Query No. 5

Subject:

Deferred tax effect of adjusting impairment loss directly against revenue

reserves pursuant to transitional provisions under AS 28.¹

A. Facts of the Case

1. A manufacturing company has an annual turnover of approximately Rs. 1800 crore. The querist has stated that the company has adopted Accounting Standard (AS) 28, ‘Impairment of Assets’, issued by the Institute of Chartered Accountants of India, as part of its accounting policies with effect from April 2004. It has identified a few assets as on 1st April, 2004, for carrying out impairment test as per the Standard. Following the exercise, an amount of Rs. 12 crore has been recognised as impairment loss in respect of an asset and adjusted against the opening balance of revenue reserves as on 1st April, 2004. This particular asset
was commissioned in September 1996 at a cost of Rs. 23 crore. Accumulated depreciation for this asset as on 31st March, 2004, following straight line method of depreciation as per the company’s accounting policy, was Rs. 9 crore. The useful life considered for the purpose of depreciation is 19 years. According to the querist, as per paragraph 61 of AS 28, the accumulated impairment loss is to be adjusted against carrying amount of the asset. The carrying/written down value of the said asset as on 1st April, 2004, is worked out as below:
 

The querist has stated that the carrying amount of Rs. 2 crore mentioned above, actually represents the recoverable amount ascertained in accordance with the requirements of AS 28, as it represents the net selling price of the asset as ascertained by the management.

2. The company has charged off the accumulated impairment loss as on 1st April, 2004, to the revenue reserves as per the transitional provision, applicable in the year when AS 28 is adopted.

3. The querist has drawn the attention of the Committee to the following definitions given in paragraph 4 of AS 22:

      “4. For the purpose of this Statement, the following terms are used with the meanings specified:

        Accounting income (loss) is the net profit or loss for a period, as reported in the statement of profit and loss, before deducting income tax expense or adding income tax saving.

      Taxable income (tax loss) is the amount of the income (loss) for a period, determined in accordance with the tax laws, based upon which income tax payable (recoverable) is determined.

      Tax expense (tax saving) is the aggregate of current tax and deferred tax charged or credited to the statement of profit and loss for the period.

      Current tax is the amount of income tax determined to be payable (recoverable) in respect of the taxable income (tax loss) for a period.

      Deferred tax is the tax effect of timing differences.

      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.”

4. From the above definitions, the querist has observed that deferred tax is the tax effect of timing differences, which have been defined as the difference between the taxable income and the accounting income for a period that originate in one period and are capable of reversal in one or more subsequent periods. The querist is of the view that in the case of accumulated impairment loss being charged off to revenue reserves as per the transitional provisions of AS 28, there is no impact on accounting income, which has been defined as the net profit or loss for a period, as reported in the statement of profit and loss, before deducting income tax expense or adding income tax saving. Since there is no difference between taxable income and accounting income on account of accumulated impairment loss being charged off to revenue reserves, there is no deferred tax effect.

5. The querist has referred to Example 3, given in the Appendix to AS 28, which illustrates the deferred tax effects of accounting for impairment loss under this Standard, which clearly shows that when impairment loss is charged off to the statement of profit and loss, the impairment loss amount is not an allowable expense under the existing income tax law and has to be added back to income for the purpose of computation of current tax. Since this difference is capable of reversing in future, the querist has expressed the view that it is a timing difference, giving rise to deferred tax asset, which has to be recognised, subject to the considerations of prudence as given in AS 22. According to the querist, for the purpose of disclosure, while AS 22 is silent in this regard, the example of deferred tax effects given in AS 28 shows that it is to be netted-off with the deferred tax liability on account of depreciation. However, the Example 3, showing the deferred tax effects of accounting for impairment loss, does not show any deferred tax effect of the accumulated impairment loss charged off to revenue reserves, which, according to the querist, implies that there is no deferred tax effect.

6. The querist has further stated that it must also be taken into consideration that in case of any reversal of the provision for impairment loss charged off to revenue reserves, in any subsequent year, the amount has to be credited to the statement of profit and loss as per AS 28. In such a situation, in the view of the querist, no deduction from taxable income would be available for such a reversal of the provision for accumulated impairment loss charged off to revenue reserves, since the amount was not subjected to income tax at the time of creating the provision. This implies that there could be a future income tax liability arising out of the accumulated impairment loss charged off to revenue reserves. Hence, as per the querist, on the consideration of prudence, the deferred tax liability created in the past should not be reversed, purely based on the mechanism of computing deferred tax liability under the balance sheet method by considering the difference between written down value (WDV) of assets for tax purposes and the net book WDV after adjusting impairment loss in accordance with paragraph 61 of AS 28, unless there is certainty that no reversal of this impairment loss provision can ever take place in future.

B. Query

7. The querist has sought the opinion of the Expert Advisory Committee as to whether there would be any deferred tax effect arising out of the charging-off the accumulated impairment loss as on 1st April, 2004, to the revenue reserves as per the transitional provisions under AS 28, in the year of adoption of this Accounting Standard.

C. Points considered by the Committee

8. The Committee is of the view that the transitional provisions are provided with a view to facilitate a smooth switch-over to a new method of accounting. In case of AS 28, had the Standard been in effect from the beginning, the impairment loss would have been recognised in the profit and loss accounts of the relevant years and deferred tax would also have been recognised in the relevant years. Therefore, effectively, as on the date of AS 28 first becoming mandatory (i.e., on 1-4-2004 for the company), the revenue reserve would have been adjusted to the extent of impairment loss net of deferred tax and deferred tax asset would have been recognised separately subject to the considerations of prudence laid down in AS 22. The impairment loss is an item of profit and loss account, and its nature is not changed only because of the special transitional provisions requiring its adjustment directly against the revenue reserves. Therefore, it would be appropriate to adjust the accumulated impairment loss net of deferred tax and to recognise the deferred tax asset separately subject to the conditions laid down in AS 22 in respect of prudence (reasonable certainty or virtual certainty, as the case may be). If the conditions laid down in AS 22 are not met, the entire amount of impairment loss should be adjusted against the revenue reserves. The reversal of the deferred tax asset should, however, be recognised in the profit and loss account of the year in which the reversal takes place.

9. In this context, the Committee notes that providing the deferred tax effect on adjustment directly against revenue reserve as a transitional provision has also been recognised in the revised Accounting Standard (AS) 15, ‘Employee Benefits’ (paragraph 142), issued by the Institute of Chartered Accountants of India.

D. Opinion

10. The adjustment of impairment loss directly against the revenue reserve pursuant to the transitional provisions under AS 28, should be made net of any related deferred tax, subject to the consideration of prudence in case of deferred tax assets in accordance with the requirements of AS 22. The reversal of the deferred tax asset should, however, be recognised in the profit and loss account of the year in which the reversal takes place.

¹ Opinion finalised by the Committee on 15.3.2005