Expert Advisory Committee
ICAI-Expert Advisory Committee
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1.21  Query:   

Accounting for provision made for Bad and Doubtful Debts

u/s 36(1) (vii a) of Income-tax Act, 1961.  

 

1.  A finance corporation, which is a Government of India undertaking, is a company registered under the Companies Act, 1956. The company is functioning as a Development Bank with the main objective of financing power projects in India. It provides term loans for the power projects which include Generation, Transmission, Urban Distribution etc., to State Electricity Boards and State Generating Corporations. The company was declared as a Public Financial Institution by the Central Government in terms of Section 4(A) of the Companies Act, 1956, vide notification dated 30th August, 1990. Thus, the company functions as a development bank similar to development institutions such as IDBI, IFCI, ICICI and NABARD etc. The resources of the corporation consist of equity from the Central Government, market borrowings through issue of bonds, foreign currency loans and generation of internal resources.

 

2. The querist has stated that the company is consistently debiting provision for bad and doubtful debts to profit and loss account, i.e., treating the said provision as part of expenses in terms of the provisions of section 36(1) (vii a) of the Income-tax Act.

 

3. The querist has further stated that during the course of Government Audit of Annual Accounts for the year 1993-94 u/s 619(3) of the Companies Act, 1956, the Principal Director of Commercial Audit and Ex-Officio Member Audit Board has given special Half Margin- 1 stating “that no provision on this account can be made by the Company for this purpose as per Schedule VI, Part I of the Companies Act, 1956. The provision is actually of the nature of ‘Reserve’ and should have been routed through ‘Appropriations’. Thus, the profit as well as appropriation for the year are understated by Rs. 1132.81 lakhs”.

 

4. The querist has informed that the company has, in its reply to the above said observation, mentioned that provision for bad and doubtful debts has been charged to profit and loss account in line with Section 36(1) (vii a) of the Income-tax Act and accounting practices. Under Section 36(1) (vii a) of the Income-tax Act, it is stated that “in respect of any provision for bad and doubtful debts made by a public financial institution or a State financial corporation or a State industrial investment corporation, an amount not exceeding five per cent of the total income (computed before making any deduction under this clause and Chapter VI-A)” is allowed as a deduction. The tax provision is clear and non-provision of bad and doubtful debts u/s 36(1) (vii a) in the accounts will disentitle the company from claiming the deduction.

 

5. The querist has further stated that the company is also entitled to claim deduction under section 36(1) (viii) of the Income-tax Act, 1961, on account of “special reserve” at the rate of 40% of total income. The provision of this section does not require special reserve to be debited to profit and loss account and since the wording used is ‘Reserve’, it is created out of appropriation of profit.

 

6. As per the querist, on comparison of the provision of section 36(1) (viii), with the provision of Section 36(1) (viia), it clearly emerges that the requirement u/s 36(1) (viii) for creation of special reserve can not be applied to the provision of Section 36(i) (viia), by implication. The company has been consistently charging the provision for bad and doubtful debts u/s 36(1) (viia) to profit and loss account over a period and no statutory auditor has raised any objection to such treatment. Therefore, the observation of the Government Auditors that such treatment of provision for bad and doubtful debt u/s 36(1) (viia) has resulted in understatement of profit is considered contrary to the tax laws and accounting practices. Moreover, the statutory auditors of the company also agreed with the company in their reply to special Half-Margin-1 on the accounts of the company for the year 1993-94.

 

7. C & A G, however, did not agree with the replies of the company as well as of the statutory auditors and stated in their comments u/s 619(4) of the Companies Act, 1956, on the accounts of the company for the year ended 31.3.94 that “provision for bad and doubtful debts Rs.1132.81 lakhs u/s 36(1) (vii a) of Income-tax Act, 1961, is not a provision but a reserve created only to avail income-tax benefit and hence should have been shown as an appropriation of profit and not as an item of expenditure. This has resulted in understatement of the current year’s profit by Rs. 1132.81 lakhs.”

 

8. The querist has sought the opinion of the Expert Advisory Committee with regard to the following issues:

 

(a)        Whether the provision u/s 36(1) (vii a) of the Income-tax Act, 1961, is to be treated as a debit to profit and loss account above the line or is it to be treated as an appropriation as per the comments of Comptroller and Auditor General of India?

(b)        In terms of Government Auditor’s observation earlier the provision for bad and doubtful debt u/s 36(1) (vii a) of the Income-tax Act, 1961, is being shown under the head Reserve and Surplus. Since it is a provision as per Section 36(1) (vii a) of the Income-tax Act, 1961, the wordings used were “provision for bad and doubtful debts”, whereas at the instance of Government Auditors, the wordings used in 1992-93 accounts were “Reserve for bad and doubtful debts”. The exact wordings to be followed and the correctness of showing it under the head ‘Reserve and Surplus’ may also be advised.

                                                           Opinion                                              November 17, 1995

 

1.  The Committee notes that the term ‘provision’ has been defined under ‘Interpretation’, Part III of Schedule VI to the Companies Act, 1956, which, inter alia, reads as follows:

 

(1)   “For the purposes of Parts I and II of this Schedule unless the context otherwise requires, -

(a)  the expression ‘provision’ shall, subject to sub-clause (2) of this clause, mean any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy;

 

(2)        Where-            ………….

(b)   any amount retained by way of providing for any known liability; is in excess of the amount which in the opinion of the directors is reasonably necessary for the purpose, the excess shall be treated for the purposes of this Schedule as a reserve and not as a provision.”

 

2. The Committee also notes in “Instructions in accordance with which assets should be made out” of Schedule VI, Part I, to the Companies Act, 1956, which read as follows:

“The provision to be shown under this head should not exceed the amount of debts stated to be considered doubtful or bad and any surplus of such provision, if already created, should be shown at every closing under “Reserves and Surplus” (in the liabilities side) under a separate sub-head “Reserve for doubtful or bad debts.”

 

3. On the basis of above, the Committee is of the view that provision can be created for any known liability, and if it is created for a liability that is non-existent or the amount is in excess of what is required, the same should be treated as a ‘reserve’ and not as a ‘provision’.

 

4. The Committee also notes the C & AG’s observations whereby they have mentioned that “As there are no debts (Loans & Advances) considered bad & doubtful as on date, no provision on this account can be made by the company for this purpose as per Schedule VI, Part I of the Companies Act, 1956.”

 

5. The Committee further notes Section 36(1) (vii a) of the Income-tax Act, 1961, which is reproduced in Para 4 of the query. The Committee is of the view that merely because this section lays down the maximum limit of deduction for provision for bad and doubtful debts, is no ground for creating the same if not warranted in the facts and circumstances of the case as per the requirements of Schedule VI to the Companies Act, 1956. Section 36(i) (viia) does not govern the preparation of financial statements for the purpose of presenting a true and fair view of the profit (loss) and the state of affairs of the company.

 

6. On the basis of the above, the Committee is of the following opinion in respect of the issues raised by the querist in para 8 of the query:

 

(a)  In case the provision for bad and doubtful debts is not as per the definition of the term ‘provision’ given in Part III of Schedule VI to the Companies Act, 1956, the same should be treated as a reserve. Section 36(i) (vii a) of the Income-tax Act, 1961, does not govern the preparation of financial statements for the purposes of the Companies Act, 1956.

(b)   Where the provision for bad and doubtful debts is required to be treated as reserve in view of (a) above, the same should be shown under ‘Reserve and Surplus’ in the liabilities side under a separate sub-head ‘Reserve for doubtful or bad debts’ as mentioned in ‘Instructions in accordance with which assets should be made out’ as per Part I of Schedule VI to the Companies Act, 1956.

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