowly but steadily towards a combination of transaction based accounting and event based accounting. For example, contemporary accounting practices use fair value, as a measurement attribute, more extensively than earlier. Fair value is an opinion. It reflects the perception of the valuer or the active market about the economic impact of events that have already happened or are likely to happen in future. Prices in an active market are considered to be the best estimate of fair value because it is better to rely on the collective wisdom than an individual’s opinion. Market assessment of the value of an asset or liability is also judgemental.
Provisions represent the best estimate of the management. An entity provides liability for an obligation to be settled after a long time after the balance sheet date. For example, it provides for asset retirement obligation. We may provide large number of examples where estimates are based on the perception of the management or an expert or the market.
As we go down the hierarchy of profit, the estimate depends more on the accounting choice and estimates become more subjective. Estimate of gross profit is less subjective than the estimate of earnings before interest, tax, depreciation and amortisation (EBITDA). Estimate of EBITDA is less subjective than net profit, which is generally considered to be distributable profit. Therefore, the amount that is distributable is the most subjective estimate of profit.
Contemporary accounting practices measure net profit without adjusting the same for inflation. Therefore, the amount of net profit presented in the profit and loss account is likely to be higher than the same in real terms. The estimated net profit in real terms is likely to be higher than the surplus measured in terms of physical capital.
If a company, which distributes the total net profit, provides depreciation at an amount lower than the amount of depreciation calculated based on the useful life of assets, it distributes a part of capital. This is so because, at some point in time the balance sheet will recognize some assets, which have been exhausted through use, and thus, will fictitiously, overstate the net worth. The extant schedule XIV provides the depreciation rates for different types of tangible fixed assets. A company has to provide, at the minimum, the amount of depreciation using Schedule XIV rates. A company may provide higher depreciation. Schedule XIV is an attempt to protect the shareholders’ interest from unscrupulous management, which may tempt to artificially estimate a longer useful life than what would be the correct estimate of the same.
In view of the contemporary accounting practices discussed above, it may be argued that there is no need to focus on a single item (depreciation). There are many other tools for earnings management in a system which relies much on estimates based on the management’s perception. Therefore, many believe that the Schedule XIV should be scrapped.
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The exposure draft of the revised schedule XIV is an attempt to balance between the above view and the view that schedule XIV should continue. The revised Schedule XIV (draft) prescribes indicative useful lives of tangible fixed assets and intangible asset with finite useful life. The use of the word indicative implies that companies can charge depreciation at amount lower than the amount calculated as per the rates provided in schedule XIV. This is a significant departure from the present position. However, the word ‘indicative’ may create confusion. In absence of a clear objective of providing indicative useful lives, companies may mechanically use the same to provide for depreciation
The schedule prescribes indicative useful life for intangible assets with finite useful life as ten years.
Ministry of Corporate Affairs should clearly articulate the objective of prescribing indicative useful lives. Does it want to maintain the present position while aligning schedule XIV with the principles stipulated in new set of accounting standards, which are fully convergent with IFRS?