Query No. 10
Subject:
Recognition
of accumulated
balance of deferred tax liability and
deferred tax liability
arising in the current period.1
A. Facts of
the Case
1. A public
limited company whose securities are listed on four major stock exchanges
commenced its operations from the accounting year 1992-93 by starting export trading activities and thereafter the
company has set up manufacturing base from the year 1993 onwards.
2. In the year
1998, the company, through a scheme of amalgamation, took over two existing
public limited companies of the group on going concern basis with effect from
1-4-1997. The said scheme of
amalgamation was approved by the Honourable
Gujarat High Court in
the year 1998
with retrospective effect from 1-4-1997.
3. The querist
has stated that the opinion of the Expert Advisory Committee has been sought
for the following reasons:
(a) Accounting
Standard (AS) 22, ‘Accounting for Taxes on Income’, issued by the Institute of
Chartered Accountants of India, is mandatory for the company for accounting
periods commencing on or after 1-4-2001.
The company visualizes severe impact of the arithmetically calculated
deferred tax liability, required to be recognised as per AS 22, on its net
worth.
(b) The querist
has mentioned that as against the above, the company has grown at a reasonable
high growth rate not only in terms of sales but also in respect of fixed assets
capitalisation.
4. According to
the querist, the management of the company also has plans to expand capacities
and set up more and more fixed assets for increasing the production
and capacity and
the management shares
philosophy of ploughing back of
every rupee earned into the business and, therefore, has pursued the policy of
low dividend pay-out inspite of reasonably high promoters’ stake in equity. The
company, therefore, carries the following vision:
(a) Plan for
direct taxes by opting for best possible means available within law and for
that purpose, if necessary, register units as eligible for exemption under
sections 10B/10C of the Income-tax Act, 1961.
(b) Improve
technology at every plant for which huge capitalisation, carrying even high
depreciation rates, could be required.
Such technology may be procured from time to time.
(c) As the
Indian taxation policy is very inconsistent, long term planning of taxes is not
feasible and, therefore, business policy decisions have to be changed
considering changes in fiscal and taxation policy.
(d) The
deduction available under section 80HHC of the Income-tax Act, 1961, has been
reduced and has also undergone other changes and, therefore, no decision based
on the same can be taken in a long-term perspective.
(e) Indian
businesses can only survive if they save on finance cost, labour cost, and
taxation and for that management has to be proactive to meet ever-changing
scenario.
5. The querist
has given the following illustration only to highlight the proactive actions
taken by the management of the company in response to the changing tax laws:
The company has also set up three 100% export oriented
undertakings (EOUs) in the past on taxation consideration of which one
100% EOU
was debonded in the year 2000 due to taxation consideration.
Another
100% EOU is sought to be partially debonded again due to
taxation consideration.
As per the querist, the above indicates that the management
of the company carries the view that major business policy decisions have to be
reviewed in line with the ever changing taxation laws as Indian businessman
cannot keep Government taxation policy
aside while taking their policy decisions.
6. According to
the querist, in view of the above business philosophy, the management of the
company visualises that the deferred tax liability,calculated by separately
applying the form
and definition and
the arithmetical rules of
AS 22, would eventually never
arise at least
in perceivable future (emphasis added
by the querist). Further,
as per the projections made for the coming 5 years, the management is perceiving planning for nil/low taxes and, therefore, various issues
have arisen on application/implications of AS 22.
7. The querist
has raised the following issues in relation to the interpretation and ambit of
clauses of AS 22:
(a)
AS 22 has
defined the term ‘timing differences’ as follows:
“Timing
differences are the
differences between taxable income and accounting income for a
period that originate in one period and are capable of reversal in one or more
subsequent periods.”
According to the querist, the scope and interpretation of
the phrase
“capable of reversal”
(emphasis added) is
required to be clarified. While reading the phrase in the context of the actual working of
taxable income the word “capable” (emphasis added) signifies two meanings,
i.e., one, capable means ‘legally capable’ and two, capable means ‘factually
capable’.
(b)
According to
the querist, a particular timing difference may be legally capable of
reversal. However, the same may not
always be capable of factual reversal.
For example, timing difference arising in view of the claim of
depreciation as per the Income-tax Act, 1961, is legally capable of reversal in
subsequent years, if depreciation for accounting purposes is calculated on
straight line method basis at a rate which is lower than that used for
calculating depreciation for Income-tax purposes on written down value basis.
However, if there is a plan/project of further capitalisation of fixed assets
in a larger way, the timing difference may not actually reverse at least in
perceivable projected period.
Therefore, the querist seeks clear definition and the ambit of phrase
“capable of reversal” (emphasis
added).
(c )According to
the querist, AS 22 defines the terms ‘timing differences’ and ‘permanent
differences’ separately so as to carry exactly opposite meanings; however, it
is not clear whether they
are mutually exclusive terms or not. If the term ‘permanen t differences’ would
have been defined as the differences other than the timing differences, the two
terms would have been stated to be mutually exclusive. However, in AS 22, the definitions are given
in a different manner which indicates that there could be a difference which is
neither classifiable as a permanent difference nor as a timing difference. The querist has requested to clarify whether
‘timing difference’ and ‘permanent difference’ are two mutually exclusive terms
or there could be a difference which is neither classifiable as a timing
difference nor as a permanent difference.
(d)
Transitional
Provisions, given in paragraph 33, which is a standard paragraph of AS 22,
provide for accounting and recognition of deferred tax balance accumulated
prior to adoption of AS 22 as deferred tax asset/liability with the
corresponding credit/charge to the revenue reserves. Paragraph 34 of AS 22 cites an example in relation to calculation
of timing difference with specific provisions relating to depreciation being
considered. As per the querist, in this
context, the following issues emerge:
(i)
Whether the
accumulated balance of deferred tax is required to be calculated by applying
the applicable tax rate to the difference in opening balance of fixed assets
for accounting purposes and tax purposes or whether the company can calculate
and recognise the tax effects of these differences in the manner which,
according to the company, gives better reflection of the tax effect of timing
differences.
(ii) As a
corollary to this proposition, in the present case, the querist is posed with
the problem of actual perception of the tax effect of timing differences and
the management of the company reiterates that according to its perception,
timing differences are not projected to be reversible within a reasonable time
and, therefore, should not be accounted for at all. However, without prejudice to the above, if the tax effect of
accumulated timing differences is to be accounted for, it should be equal to
the tax saved on timing differences calculated on the basis of the past years’
tax return s and not on the basis of difference in the opening balance of fixed
assets for accounting purposes and tax purposes.
8. As mentioned
earlier, the company, through the scheme of amalgamation approved by the
Honourable High Court of Gujarat, had taken over two existing companies in the
year 1998 with effect from 1-4-1997. As
per the prevalent taxation laws, the WDV of fixed assets of two companies, as
on 31-3-1997, for income-tax purposes was treated as opening
balance of fixed assets for the accounting year commencing from 1-4-1997.
9. According to
the querist, the WDV of the depreciable fixed assets, as per income-tax records
of the two amalgamating companies, is undergoing change due to revocation of
the claim of high depreciation in their respective assessment/appeal proceedings
and, therefore, the
opening WDV of the depreciable fixed assets for the company
has also undergone change. The company has, therefore, reworked the additional
depreciation available due
to the above change and has revised its taxable income as a
result of the above change. The
querist has also supplied statement showing original taxable income and revised
taxable income for the assessment years 1998-99 to 2001-02.
10. The querist
has also supplied a statement wherein revised accounting income for the
assessment years 1998-99 to 2001-02, after deducting the permanent differences
as defined in AS 22, has been worked out.
According
to the querist, the revised accounting income, so worked out,
is the income on which the tax would have been payable, if the company did not
have any differential depreciation benefit.
Further, the company has never paid tax under the normal income tax
provisions from the assessment year 1998-99 onwards due to higher
depreciation allowed under
the Income-tax Act provisions. The querist has stated that only the income-tax benefit, arising
as above, could be considered as reversible in future, if at
all the company’s perception of planning for tax is not to be considered and
suggested that accumulated deferred tax balance should be recognised
accordingly which, as per the statement, comes out to be Rs. 387.84 lakh.
11. The querist
has also supplied a statement with the query papers wherein the difference
between the written down value of the depreciable fixed assets as on 1-4-2001 as per the books of account and that as per
the income-tax records has been worked out.
The difference, so worked out comes out to be Rs. 8413.15 lakh. In this statement, the accumulated balance
of deferred tax liability is demonstrated and calculated by applying tax rate
of 35.7% to the above difference of Rs. 8413.15 lakh. As per this statement,
accumulated balance of deferred tax liability, calculated as above, is Rs. 3003.49
lakh.
12. According to
the querist, the carried forward depreciation loss of Rs.1521.16 lakh of
two amalgamating companies as
on 31-3-1997 was not allowed to
be carried forward by the amalgamated company in its income- tax assessment.
13. Along with
the query papers, the querist has also supplied a statement showing details of the
written down values of the depreciable fixed assets in the books
of account and
as per the income-tax records
of the two amalgamating companies as on 1-4-1997.
14. Paragraph 30
of AS 22 requires that deferred tax assets and liabilities should be disclosed
under a separate heading in the balance sheet, separately from current assets
and current liabilities. The querist has mentioned that no corresponding
changes have been made in the format of Part II and Part III
of Schedule VI to the Companies Act, 1956.
15. The querist
has also drawn attention of the Committee to the provisions
of Investment Allowance Reserve that were prevalent under
the provisions
of section 32A of the Income-tax Act, 1961 and the
consequent accounting practices in existence. According to the querist, in
those years, the companies used to create Investment Allowance Reserve to the
extent of 75% of 25%
of the value of eligible fixed assets capitalised and,
thereafter, once further new assets were put up to the extent of the Investment
Allowance Reserve, the amount of the Investment Allowance Reserve was being
transferred by
a book entry to Investment Allowance Utilisation Reserve
and, thereafter, upon expiry of 8/10 years from the date of original assets
capitalised, this Investment Allowance Utilisation Reserve was being
transferred to General Reserve. Thus,
Investment Allowance Reserve and Investment Allowance Utilization Reserve were
earmarked reserves under the statutory provisions.
16. The querist
has requested the Committee to consider that if deferred tax liability is
considered as liability, it would affect the following:
(a) Net worth of
the company.
(b) Net asset
value of the equity shares.
(c) Debt-equity
ratio.
(d) Credit
rating of the company.
(e) Borrowing capacity
of the company.
(f) Rate of
interest for financing.
(g) The amount
of public deposits that can be accepted which are calculated on the basis of
paid up share capital and free reserves.
(h) Such other
impacts.
As per the querist, in view of the above, the deferred tax
liability will hamper the financial leverage of even good companies and, hence,
AS 22 would not only provide for accounting for taxes but would also inflict
huge financial burden and may also affect the credibility and long-term view of
the company.
17. The querist
has also mentioned that the Reserve Bank of India has recommended the
credit rating norms for determining credit rating of a borrower on
the basis of which interest rate for the borrowing is determined. The two
aspects of the norms that would be affected as a result of above are current
ratio and debt-equity ratio. If deferred tax assets/liabilities are not
regarded as current assets/liabilities as per AS 22, the current ratio would be
directly affected which may dampen the credit rating. Similarly, debt- equity
ratio is largely affected due to heavy provision of deferred tax liability and
the points for the debt-equity ratio would also be affected. If the overall
score of the company is affected by even few points, the rating could change
substantially. If the rating changes, the interest rate would also change
leading to higher cost of finance.
18. As per AS 22, accounting for accumulated balance of deferred tax prior to 1-4-2001 is
required only once in the accounts for the year ended 31-3-2002. According to the querist, this would distort the
figure in a large way and results would not be comparable for the subsequent
period.
19. The querist
has referred to Part III of Schedule VI to the Companies
Act, 1956, which defines the terms ‘Provisions’, ‘Reserves’
and ‘Liability’ as under:
“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.”
“the expression “reserve” shall not, subject as aforesaid,
include 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.”
“the expression “liability” shall include all liabilities in
respect of
expenditure contracted for and all disputed or contingent
liabilities.”
Sub-clause (2) to the above clause provides as follows:
“Where-
(a)
any amount
written off or retained by way of providing for depreciation, renewals or
diminution in value of assets, not being an amount written off in relation to
fixed assets before the commencement of this Act; or
(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.”
20. According to
the querist, deferred tax liability, calculated as per the strict and legal
form in letter and not in spirit and as per the arithmetical calculations
prescribed in AS 22, is required to be classified as a particular class. Further, it is required to be determined
whether it is a provision, or reserve or liability and for the purpose, the
following questions are required
to be answered:
(a) Whether
deferred tax liability is an expenditure contracted for.
(b) Whether
deferred tax liability claim is raised at all by anybody.
(c) Whether
deferred tax liability, therefore, is a disputed liability. (d) Whether
deferred tax liability is the amount written-off or retained by way of
providing for depreciation, renewals or diminution in value of assets.
(e) Whether
deferred tax liability is the amount not written-off in relation to fixed
assets before the commencement of the Act.
(f) Whether
deferred tax liability, in the opinion of the directors, can be considered
reasonably necessary for the purposes stated at (d) or (e) above.
21. According to
the querist, the answers to all the above questions are in the negative and,
therefore, as per the Companies Act, 1956, deferred tax liability is nothing
but a sort of reserve.
B . Query
22.The querist
has sought the opinion of the Committee on the following issues:
(a)Whether
deferred tax liability can be taken to be NIL under the given circumstances and
the management perception that there is no tax liability in the immediately
forthcoming 5 years/immediately perceivable future.
(b) If deferred
tax liability can be taken as NIL, whether any disclosure
is required. If yes,
whether the disclosure can be in the form of specific mention in the Directors’
Report or it is required to be made a part of accounting policies or whether
such a disclosure is required to be made in the notes to the accounts or
whether such a disclosure is required to be made in combination of any
two or more.
(c) In such a
case, whether the auditor is required to state about such management perception
in its report and whether the auditor is required to refer to specific
paragraph of the Directors’ Repor t and/or to specific accounting policy and/or
notes to accounts if such disclosure is found necessary.
(d) If accumulated deferred tax liability cannot be taken to be NIL, what should be the amount of deferred tax liability, i.e., which of the following amount should be recognised as accumulated deferred tax liability:
(i) Rs.
3,003.49 lakh being the tax calculated as per paragraph 11 above.
(ii) Rs. 387.84
lakh calculated as per paragraph 10 above.
(iii) Alternatively, whether deferred tax liability can be calculated by
applying tax rate of 35.7% to the difference between WDV of depreciable assets
for accounting purposes and for taxation purposes as reduced by depreciation
loss of the amalgamating companies not permitted to be carried forward by the
company. According to the querist, the
amount so calculated comes out to be Rs. 2,460.44 lakh.
(iv) Alternatively,
whether deferred tax liability can be calculated by applying tax rate of 35.7%
to the difference between WDV of depreciable assets for accounting purposes and
taxation purposes as reduced by the difference between the WDV of depreciable
assets for accounting purposes and taxation purposes as o n 1.4.97 in respect o f th e amalgamating companies as that difference was in relation to
the other companies or for any other reason.
According to the querist, the amount so calculated comes out to be Rs.913.10 lakh.
(e) If
accumulated deferred tax liability cannot be taken to be NIL though supported
by the management perception and still the company chooses not to provide
deferred tax liability, whether the auditors would be required to qualify their
audit report, and if yes, in what way they should highlight or focus their
qualification.
(f) In such
circumstances, if the company prescribes the accounting policy, wherein such
specific disclosure is made without stating anything in the notes to accounts,
whether it would be sufficient for the auditors not to qualify at all or will
it be required for the auditors to refer to such accounting policy and/or will
it be required to qualify the report by quantifying the amount of deferred tax
liability. If the amount of deferred tax liability is not quantified, whether
the auditors would be required to give a disclaimer in their report. Further,
what would be the specimen of the qualificatory/ disclaimer report in such
circumstances.
(g) In such
circumstances, if the company decides to follow accounting policy of disclosure
in notes to accounts and not providing for in the books of account in respect
of deferred tax assets/liabilities, whether it would be sufficient for the
auditors not to qualify their audit report at all or whether it would be
regarded as non-complianceof AS 22, particularly when full facts of the amounts and
its break- up are disclosed. Whether it
would be required for the auditors to refer in their report to such notes on accounts and accounting policy and/or whether the auditor would be required to
qualify the report by referring to the amounts quantified in the notes to
accounts. Further, what would be the specimen of the qualificatory report in
such circumstances.
(h) If mere
disclosure of accounting policy and/or notes to accounts is not sufficient, whether auditors are required to qualify
their report by referring to notes to accounts or they have to qualify by
stating that the accounts do not give true and fair view in view of
non-provision of the deferred tax liability as referred to in the notes to
accounts or whether the auditors have to report suggesting that the accounts do
give a true and fair view of the state of affairs and the results of the period
under review subject to the above fact of non-provision of deferred tax
liability in the books of account.
(i) If the
Committee is of the opinion that in the present case inspite of the management
vision of tax planning, the company is required to provide for deferred tax
liability, then as against the following alternative propositions, the querist
has sought the opinion of the Committee:
(i) What if the
company adopts a policy of providing for deferred tax assets/liabilities
prospectively from 1.4.2001 and states clearly about non-determination of
accumulated balance of deferred tax assets/liabilities as on 1.4.2001 on the
following grounds:
- that
provisions for the past years, i.e., cumulative position as on 1.4.2001, would
render the accounts uncomparable from year to year.
(ii) Whether it
would be due compliance of AS 22, if deferred tax liability is shown under the
heading ‘Reserves and Surplus’ as a separate/distinct item like ‘DTL Reserves’,
because according to the definition of liabilities and reserves under Part III
of Schedule VI to the Companies Act, 1956, deferred tax liability can at the
best be reserve, even if it is to be disclosed. Similarly, whether it would be
due compliance of AS 22, in case of deferred tax assets, if after the 4
sub-heads under the heading ‘Current Assets, Loans and Advances’, the 5th heading is added in the nature of deferred
tax assets before deducting the current liabilities therefrom.
(iii) Whether it
would be due compliance of AS 22, if the company segregates the general
reserves into two parts as under by passing an entry through profit and loss
account for the year ended 31.3.2002 in respect of the deferred tax liability
arithmetically calculated for the period prior to 1.4.2001:
· Special
general reserves to the extent it covers or is more than the deferred tax
liability arithmetically calculated as per the option(s) finally found reasonable
by the Board of Directors; and
· General
reserves for the balance amount.
(iv) Whether it
would be due compliance of AS 22, if deferred tax asset/liability is
affected/accounted for in the account of revenue reserves (general reserves)
through the profit and loss account and then taking credit/debit from the
revenue reserves.
(v) Whether
accounting policy or presentation as mentioned in various alternatives as above
give true and fair view in the case of balance sheet of the state of affairs of
the company with reference to sections 209, 211 and 227 of the Companies Act,
1956.
(vi) AS 22 provides
for reassessment of deferred tax assets while nothing is mentioned for
reassessment of deferred tax liabilities. What are the reasons for such
differentiation, particularly when both of them are the result of the conceptof prudence. Whether it would be inappropriate, if deferred
tax liabilities are also reassessed considering the ever changing taxation
provisions and the profitability from year to year.
While referring to deferred tax liability, the querist has
sought the opinion considering deferred tax liability in respect of liability
of prior to 1.4.2001 separately and deferred tax liability for respective
accounting years separately.
C. Points considered
by the Committee
23. The Committee
notes that paragraph 13 of AS 22 provides the following:
“13. Deferred tax should be recognised for all the timing
differences, subject to the consideration of prudence in
respect of deferred tax assets
as set out in paragraphs
15-18.”
24. The Committee
notes from the above that AS 22 requires that deferred tax should
be recognised for
all the timing
differences, subject to
the consideration of prudence
in respect of
deferred tax assets,
i.e., its requirements are based
on what is known as the ‘full provision method’. The method is based on the
principle that financial statements for a period should recognise the tax
effect, whether current or deferred, of all transactions occurring in that
period. The other method for accounting for taxes on income is
the ‘partial provision method’ under which tax charge for a period excludes the
tax effects of certain timing differences which will not reverse for some
considerable period (say, at least five years) ahead. Partial provision method
recognises that, if an enterprise is not expected to reduce the scale of its operations
significantly, it will
often have a
hard core of
timing differences. Thus, for instance, in many cases, the effect of
timing differences may be such that the payment of some tax is permanently
deferred. On this basis, under this method, deferred tax has to be provided
only where it is probable that tax will become payable as a result of the
reversal of timing differences.
In this regard,
the Committee notes
that requirements of International Accounting Standard (IAS)
12 (revised), ‘Income Taxes’, issued by
the International Accounting Standards Board,
Financial Accounting Standard
(FAS) 109, ‘Accounting for Income Taxes’, issued by Financial Accounting
Standards Board, USA and Financial Reporting Standard (FRS)
19, ‘Deferred Tax’ issued by Accounting Standards Board, UK,
are based on full provision method, i.e., partial provision method has been
rejected in these accounting standards
as well as
by the Institute of Chartered Accountants of India in AS 22. The Committee notes that partial provision method has been
rejected primarily on the ground that following of ‘partial provision method’
would involve subjective judgements regarding (i) the time-frame within which
future tax liability will have to be considered, and
(ii) estimation of the liability. These judgements involve
assumptions regarding future profitability, future capital expenditure and
other relevant matters.
25. The Committee
is of the view that
consideration of management perception regarding availing
deduction/exemption under various sections of Income-tax Act,
1961, and regarding
future capitalisation, etc.,
in determination of deferred tax, as argued by the querist, involves
subjective judgements about the future which is the ground on which the partial
provision method has been rejected. The company, therefore, should recognise
deferred tax for all the timing differences originating during the year,
subject to the consideration of prudence in respect of deferred tax assets,
based on the full provision method as required to be followed under AS 22
without considering the impact of management perception regarding tax planning.
26. The Committee
notes that AS 22 defines the term ‘timing differences’ and ‘permanent differences’ as follows:
“Timing
differences are the
differences between taxable income and accounting income for a period
that originate in one period and are
capable of reversal in one or more subsequent periods.
Permanent differences are the differences between taxable
income and accounting income for a period that originate in one period and do
not reverse subsequently.”
27. The Committee
is of the view that the phrase ‘capable of reversal’ used in the definition of the term ‘timing differences’
means ‘legally capable’ as well as ‘factually capable’ of reversal. The Committee does not agree with the view
that in case the company continues to acquire more and more fixed assets in
subsequent years resulting in higher depreciation for taxation purposes, tax
liability arising for the timing differences arising in the current period would
not reverse in
subsequent year(s) for
the reason that
new timing differences would arise in such subsequent year(s). The
Committee notes that although aggregate amount of timing differences may
increase due to further capitalisation, expansion of enterprise activities, or
any other reasons, yet timing
differences relating to
depreciation on a
particular depreciable asset originating in the current year would
definitely reverse in subsequent year(s) in respect of that asset. Accordingly, the Committee is of the view that all the timing differences, arising in the
current period, are capable of reversal in subsequent year(s). This view is also in consonance with the full
provision method adopted in AS 22.
28.The Committee
notes that as per the definitions of ‘timing differences’ and ‘permanent
differences’ given above, timing differences are differences between accounting
income and taxable income that would be reversing in the future years whereas
permanent differences are differences that do not reverse subsequently. The Committee, accordingly, is of the view
that the terms ‘timing differences’ and ‘permanent differences’, as defined in
AS
22, are mutually exclusive terms, i.e., as per the
definitions, the difference between accounting income and taxable income would
be either a permanent difference or a timing difference and there would not be
any difference which is neither permanent difference nor timing difference.
29. The Committee
notes that paragraph 34 of AS 22, inter alia, provides the following:
“For the purpose of determining accumulated deferred tax in
the period in which this Statement is applied for the first time, the
opening balances of assets and liabilities for accounting purposes and for tax
purposes are compared and the differences, if any, are determined. The tax effects of these differences, if
any, should be recognised as deferred tax assets or liabilities, if these
differences are timing differences. ...”
30. The Committee
further notes that Accounting Standards Board of the Institute has issued a
Clarification 2 on AS 22 which, inter
alia, provides the following:
“.... it is clarified that an enterprise, which applies AS 22 for the first time in respect of accounting period commencing on 1st April, 2001, should determine the amount of
the opening balance of the accumulated deferred tax by using the rate of income
tax applicable as on 1st April, 2001.”
31. The Committee
notes from the facts of the case as given in paragraph 11 above that there is a difference of Rs. 8413.15 lakh in
WDV of fixed assets as on 1-4-2001 for taxation purposes and accounting
purposes resulting
2 Published in
October, 2001 issue of the Institute’s Journal, ‘The Chartered Accountant’.in timing difference in respect of depreciation. The Committee is of the view that apart
from depreciation, there could be differences in balances of assets and
liabilities, other than fixed assets, as on 1-4-2001 for accounting purposes
and taxation purposes which are also required to be considered for
determination of accumulated balance of deferred tax assets/liabilities. The
querist, in the facts of the case, has not mentioned about any difference in
the balance of assets and liabilities, other than fixed assets, as on 1-4-2001
for accounting purposes and taxation purposes. The Committee, accordingly,
presumes for expressing its opinion that there are no other differences in the
balance of assets and liabilities, other than fixed assets, as on 1-4-2001 for
accounting purposes and taxation purposes.
32. The
Committee, on the basis of the above presumption, is of the view that the
company should calculate the accumulated balance of deferred tax liability by
using the rate of income-tax applicable to the company as on 1st April, 2001,
to the difference of Rs. 8413.15 lakh being the difference between deferred
opening balances of assets and liabilities for accounting and taxation
purposes. The accumulated balance of
deferred tax liability, so calculated, is required to be recognised in the books by a corresponding
charge to revenue reserves as per paragraph 33 of AS 22. The Committee, accordingly, does not accept
the view of the querist that adjustment of accumulated deferred tax liability
would distort the operating results in a large way and would make the same
incomparable with the results of subsequent years for the reason that
adjustment of accumulated deferred tax liability is required to be made to
revenue reserves and it would not have any impact on the operating results as
reflected by the profit and loss account for the year.
33. With regard
to whether the deferred tax liability is of the nature of a reserve, the
Committee notes that deferred tax liability arises as a result of less
income-tax paid in the current period under the provisions of the Income- tax
Act, 1961, as compared to the tax that should have been recognised on the basis
of accounting income. In subsequent
years, the differential will reverse as
higher tax will be payable in
the future. In other words, the deferred tax liability represents the amount to be paid in
future in the form of excess tax payments.
34. The Committee
further notes that paragraph 30 of AS 22 provides that deferred tax assets and
liabilities should be distinguished from assets and liabilities representing
current tax for the period. Deferred
tax assets and liabilities should be disclosed under a separate heading in the
balance sheet from current tax and current liabilities. The Committee is of the
view that the paragraph clearly indicates that deferred tax liability is a
liability though not of the nature of a current liability.
35. The Committee
also notes that under the transitional provisions of AS22, the accumulated deferred tax liability is required to be
recognised in the financial statements as a corresponding adjustment to the
revenue reserves. The Committee, accordingly, is of the view that if deferred
tax liability is considered as a reserve equivalent, there would not have been
any need to provide that its corresponding adjustment should be made against
revenue reserves.
36. The
Committee, on the basis of the above, is of the view that deferred tax
liability is a known liability of the company and, therefore, is required to
be disclosed as per the
requirements of Part
III of Schedule VI to the Companies Act, 1956.
37.The Committee
notes that as per section 211(1) of the Companies Act, 1956, every balance sheet of the company is required to be
prepared in the forms set out in Part I of Schedule VI, or near thereto as
circumstances admit. The Committee is,
therefore, of the view that format of balance sheet as set out in Part I of
Schedule VI to the Companies Act, 1956, has inbuilt flexibility to accommodate
necessary modifications. The Committee is, accordingly, of the view that
deferred tax liability should be disclosed separately after the heading
‘Unsecured Loans’. Similarly, the
company should disclose deferred tax assets separately as an asset after the
heading ‘Investments’. Accordingly, in the view of the Committee, it
is not proper to show the deferred tax liability as a part of reserves.
38. The Committee
notes that sub-section (3) of section 209 of the Companies Act, 1956, provides the following:
“For the purposes of sub-sections (1) and (2), proper books
of account shall not be deemed to be kept with respect to the matters specified
therein, –
(a) if there are
not kept such books as are necessary to give true and fair view of the state of
affairs of the company or branch office, as the case may be, and to explain its
transactions; and
(b) if such
books are not kept on accrual basis and accordingto the double entry system of accounting.”
39. The Committee
also notes that as per ‘Announcements of the Council regarding various documents issued by the Institute of
Chartered Accountants of India’, the pronouncements of the Institute seek to
describe the accounting principles and the methods of applying these principles
in the preparation and presentation of financial statements so that they give a
true and fair view. The Committee further notes that paragraph 8.1 of the
‘Guidance Note on Accrual Basis of Accounting’, issued by the Institute of Chartered
Accountantsof India, inter alia, provides the following:
“The Council of the ICAI and its various committees have
issued various Guidance Notes, Statements and Accounting Standards. The
accounting treatments contained in these documents are primarily based on
accrual accounting. Thus, adoption of accounting treatments recommended in
these documents would ensure that a company has followed accrual basis of
accounting.”
40. The Committee,
on the basis of the
above, is of
the view that requirements of section 209 of the
Companies Act, 1956, would not be fulfilled, if the company does not prepare and present its financial
statements as per the requirements of AS 22.
41. The Committee
notes that sub-sections (3A), (3B) and (3C) of section 211 of the Companies Act, 1956, provide the following:
“(3A) Every profit
and loss account and balance sheet of the company shall comply with the
accounting standards.
(3B) Where profit
and loss account and balance sheet of the company do not comply with the
accounting standards, such companies shall disclose in its profit and loss
account and balance sheet, the following, namely:-
(a) the
deviation from the accounting standards;
(b) the reasons
for such deviation; and
(c) the
financial effect, if any, arising due to such deviation.
(3C) For the
purposes of this section, the expression “accounting standards” means the
standards of accounting recommended by the Institute of Chartered Accountants
of India constituted under theChartered Accountants Act, 1949 (38 of 1949), as may be
prescribed by the Central Government in consultation with the National Advisory
Committee on Accounting Standards established under sub-section (1) of section
210A:
Provided that the standards of accounting specified by the
Institute of Chartered Accountants of India shall be deemed to be the
Accounting Standards until the accounting standards are prescribed by the
Central Government under this sub-section.”
42.The Committee
notes that under section 227(3)(d) of the Companies Act, 1956, the auditor is
required to state in his report as to whether, in his opinion, the
profit and loss
account and balance sheet comply with the
accounting standards referred to in sub-section (3C) of section 211.
43. The Committee
also notes that section 227(2) of the Companies Act, 1956, provides the following:
“(2) The auditor
shall make a report to the members of the company on the accounts examined by
him, and on every balance sheet and profit and loss account and on every other
document declared by this Act to be part of or annexed to the balance sheet or
profit and l oss account, which are laid before the company in general meeting
during his tenure of office, and the report shall state whether, in his opinion
and to the best of his information and according to the
explanations given to him, the said accounts give the information required by
this Act in the manner so required and give a true and fair view –
(i) in the case
of the balance sheet, of the state of the company’s affairs as at the end of its financial year; and
(ii) in the case
of the profit and loss account, of the profit or loss for its financial year.”
44. The Committee
is of the view that under clause (d) of section 227(3) of the Companies Act,
1956, the auditor should, with regard to matters covered under this query,
state that balance sheet and profit and loss account of the company do not
comply with AS 22, if the requirements of AS 22 have not been followed in the
preparation and presentation of financial statements.
45.The Committee
notes that paragraphs 3.6, 3.7 and 3.9 to 3.12 of the ‘Statement on Qualifications in Auditor’s Report’, issued by
the Institute of Chartered Accountants of India, provide the following:
“3.6
While
qualifying a report, it is important to appreciate:
(i) as to which
of the various items (the statements of fact and opinion) require a
qualification;
(ii)
whether the
auditors are in active disagreement with something which has been done by the
company or are merely unable to form an opinion in regard to items for which
there is lack of adequate information;
(iii) whether the
matters in question are so material as to affect the presentation of true and
fair view of the whole of the affairs of the company or are of such a nature as
to affect only a particular item disclosed in the accounts; and
(iv) whether the
matters constituting qualification involve a material contravention of any
requirements of the Companies Act, 1956 which have a bearing on the accounts.
3.7 In a majority
of cases, items which are the subject matter of qualifications are not so material
as to affect the truth and fairness of the whole of the accounts. In such cases, it is appropriate for the
auditors to report that in their opinion, subject to the specific
qualifications mentioned, the accounts present a true and fair view. Sometimes, however, the items which are the
subject matter of qualifications are so material that it would be meaningless
to state, that subject to the qualifications, the accounts disclose a true and
fair view. An example would be where all the qualifications taken together
substantially affect the profit or loss as shown in the profit and loss
account, including where the profit is converted into a loss or vice
versa. In such a case, the auditor
should state that the profit and loss account does not reflect a true and fair view of profit or loss for the period. Another example would be where the auditors
were not able to examine a substantial part of the books of account, e.g., they
were in police custody. In such a case it would not be proper to express an opinion on the
truth and fairness of the accounts after merely stating that the books of
account were not examined. In such
cases the auditors must report that either -
(i)
they are
unable to state whether the accounts present a true and fair view; or
(ii)
make a
categorical statement that in their opinion the accounts do not present a true
and fair view.
Which of the above two alternatives should be followed would
depend upon the facts of each case. An
example of a situation referred to in paragraph 3.7 (ii) is as follows:
(a)
The company
has adopted the method of taking entire profits on construction contracts to
the Profit and Loss Account on entering into the contract. This has resulted in anticipating the profit
in cases where contracts have not even been commenced or where only a very minor part
of the expenditure on the contract
has been incurred. We are of the opinion that this method of accounting is
contrary to accounting principles and methods;
(b)In view of
para (a) above, we are of the opinion that the said accounts do not give a true
and fair view –
(i)
In the case
of Balance Sheet, of the state of affairs of the Company as at 31st March, 1980; and
(ii)
in the case
of the Profit and Loss Account, of the profit of this year ended on that date.”
“3.9
In order to
ensure a certain degree of uniformity and to assist the public in evaluating
the contents of auditor’s reports, it is desirable that the manner in which
qualifications are made in auditors’ reports is such as not to leave any room
for doubt in the minds of the public.
3.10
All
qualifications should be contained in the auditors’ report. The notes to the
accounts normally represent explanatory statements given by the directors of
the company and should not contain the opinion of the auditors. Some of the
notes may be subject matter of qualifications in the auditors’ report while some others may be merely
clarificatory.It is necessary that, in their audit reports, the auditors
should reproduce 3 the notes which are subject matter of qualifications so that the readers may
properly appreciate the significance of those qualifications. It is also
necessary that the auditors should quantify, wherever possible, the effect of
individual qualifications as well as the total effect of all the qualifications
on profit or loss and /or state of affairs in clear and unambiguous manner. In
circumstances where it is not possible to quantify the effect of the
qualifications accurately, the auditors may do so on the basis of estimates made
by the management after carrying out such audit tests as are possible and
clearly indicate the fact that the figures are based on management estimates.
3.11
The qualifying
remarks should be placed in such a manner as to make it very clear as to the
particular item of the auditors’ report t o which the qualifications relate
e.g., if the qualification is of such a nature that it affects the truth and
fairness of the accounts, it should not be placed in such a manner as to give
an impression that the auditors have not obtained all the information which has
been required in th e performance of their work.
3.12 It is customary for qualifications to be made by the
use of expressions such as, “subject to” or “except that”. The
expression s “read with the notes thereon” or “together with the notes
thereon ” are of an explanatory nature and do not constitute
qualifications.It is therefore important when seeking to qualify a report,
that the auditors shall use such recognised terminology which clearly implies a
qualification. It is not a correct practice to merely make a factual statement
in the auditors’ report without taking exception thereto. In a case where the
treatment of underwriting commission was not i n accordance with the accepted
accounting practice, the auditors reported as under:
“Underwriting commission on shares taken up by the
corporation under underwriting arrangements has been taken to Profit and Loss
Account. This is contrary to accepted accounting practice.
We report that the Balance Sheet shows a true and fair view
....”
This method of reporting is not proper. The report should have been worded as
follows:
“Underwriting commission on shares amounting to Rs.... taken
up by the Corporation under underwriting arrangements has been taken to Profit
and Loss Account. This is contrary to
accepted accounting practice and has resulted in the profit being overstated by
Rs .......
Subject to the above, we report that the Balance Sheet shows
a true and fair view...”
The use of the words “subject to” is essential to bring out
the qualification.”
46. The
Committee, on the basis of the above, is of the view that if the requirements
of AS 22 have not been followed, the auditors should consider the aspects laid
down in paragraph 3.6 of the ‘Statement on Qualifications in Auditor’s Report’,
reproduced above, to determine whether they are required to give a qualified opinion/adverse opinion/disclaimer of
opinion in their audit report. As per
paragraph 3.7 of
the Statement, reproduced
above, in a majority of cases, items which are the
subject matter of qualifications would not be so material as to affect the
truth and fairness of the whole of the accounts. In such cases, it is appropriate for the auditors to report that
in their opinion, subject to the specific qualifications mentioned, the accounts
present a true and fair view. In such a case, the auditors should give
qualified opinion. Thus, where a
company has not charged deferred tax liability for the year, the qualification
may appear as below:
“Deferred tax liability amounting to Rs._
has not been provided for in the
books by charge to the statement of profit and loss. This is contrary to the
requirements of AS 22 and has resulted in an overstatement of profit by
Rs.______. As a result, revenue reserves have been overstated and liabilities
have been understated in the balance sheet by the same amount.
Subject to the above, we report that.............”
47. The Committee
notes that AS
22 prescribes the
requirements for reassessment of
unrecognised deferred tax assets and review of deferred tax assets at each
balance sheet date. Reassessment of
the unrecognised deferred tax assets is necessary in view of the fact that
there may be certain deferred assets which have not been recognised because of
the considerations of prudence laid
down in paragraphs
15 and 17, but which
need to be recognised since the said assets now meet
the criteria for recognition laid down in the aforesaid paragraphs. Review of the deferred
tax assets is necessary to assess whether the criteria
for recognition as per the aforesaid paragraphs of AS 22 continue to be met.
The aforesaid considerations, however, are not relevant in case of a
deferred tax liability, since, as per the generally accepted accounting
principles, once a provision for a liability is created, it continues in the
accounts unless a change in the circumstances warrant a writeback, e.g., where
a liability is waived by a creditor. In
case of a deferred tax liability such a situation may arise in
case the tax laws undergo changes. The
Committee notes that this aspect has been taken care of in AS 22, as it has
been provided that all deferred tax assets and liabilities are required to be
measured using the tax rates and tax laws that have been enacted or
substantively enacted by
the balance sheet
date (paragraph 21). The
Committee is of the view that the amount of deferred tax liabilities would have
to be adjusted as per this requirement for subsequent changes in tax rates or
tax laws, but not for expected changes in profitability.
D. Opinion
48. The Committee
is of
the following opinion on
the issues raised in paragraph 22 above:
(a) No.
(b) Question
does not arise, since answer to (a) above is in the negative.
(c) Question
does not arise, since answer to (a) above is in the negative.
(d) Subject to
the presumption made in paragraph 31 above, the company is required to
recognise the accumulated balance of deferred tax liability at an amount
calculated by using the rate of income tax applicable to the company as on 1st
April, 2001, to the difference of Rs. 8,413.15 lakh.
(e) If the
company chooses not to provide for accumulated deferred tax liability, under
clause (d) of section 227(3) of the Companies Act, 1956, the auditors should,
with regard to matters covered under this query, state that balance sheet and
profit and loss account of the company do not comply with AS 22. Further, with regard to opinion under section 227(2) of the Companies Act, 1956, the auditors would be required to give qualified
opinion/ adverse opinion/disclaimer of opinion in their audit report in
accordance with the paragraphs 45 and 46 above.
(f) In case the
requirements of AS 22 are not followed, its disclosure either in accounting
policy or in notes to accounts would not be sufficient for the auditors to not
to qualify their audit report. Accordingly, in such a case, under clause (d) of
section 227(3 ) of the Companies Act, 1956, the auditors should, with regard to
matters covered under this query, state that balance sheet and profit and loss
account of the company do not comply with AS
22. Further with
regard to opinion under section 227(2) of th e Companies Act, 1956, the
auditors would be required to give qualified opinion/adverse opinion/disclaimer
of opinion in their audit report in accordance with the paragraphs 45 and 46
above.
(g) Refer to (f)
above.
(h) Refer to (f)
above.
(i)
(i) As per AS 22, the company is also required to provide for accumulated balance of deferred tax liability which has accumulated as on the adoption of the Standard. Accordingly, it would not be a due compliance of AS 22.
(ii) No, since deferred tax liability is a liability it cannot be shown under the heading ‘Reserves and Surplus’ .
(iii) No.
(iv) No.(v) No.
(vi) Refer to
paragraph 47 above.
1Opinion finalised
by the Committee on 30.5.2002.
2 Published in October, 2001 issue of the Institute’s Journal, ‘The Chartered Accountant’.
3 For removal of
doubts, it is clarified that the use of the word “reproduce” here does not
imply a verbatim reproduction. Where
notes of a qualificatory nature appear in the accounts, the auditor should
state all qualifications independently in his report in an adequate manner so
that a reader can assess the significance of these qualifications. For this purpose, where a note is already given in detail by
the management, it is not necessary to reproduce verbatim such a note in the audit report and a brief self- explanatory
statement may be sufficient.
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