Articles >> Accounting Standard

Introduction

Suddenly, Accounting has become as dynamic a subject as Income Tax. Textbooks on Accounts, which were just re-printed earlier, are revised every year with the advent of new Accounting Standards (AS).

The Institute of Chartered Accountants of India (ICAI) has so far pronounced 28 Accounting Standards (AS) and some more standards are in the making. Not to be left behind, the other associate Institutes of ICAI have also caught up with the game. Thus, The Institute of Company Secretaries of India (ICSI) has issued so far 3 secretarial standards (SS) and The Institute of Cost & Works Accountants of India (ICWAI) has so far issued 4 Cost Accounting Standards (CAS).

Most of the AS issued by ICAI have either very little or no Accounting Implications. The one AS which stands out, as a thorough exception to this statement, is perhaps "AS-22: Accounting for Taxes on Income" popularly called as the standard on Deferred taxes. With the introduction of this AS, the face of the P&L account and the Balance Sheet changes, bringing with it certain serious and unintended implications. The seriousness of the implications could be better judged by the fact that several companies have approached the Courts to bring about a stay on the application of the standard itself or on certain provisions of the standard.

Objective of the Standard

Tax on income is a very important expense in the P & L account. There is always a difference between "Accounting Income (AI)” (Book profit) and "Taxable Income (TI)" for a year. The practice in India till 2001 was to provide for the income tax actually paid in a year and not what would have been payable as per accounting results.

Deferred tax is intended to rectify this anomaly and provide for the income tax on a "matching" basis, i.e., provide tax mostly on the book profit and not what is paid to the government in a year.

The difference between Accounting Income and Taxable Income could be classified into two categories, viz., Permanent Differences and Timing Differences.

Permanent differences (PD) are the differences between AI and TI for a period that originate in one period and do not reverse subsequently. Permanent differences do not give rise to deferred taxes.

Examples of permanent differences:
(a) Deduction u/s. 80 like 80HHC, 80-IB, 80G, etc.;
(b) Donations disallowed;
(c) Weighted deduction available for expenditure on scientific research u/s 35;
(d) 40A(3) disallowance.

Timing Differences (TD) are the differences between AI and TI for a period that originate in one period and are capable of reversal in one or more subsequent periods. Timing differences reflect the excess/shortfall between what is provided for in the books and what the tax authorities allow, but such excess/shortfall is adjusted against profits of future years. Typically, depreciation could differ between the book and the tax figures. Generally, in the initial years of an asset’s life, larger depreciation is allowed by the tax authorities, thereby demanding less tax, but this gets adjusted in the later years.
Examples of Timing differences:
(a) Difference in Depreciation/ Profit or loss on sale of fixed asset;
(b) Deferred Revenue Expenditure / Expenses amortized in the books over a period of years but are allowed for tax purposes wholly in the first year or vice versa;
(c) Section 43B expenditures;
(d) Provision for bad debts not written off from Books.

Deferred tax–(DT) - is the tax effect of timing differences. DTs are ‘taxes on income’ which arise in one period but because of TD will have to be actually paid in later years.

Where the tax payable as per books viz., Tax Expense (TE), is more than what is actually paid viz., Current Tax (CT), the balance is provided for as Deferred Tax Liability (DTL). In case where the tax payable as per books (TE) is less than what is paid (CT), Deferred Tax Asset (DTA) arises.
Thus,
a. If TE > CT, then TE-CT is DTL.
b. If CT > TE, then CT-TE is DTA.

Applicability of the standard

Taxes on income include all domestic and foreign taxes, which are based on taxable income. Thus, application of this statement is not restricted to taxes arising in India. This standard specifically excludes tax payable on distribution of dividends and other distribution made by an enterprise.

This standard is mandatory for all companies as of now, although for listed and their group companies, the standard has been mandatory for the last one year. Thus, all companies finalizing their accounts for the YE 31.3.2003 must necessarily consider the provisions of this standard.

From the next year onwards, this standard is applicable for all enterprises – including non-corporate entities like partnership firms and proprietorship concerns. At present, the non-corporate entities, especially the proprietorship concerns, are not even recognizing the provision for current tax in their P&L account. In a majority of the cases, Income tax is being routed through the proprietor’s capital account. But come next year, they will have to recognize both provision for current tax and deferred tax in their final accounts. As a result, the non- corporate entities will have to double graduate themselves, with respect to this issue, in just one year from now.

Interestingly, prior to the issue of this AS, the Guidance Note on ‘Accounting for Taxes on Income’, issued by ICAI in 1991, was applicable. The Guidance Note recognized two methods of accounting for taxes on income, viz., Taxes payable method’ and ‘Tax effect accounting method’.

Under the ‘Taxes payable method’, the amount of tax charged in the P&L A/c is equal to the amount payable to the taxation authorities. The Guidance Note recognized that the ‘taxes payable method’ is permitted only to provide sufficient time for developing necessary awareness and expertise for the application of the ‘tax effect accounting method’. This method ignores the Timing Difference and in some cases results in there being no charge for taxes on income in the P & L account despite substantial accounting income.

Under the ‘Tax effect accounting method’, (which is what AS-22 advocates) taxes on income are accounted for and accrued in the same periods as the revenues and expenses to which they relate. The resulting tax effects on account of Timing difference are reflected in the tax charge in the P&L A/c and in the Deferred tax balance in the Balance Sheet.

The Guidance Note recommended that the tax expense for the period should be determined on the basis of ‘tax effect accounting method’, but permitted an enterprise to follow the ‘taxes payable method’. Since the Guidance Note permitted both the methods, the ‘taxes payable method’, a simpler and a convenient one, was widely adopted and there was hardly any company which followed the ‘Tax effect accounting method’.

With the issue of the AS-22, this Guidance Note has been withdrawn.

Recognition of Tax Effect

• Tax Expense for the period, comprising current tax and deferred tax, should be included in the determination of the net profit or loss for the period.
• DTA / DTL should be recognized for all timing differences in the Balance Sheet. The idea is to recognize the tax effect of all transactions occurring in a period irrespective of whether the tax effect is current or deferred. Permanent differences do not result in DTA or DTL.
• Consideration of PRUDENCE is a must while recognizing DTA. DTL has to be recognized in all situations, but DTA must be recognized conservatively as follows:

Virtual Certainty (VC) is stronger than reasonable certainty. The requirement of VC is brought out in case of creation of DTA when unabsorbed depreciation and business loss exists since normally it is observed that unabsorbed depreciation and carried forward of losses would lead to non-availability of future taxable income. VC cannot be based merely on forecasts of performance such as business plans or projections. VC refers to the extent of certainty which, for all practical purposes, can be considered CERTAIN. Further VC should also be supported by Convincing evidence (such as confirmed orders) for justifying creation of DTA.

Review of recognized DTA and Re-assessment of unrecognized DTA

• Previously recognized DTA should be reviewed at each Balance Sheet date. This amount of DTA is to be written down, if it is evident that any portion of the DTA is not recoverable because of uncertainty of future income.
• Previously unrecognized DTA is re-assessed at every Balance Sheet date. If it becomes reasonably certain that such unrecognized DTA will be realized, then unrecognized DTA is recognized now.
• Re-assessment of DTL may also become necessary to consider the effect of change in the tax rates or other developments. (not specifically mentioned in the AS but may be a logical conclusion)

Measurement of Deferred Tax

• Current tax is to be measured considering the tax payable based on prevalent tax law for the relevant assessment year. (35% plus a SC of 5% for companies for AY 2003-04).
• Deferred Tax should be measured using the tax rates and tax laws that have been enacted or substantively enacted by the Balance Sheet date. In other words, deferred taxes should be measured at the tax rates applicable for the subsequent relevant year known at the balance sheet date as the deferred taxes payable, if at all, are during the subsequent years. (35% plus a SC of 2.5% for companies for calculation as on 31.3.2003 balance sheet).
• When different tax rates apply to different levels of taxable income, DTA/DTL are measured using Average rates. This will have to be considered during the next year to compute deferred taxes in case of proprietorship concerns. (Average rate of 20% could be used when the slab for individuals is known to be 10%, 20% and 30%. The other interpretation of average rate could be 'Average rate' as per income tax as is worked out for TDS on salaries. The later interpretation appears to be logical)
• Deferred Tax should not be discounted to their present value.

Disclosure

The following disclosure requirements are notified by AS 22:

• The break-up of major components of DTA / DTL should be disclosed.
• DTA / DTL should be disclosed separately from current asset / liabilities.
• DTA and DTL should be set off, if permissible under the tax laws, but to be shown separately if not permissible.
• In case where there is an unabsorbed depreciation or carry forward of losses, the nature of evidence supporting the recognition of DTA should be disclosed.

Transitional Provisions

As per clause 33 of AS-22, on the first occasion, the enterprise should recognize, in the financial statement, the deferred tax balance that has accumulated prior to adoption of this statement as DTA/DTL with the corresponding credit/charge to the revenue reserves, subject to the consideration of prudence in case of DTA. The amount so credited/charged to the revenue reserves should be the same as that which would have resulted if this statement had been in effect from the beginning.

The above transitional provision is quite simple and logical, but this is what creates shivers in the corporate field especially for valuation purposes. Let us take a case of a company whose networth as on 31.3.2002 was Rs.100 crores and by virtue of net profit after dividend for FY 2002-03 of Rs.15 crores, the networth of the company as at 31.3.2003, without the effect of deferred taxes, should have been Rs.115 crores. On account of the transitional provision being applied, wherein deferred tax accumulated balance has to be recognized for all the earlier years, the net worth of the company as at 31.3.2003 could fall and in some cases, even below the networth as compared to 31.3.2002. In the above illustration, if the accumulated deferred tax liability for all the earlier years works out to Rs.20 crores the networth of the company stands reduced to Rs.95 crores as at 31.3.2003 when compared to Rs.100 crores as at the end of the previous year although the company has earned a neat Rs.15 crores during the FY 2002-03.

Several companies like SPIC have approached the courts and have got a stay on the application of the above transitional provision.

Another prominent case on the subject was that of Kesoram Industries Ltd.. Kesoram Industries Ltd., while implementing AS-22 for the YE 31.3.2002 have debited the accumulated DTL of Rs. 81 crores and the DTL for the year 2001-02 amounting to Rs. 15 crores to the Securities Premium Account (with the approval of Kolkata High Court under Section 78 read with section 100 of companies Act, 1956) when ICAI have clearly laid down in the AS that the accumulated DTL up to 31.3.2001 should be debited to the Revenue Reserves and the DTL from 01.04.2001 should be routed through the P&L Account.

Presentation of DTA/DTL in Financial Statement

• In the P&L Account:

Deferred Tax for the current year should be considered as a part of tax expense.

• In the Balance sheet:
DTA / DTL should be disclosed separately from current asset / current liabilities.

(According to the Background material for seminars on AS-22 issued by ICAI, DTL should be disclosed separately after the head
' Unsecured loan'. But in the above disclosure, DTL has been shown before loan funds and after shareholders funds for reasons
mentioned under the interpretation heading)

• In the Notes on Accounts :

The following disclosure is required to be made in the Notes on Accounts.

Extracts of Notes to Accounts:

To comply with the newly introduced AS-22, Taxes on Income issued by the ICAI, which is mandatory WEF April 1, 2002, the
Company has made provision for taxation after considering deferred tax to recognize timing difference in tax. As per the
requirement of the standard, the effect of deferred tax upto March 31, 2002 has been worked out at Rs. 5 crores and has
been adjusted from the balance in General Reserve. The Company has also created net deferred tax for the current year of
Rs. - 0.72 crores on account of which the profit for the current year is higher by the equivalent amount.

With the introduction of deferred taxes, the overall tax provision in accounts would go up. The case of Reliance Industries Ltd.,
given below shows the impact of this more clearly.

From the above table, it is clear that upto March 2001, tax to PBT percentage was as low as 5%. But from the year
2001-2002 (after the introduction of AS-22 for listed companies), tax to PBT percentage has sharply increased, which is due
to the creation of provision for deferred tax. Otherwise it would have been 4.29% and 4.95% for the year ending 31.3.2002
and 31.3.2003 respectively.

Although As-22 is on Accounting for Income Tax, the income tax outflow for an enterprise for any given year is not going to
increase on account of introduction of this standard from what has to be paid otherwise. In other words, there is no impact of
Deferred Taxes on income tax itself.

Apart from the above, there are other implications of the standard which has been enlisted below:

(1) Affects Debt-Equity Ratio (Double edged sword): Treating DTL as part of liability will adversely impact the D/E Ratio,
thereby affecting the leveraging capacities of companies. It acts like a double-edged sword and affects D/E ratio severely.
But for DTL, the amount would have been under equity and with DTL it gets reduced from equity (denominator) and probably
gets added to debt (numerator). Fortunately, there is no impact of DT on Current ratio as the DTL and DTA are not considered
as current liability and current asset respectively.

(2) Affects Net Worth: Treating DTL as part of liability adversely affects the Net Worth of the Company.

(3) Affects Net Profit Ratio (PAT/Net Sales): Considering DT as a tax expense would severely affect the Net Profit ratio, as the
profit after tax would reduce by that extent.

(4) Affects EPS: Considering DT as a tax expense would severely affect the Earning per share, as the earnings available to
equity shareholders would reduce by that extent.

(5) Affects Dividend declaration: There is no specific reference in the Company Law on DT. But dividend declaration gets
affected with the introduction of DT.

(6) Affects Capital Adequacy norms in case of banks: Since DTL is not considered as part of Tier-I or Tier-II capital, the creation of deferred taxes affects the Capital to Risk Weighted Assets Ratio (CRAR).

Issues relating to DT

(1) Deferred Tax and MAT: The payment of tax U/s. 115JB of the Act is a current tax for the period.
Measurement of deferred tax using the 7.5% rate, on the basis that the timing differences would reverse in a period in which the enterprise may pay tax @ 7.5%, is rejected. (As per Accounting Standard Interpretation (ASI) - 6 issued by ICAI)

(2) Deferred Tax and Capital Gain Taxes: Where an enterprise’s statement of profit & loss includes an item of ‘loss’ which can be set-off against in future for taxation purposes, only against the income arising under the head ‘Capital gains’ as per the requirements of the Act, that item is a timing difference to the extent it is not set-off in the current year and is allowed to be set-off against the income arising under the head ‘Capital gains’ in subsequent years subject to the provisions of the Act. In respect of such ‘loss’, DTA should be recognized and carried forward subject to the consideration of prudence.

In cases where there is a difference between the amounts of ‘loss’ recognized for accounting purposes and tax purposes because of cost of indexation under the Act in respect of long-term capital assets, the DTA should be recognized and carried forward on the amount which can be carried forward and set-off in future years as per the provisions of the Act. (As per ASI - 4 issued by ICAI)

(3) Deferred Tax and 100% EOU cases: It is wrong notion that in the case of 100% EOU companies, deferred tax is not applicable. Deferred tax in respect of timing differences which originate during the tax holiday period and reverse after the tax holiday period should be recognized in the year in which the timing differences originate. For the above purposes, the timing differences which originate first should be considered to reverse first. (As per ASI 5 issued by ICAI).
In the same lines as that of above, Deferred Taxes has to be calculated in the case of enterprises to whom Tax holiday is applicable U/s.80-IA and U/s.80-IB of the I.T.Act. (As per ASI 3 issued by ICAI).

Should DTL be considered as a Liability or a Provision or part of Reserves?

There are differing views on this issue. One of the interesting views is that, DTL should be treated as part of the ‘Reserves’ only. This view is substantiated by the following argument.

The Guidance Note issued by ICAI on ‘Terms used in Financial Statements’ defines the term ‘liability’ as the ‘financial obligation of an enterprise other than owner’s funds’. Since, the liability for paying income tax in the future will arise only if the company for that year is chargeable to tax. Again, for growth oriented companies who are on investment mode, DTL will not fructify at all because of higher depreciation benefit available under the Income Tax Act, year after year.

‘Provision’ has been defined in the Companies Act to mean ‘ any amount written off or retained by way of providing for depreciation …….. Or retained by way of providing for any known liability’. Since DTL is not a liability in the strictest sense of the term, this also would not amount to provision.

As DTL is neither a liability nor a provision, this should be treated as ‘Reserves’.

A contrary view to the one mentioned above is that, treating DTL, as part of the Reserves in general would negate the very purpose of introduction of AS-22. Introduction of AS-22 increases the transparency in accounts. In certain companies like L&T, Grasim, Reddy’s lab, Tata steel, the cumulative DTL as on 01.04.2001 accounted for as high as 15% to 24% of the Reserves. Now, after the introduction of AS-22, the book value per share for these companies would undergo drastic changes, which would help the investors to take correct investment decisions.

Treating DTL as part of liability will impact the debt equity ratio of companies doubly. As already stated, in growth oriented companies, DTL will never fructify at all. In such cases, decision-makers (bankers/investors) should take a pragmatic view and consider at least a part of DTL as notional and add it back to the Reserves to arrive at the Debt Equity Ratio. In the least, DTL should not be added to the debt of the company.

Conclusion

- Introduction of AS-22 in India is an attempt by ICAI to increase transparency in financial statements and to align our AS with global AS. But this AS is a deterrent for companies who were hitherto showing high valuation on account of the timing differences.

- AS-22 is aptly called the catch 22 standard. Growth oriented companies, in-order to conserve the outflow of current taxes will acquire additional fixed assets which would only shoot up the Deferred Taxes. This happens particularly on account of the depreciation differential that exists between the books and income tax. Harmonization of depreciation rates between Companies Act and Income Tax Act will resolve the conflict of Deferred Taxes to a great extent.

- In most of the cases, the task of ascertaining the provision for taxes even without deferred taxes has been difficult because of the disputes at various stages in appeal. The task of the Chartered Accountant certifying the accounts, taking into consideration the requirement of AS-22, is not going to be easy.

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