Query No. 16 Subject: Treatment of deferred tax on provision for doubtful debts1 A. Facts of the Case 1. A company is a leading design and engineering consultancy organisation in the business of providing engineering and consultancy services in the field of petroleum refineries, petrochemicals, oil and gas processing, offshore structures and platforms, fertilisers, metallurgy and power. 2. The company is not reflecting deferred tax provision on doubtful debts on the face of the profit and loss account in view of certainty of collectability of debts but discloses the same by way of notes to accounts duly indicating the amount of such deferred tax. 3. During the course of audit of accounts of the company for the year ending 31st March, 2004, the Office of the Principal Director, Commercial Audit and Ex-Officio member, Audit Board, has expressed certain reservations with regard to non-reflection of deferred tax with respect to provision for doubtful debts and advances on the face of the profit and loss account. It was of the view that the same is not in line with Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, issued by the Institute of Chartered Accountants of India. 4. Most of the clients of the company are oil sector public sector undertakings (PSUs). The company enters into contracts with the clients on the following bases:
5. The invoices are raised as per the terms of the contract. Sometimes, there are delays in releasing the payments by the clients due to the following reasons:
Pending the settlement of the above issues at the clients’ end, the clients do not release the outstanding payments and sometimes release of payments takes considerable time. 6. The company, as a matter of policy, creates provision for any debts outstanding for more than three years as a prudent accounting policy consistently followed over the years. However, as the company is mainly dealing with PSU clients, chances of such debts becoming bad are very remote and management has reasons to believe that these debts will be recovered during the course of time. The company has also analysed the data for the last four years and has observed that against the provision for doubtful debts, the company has recovered approximately 30% during the last four years. 7. The company is also indicating the impact of deferred tax provision on its doubtful debts and advances in its notes forming part of accounts for the year ending 31st March, 2004, which is reproduced below:
8. Further, paragraph 16 of AS 22 states that while recognising the tax effect of timing difference, consideration of prudence cannot be ignored. Since the management is certain that the debts, in respect of which, provision for doubtful debts has been made in the books of account, shall be recovered subsequently, there is no need to create any deferred tax asset in respect of such provisions for doubtful debts.
B . Query 9. The opinion of the Expert Advisory Committee has been sought on the following issues:
C. Points considered by the Committee 10. The Committee notes that Part III of Schedule VI to the Companies Act, 1956 states in para 7(2) as below:
11. The Committee also notes that Schedule VI to the Companies Act, 1956, under ‘Instructions in accordance with which assets should be made out’ in respect of ‘sundry debtors’ provides that "The provisions 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" (on the Liabilities side) under a separate sub-head "Reserve for Doubtful or Bad Debts"."
12. The Committee notes that the querist has stated in paragraph 6 of the Facts of the Case that the chances of debts (against which provision has been created) becoming bad are very remote and management has reasons to believe that these debts will be recovered during the course of time. The Committee also notes from the said paragraph that recovery to the extent of 30% has also been made by the company during the last four years.
13. From the above paragraphs, the Committee is of the view that creation of provision by the company against debts that are considered to be recoverable, merely because the said debts are outstanding for more than three years, is not a correct accounting policy. The provision should not be in excess of its reasonable requirement. The excess amount of provision should be treated as a reserve and disclosed as such on the ‘Liabilities’ side of the balance sheet.
14. The Committee further notes that the provision for bad and doubtful debts represents impairment of receivables which is covered by Accounting Standard (AS) 4, ‘Contingencies and Events Occurring After the Balance Sheet Date’, issued by the Institute of Chartered Accountants of India. In this context, the Committee notes that AS 4 provides that the estimation of the amount of such loss to be provided for in the financial statements should be based on the estimates of the outcome and of the financial effect of contingencies determined by the judgement of the management of the enterprise. This judgement should be based on consideration of information available upto the date on which financial statements are approved and should include a review of events occurring after the balance sheet date supplemented by experience of similar transactions. Therefore, the Committee is of the view that creation of provision in excess of the amount required is in violation of AS 4.
15. The Committee notes that as per Accounting Standard (AS) 22, ‘Accounting for Taxes on Income’, issued by the Institute of Chartered Accountants of India, the ‘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". The Committee notes that creation of provision for bad and doubtful debts gives rise to timing differences for which deferred tax should be recognised. 16. The Committee also notes paragraphs 13, 15 and 16 of AS 22 which provide as below:
17. From the above, the Committee notes that the term ‘prudence’ contained in paragraphs 13 and 16 of AS 22, has been used in relation to reasonable certainty regarding availability of sufficient future taxable income for realisation of deferred tax assets. The term ‘prudence’ has not been used in these paragraphs with reference to the realisability of the debts against which provision has been created, as argued by the querist. Therefore, the Committee is of the view that deferred tax should be recognised as per AS 22 in respect of provision against doubtful debts which should be created in accordance with the requirements of AS 4. D. Opinion 18. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 9 above:
1 Opinion finalised by the Committee on 6.10.2004 |