12 Inter-Relationship between Accounting and Taxation

Transcription

1 12 Inter-Relationship between Accounting and Taxation Are accounting principles and accounting standards recognized under taxation laws? Apparently, this question seems to be very simple. However, when you delve into the depth of the question, you may find that there are conflicting answers Yes and No. The answer may be yes or no depending on the specific issue in taxation in respect of which the question is raised. In this chapter, we have tried to make an effort to analyse the different facets of this question and find an appropriate answer. This chapter gives a macro view of the inter-relationship between accounting and taxation. It spells out the extent of recognition of the accounting principles by the judicial forums in settling tax disputes, the extent of convergence and divergence between Accounting Standards and the income-tax law, the treatment of income-tax expense under Accounting Standards, the relevance of method of accounting under income-tax law, the differences in the method of accounting of tax, duty etc. in valuation of stock as per Accounting Standard and the income-tax law, the requirement of compulsory maintenance of prescribed books of account under the income-tax law and the relevance of profit and loss account prepared under the Companies Act, 1956 for levy of Minimum Alternate Tax (MAT). First of all, let us understand the extent of recognition of the accounting principles by the judicial forums while settling tax disputes Recognition of accounting principles by judicial forums while settling tax disputes Various judicial authorities in the country, including the Supreme Court of India, have recognized the accounting principles and accounting standards laid down by the ICAI while deciding tax disputes. There have also been instances when Courts have purposefully synchronized the Statements/Guidance Notes/Accounting Standards issued by the Institute while deciding about certain issues from the taxation point of view. However, there have also been occasions when appellate and judicial forums have not followed the accounting principles and Accounting Standards in the context of determining certain issues under the tax laws. This is for the reason that the courts, having recognized the authenticity of accounting principles and Accounting Standards, have felt that in the matter of computation of income, effect should be given to the specific provisions of the tax laws. In Challapalli Sugars Ltd. v CIT 98 ITR 167, the Supreme Court, while deciding the question of expenditure during construction period, held that interest paid on monies borrowed during construction period should be capitalized. While laying down this principle, the Supreme Court observed that it would be necessary to ascertain the connotation of the expression actual cost in

2 12.2 Income Tax accordance with the normal rules of accounting. Accordingly, the Apex Court held that the actual cost will include the interest paid on monies borrowed during the construction period. In Tuticorin Alkali Chemicals and Fertilizers Ltd. v. CIT 227 ITR 172, the Supreme Court referred to the Challapalli Sugars Ltd s case and observed that the ICAI is a recognized authority on accounting principles and its view has to be respected. However, while dealing with the question of taxability of interest income from investment of borrowed funds prior to commencement of business, the Court did not follow the research publication and Accounting Standard of the Institute and held that the income was taxable under the head Income from other sources as it arose from an independent source of income not connected with the construction activities or business activities. The Supreme Court observed that though the Court had very often referred to accounting practice for ascertainment of profits, when the question was whether a receipt of money was taxable or not or whether certain deductions from that receipt were permissible in law or not, the question had to be decided according to the principles of taxation laws and not only in accordance with accountancy practice. When a similar issue came up before the Supreme Court again in CIT v. Bokaro Steel Ltd. 236 ITR 315, the Supreme Court followed the relevant Accounting Standard and held that rent of quarters given to contractors and charges for plant and machinery given to contractors for use in construction work and interest from advances made to contractors for facilitating the construction work should be deducted from the cost of construction on the ground that these receipts were inextricably linked with the setting up of the capital structure of the company and hence should be viewed as capital receipts which would go to reduce the cost of construction. The Madhya Pradesh High Court has, in CIT v. State Bank of Indore (2005) 146 Taxman 65, observed that the amount of bad debts should be debited to the provision for bad and doubtful debts account and only if such amount is more than the credit balance in the provision for bad and doubtful debts account, the excess is eligible for deduction under section 36(1)(vii). As per generally accepted accounting principles, the allowability of deduction in respect of bad debts is clearly governed by the method of accounting as explained by the High Court in CIT v. State Bank of Indore. The above judicial pronouncements and other similar cases indicate that accounting concepts are now being increasingly recognized for the purpose of tax laws Accounting Standards and Income-tax law - Convergence and Divergence Now, we shall study the points of similarity and differences between the principles laid down under the Accounting Standards and income-tax law. The significant points of divergence are as follows - (1) AS 2 [Valuation of Inventories] AS 2 recognises Exclusive method of inventory valuation whereas section 145A of the Income-tax Act, 1961 prescribes Inclusive method of inventory valuation. These two methods have been discussed in detail in para 12.5 of this Chapter.

3 Inter-relationship between Accounting and Taxation 12.3 (2) AS 6 [Depreciation Accounting] (i) The basis for provision of depreciation as per this Accounting Standard is the estimated useful life of an asset. However, under the Income-tax Act, 1961, the useful life of an asset is not relevant. The concept of block of assets is applicable and the rates of depreciation are higher under the Income-tax Act, 1961 with the objective of providing incentive to the assessee. Further, incentive is also provided by way of additional depreciation in respect of new plant and machinery installed by assessees engaged in the manufacture or production of any article or thing or in the business of generation or generation and distribution of power. (ii) The Accounting Standard provides for allowance of depreciation on revalued amount in the case of revaluation. Under the Income-tax Act, 1961, depreciation is allowed only on the written down value of block of assets. Revaluation is not recognized for income-tax purposes. (iii) For the purpose of claiming depreciation under section 32, the asset, in respect of which the depreciation is claimed, must have been used for the purpose of business or profession. However, use of asset is not a pre-condition for provision of depreciation under AS 6. (3) AS 11 [Accounting for the Effects of Changes in Foreign Exchange Rates] As per AS 11, exchange differences relating to a liability incurred for the purpose of acquiring fixed assets, which are carried in terms of historical cost, cannot be adjusted in the carrying amount of the respective fixed assets. The exchange difference has to be charged to profit and loss account. However, section 43A requires such exchange differences to be adjusted against the actual cost of the asset. Such adjustment has to be made in the year in which the actual payment is made irrespective of the method of accounting followed by the assessee. However, it may be noted that in the case of companies, the exchange difference relating to acquisition of a depreciable capital asset can be adjusted against the cost of the asset, at the option of the enterprise 1. Such option is irrevocable and has to be applied to all such foreign currency monetary items. (4) AS 13 [Accounting for Investments] As per this Standard, long-term investments should be carried at cost and provision should be made to recognize a decline other than temporary in the value of long-term investments. Such reduction should be determined and made for each investment individually. However, under the Income-tax Act, 1961 there is no provision to recognize a decline in the value of investments. Only if the investments are disposed off, the profit/loss on account of the same is recognized. In Kerala Small Industries Development Corporation Ltd. v. CIT (2004) 270 ITR 0452, the assessee had written off ` 80 lacs, representing investment in shares of co-operative societies, in its profit and loss account considering the fact that the said co-operative societies were either defunct or under liquidation. The High Court observed that any loss on shares representing investment of the assessee cannot be termed as trading/revenue loss. Further, the High Court observed that the reduction in the value of shares was effected through book entries only and there was no actual 1 Necessary process is being followed to make this option applicable to non-corporate entities also.

4 12.4 Income Tax transfer of shares. Therefore, it could not even be construed as a capital loss arising out of trading in capital assets. Note All entities are encouraged to follow AS-30 [Financial Instruments: Recognition and Measurement] in respect of shares held as investments. (5) AS 14 [Accounting for Amalgamations] As per this Standard, amalgamation expenses incurred by the transferee company should be debited to profit and loss account where the amalgamation is in the nature of merger and to Goodwill/Capital reserve account where the amalgamation is in the nature of purchase. Under section 35DD of the Income-tax Act, 1961, deduction of one-fifth of such expenditure is allowed for five successive previous years, beginning with the previous year in which amalgamation takes place. Further, the Income-tax Act, 1961 does not distinguish between amalgamation in the nature of merger and amalgamation in the nature of purchase. (6) AS 18 [Related Party Disclosures] This Standard prescribes disclosure of related party relationships and transactions between a reporting enterprise and its related parties. It does not prescribe any accounting requirement. However, under the Income-tax Act, 1961, a specific disallowance has been provided. Under section 40A(2), where the assessee incurs any expenditure in respect of which a payment has been or is to be made to a relative or associate concern, so much of the expenditure as is considered to be excessive or unreasonable shall be disallowed by the Assessing Officer. Further, the transfer pricing provisions in the Income-tax Act, 1961, provide for application of arm s length price for determining the income from an international transaction with an associated enterprise or a specified domestic transaction. For the meanings of international transaction, specified domestic transaction and arm length price, please refer to Chapter-16 on Transfer Pricing. (7) AS 19 [Leases] The leases are classified into finance leases and operating leases as per this Standard. A finance lease is a lease that transfers substantially all risks and rewards incidental to ownership of an asset. In operating lease, only the right to use the asset is transferred. Depreciation on leased asset is allowable as per AS 6 in the hands of the lessee in case of a finance lease. However, AS 6 will have no implication on the allowance of depreciation on assets under the provisions of the Income-tax Act, The owner of the asset (i.e., the lessor) is entitled to depreciation under section 32 of the Income-tax Act, 1961, if the asset is used in the course of his business. This has been clarified by Circular No.2 dated The Apex Court, in I.C.D.S. Ltd. v. CIT (2013) 350 ITR 527, held that section 32 requires that the asset must be used in the course of business. It did not mandate actual usage by the assessee itself. Therefore, the lessor is entitled to claim depreciation since he is using the asset in the course of his leasing business. Lease rentals from finance lease are apportioned between finance income and reduction of lease receivable outstanding in the books of the lessor as per AS 19. Only finance income is credited to the profit and loss account whereas the full lease rental is treated as income for tax purposes. Similarly, in the books of the lessee, lease rental is apportioned between finance charges and reduction of liability. Only the finance charges are debited to the profit and loss account whereas the full lease rental is deductible for tax purposes.

5 Inter-relationship between Accounting and Taxation 12.5 (8) AS 26 [Intangible Assets]: As per para 56 of AS 26 Intangible Assets, some expenditures are incurred to provide future economic benefits to an enterprise but no intangible asset or other asset is acquired or created that can be recognized. In this case, the expenditure is recognized as an expense when it is incurred, for example, preliminary expenses. However, section 35D provides for amortization of preliminary expenses over a period of five years. (9) AS 28 [Impairment of Assets] As per this Standard, if the carrying amount of an asset exceeds its recoverable value, the excess is impairment loss. Such loss should be provided for in the statement of profit and loss. It must be noted that impairment provision is in addition to the depreciation provided as per AS-6. However, there is no such provision for impairment loss under the income-tax law. The significant points of convergence are as follows - (1) AS 2 [Valuation of Inventories] As per AS 2, inventory has to be valued at lower of cost and net realizable value. This method is also recognized for income-tax purposes in case of a going concern. Only in a case where the fundamental accounting assumption of going concern no longer holds good, the closing stock has to be valued at market price. The Supreme Court, in ALA Firm v. CIT (1991) 189 ITR 285, held that when a firm is dissolved and the business is discontinued, closing stock taken over by the partner has to be valued at market value and not at cost. The principle involved in this case is that the fundamental accounting assumption of going concern cannot be applied for valuing stock-in-trade at the time of dissolution. (2) AS 9 [Revenue Recognition] This standard provides that revenue recognition should be postponed if there is significant uncertainty regarding collectability. This principle has been recognized for tax purposes also by the Supreme Court in the case of UCO Bank v. CIT 237 ITR 889, where it was held that interest on sticky loans would not accrue if the same was not recoverable. The decision of the Allahabad High Court in CIT v. U.P. Financial Corporation (2005) 143 Taxman 47 that interest accrual should be postponed where suits for recovery of interest-bearing loans are pending, is also in consonance with this principle enunciated in AS Treatment of income-tax expense under Accounting Standards AS-3 and AS-22 provides for the accounting treatment of income-tax expense. In particular, AS-22 on Accounting for taxes on income is very important in this regard and hence has been discussed in some length. Let us try to understand the accounting treatment of incometax expense as per these Standards. (1) AS 3 [Cash flow statement]: As per this Standard, cash flow on account of income-tax has to be shown as an operating activity unless it can be specifically identified with an investing or financing activity. If income-tax paid is segregated between these activities, then total tax paid should also be disclosed. Income-tax paid should be shown net of TDS.

6 12.6 Income Tax (2) AS 22 [Accounting for taxes on income]: Accounting for taxes on income should be in accordance with AS 22, irrespective of whether such taxes are imposed by an Indian law or by the law of a foreign country. Prior to AS 22, corporates were making a provision for the actual tax liability calculated in accordance with the Income-tax Act, 1961 (i.e., current tax). The accounting effect for differences between taxable income and accounting income was not given. In the case of a loss-making entity, no provision for taxation was made. Neither was any entry passed for accounting for tax savings as a result of the loss. However, such treatment is not permitted under AS 22. As per AS 22, the amount to be included in respect of income-tax in the profit and loss account should be the current tax plus or minus the deferred tax. Current tax is the tax determined in accordance with the provisions of the Income-tax Act, Deferred tax is the tax effect of timing differences. There is always a difference between the accounting income and the taxable income. AS 22 requires classification of these differences into permanent differences and timing differences. Permanent differences: Permanent differences are those differences which originate in one period and do not reverse subsequently. These differences will not at all reverse in subsequent periods. These differences do not result in deferred tax assets (DTAs) or deferred tax liabilities (DTLs). Such differences are on account of - (i) Recognition of revenues/gains/expenses/loses in the profit and loss account but not for income-tax computation. One example is goodwill, which is amortised in accounts. However, the same is not a deductible expense while computing income-tax. Another example is unrealised exchange gain, which is credited to profit and loss account but not taxed as income. (ii) Recognition of revenues/gains/expenses/losses for income-tax purposes but not in the profit and loss account for accounting purposes. One example is expenditure in respect of which weighted deduction is allowable under the Income-tax Act, 1961, namely, contribution made for research in social science or statistical research or any other research, which is eligible for a deduction of 125% under section 35 of the Income-tax Act, The excess deduction of 25% is not recognized in the profit and loss account but considered for computation of taxable income. It may be noted that no accounting adjustments are necessary for tax effects of permanent differences. Timing differences: Timing differences are the differences between the accounting income and the taxable income that originate in one period and are capable of reversal in one or more subsequent periods. The words capable of reversal means that there are chances of reversal, however good or remote they may be. It does not, however, indicate 100% certainty of reversal. Timing differences arise only in respect of incomes/expenses which are considered both in the profit and loss account as well as for computation of taxable income, although, in different periods. Some examples of timing differences are given below - (1) Expenses debited to profit and loss account but allowed for tax purposes in subsequent years, for example - (i) Expenditure covered by section 43B of the Income-tax Act, 1961, which are allowed only in the year of actual payment. However, in the previous year in which the expenditure is

7 Inter-relationship between Accounting and Taxation 12.7 incurred, it can be claimed as deduction, provided it is paid on or before the due date for filing the return of income. (ii) Any interest, royalty, fees for technical services payable outside India or in India to a non-resident, on which tax has not been deducted at source and hence, disallowed during the previous year. However, the same has been allowed for tax purposes in the subsequent year when such tax is deducted and paid. (iii) Any interest, commission or brokerage, fees for professional services or fees for technical services payable to a resident, on which tax has not been deducted at source and hence disallowed during the previous year. However, the same has been allowed in the subsequent year when such tax is deducted and paid. (iv) Provisions made for liabilities in the books of account. However, deduction is allowed under the Income-tax Act, 1961 in the subsequent years when the liability crystallizes e.g., provision for warranties. (v) Preliminary expense written off completely in the year in which they are incurred as per AS 26 but allowed to be amortised over 5 years for tax purposes as per section 35D. (2) Difference between depreciation as per books of account and depreciation allowable for tax purposes under section 32. (3) A deduction which is allowed for tax purposes on the basis of a deposit made, for example, tea/coffee/rubber development account scheme under section 33AB and site restoration fund under section 33ABA. The withdrawal from such deposit is debited to the profit and loss account in the subsequent years. (4) Income credited to profit and loss account in a particular year but brought to tax in a later year. For example, where a capital asset is converted into stock in trade, the capital gains would be charged to tax only in the previous year in which the stock in trade is sold. A timing difference may result in a deferred tax asset or a deferred tax liability. A deferred tax asset arises on account of (i) (ii) Recognition of revenue/gain in an earlier period for tax purpose, but in a later period for accounting purpose. e.g. operating lease rentals, in a case where the amount received in an earlier year is high, the same would be recognized as income for tax purpose. However, for accounting purpose, the recognition would be deferred since such lease rentals are recognized on a straight line basis as per AS-19. Recognition of expenses/losses in an earlier period for accounting purpose, but in a later period for tax purpose. e.g. (i) Expenditure in relation to which section 43B applies, in respect of which payments have not been made on or before the due date for filing the return of income. Such expenditure will be allowed for tax purposes in the year of actual payment. (ii) Preliminary expenses written off during the year in the profit and loss account but deferred over a period of 5 years for tax purposes as per section 35D.

8 12.8 Income Tax A deferred tax liability arises on account of - (i) Recognition of revenue/gain in an earlier period for accounting purpose, but in a later period for tax purpose - e.g. conversion of a capital asset into stock-in trade recognized in the year of conversion for accounting purpose but only in the year of sale of stock-in-trade for tax purpose. (ii) Recognition of expenses/losses in an earlier period for tax purpose, but in a later period for accounting purpose - e.g. Depreciation, since the tax depreciation is higher than the depreciation as per accounting books on account of the higher rates of depreciation under the Income-tax Act. The tax effect of timing difference i.e. deferred tax should be treated in the following manner (i) the deferred tax should form part of the tax expenses in the profit and loss account; and (ii) it should be accounted as a deferred tax asset (DTA)/deferred tax liability (DTL) in the balance sheet. The criteria for recognizing DTAs are - (i) In a case where there are unabsorbed losses/deprecation under the tax laws DTA should be recognized only to the extent there is virtual certainty supported by convincing evidence that adequate future taxable income will be available against which DTAs can be realised. Virtual certainty means certain for all practical purposes. Mere forecasts of performance would not satisfy this criterion. Further, virtual certainty is not a matter of perception. It has to be backed up by convincing evidence i.e. evidence available at the reporting date in concrete form e.g. a profitable binding export order, cancellation of which would attract high penalty in the hands of the defaulting person. Future profitability projections would not, in isolation, be taken as convincing evidence, even though they may be submitted to an outside agency like a bank and accepted by them. (ii) In any other case (i.e. where there are no unabsorbed losses/depreciation under tax laws) DTA should be recognized and carried forward only to the extent there is reasonable certainty that adequate future taxable income would be available against which DTAs can be realised. Accounting treatment for DTA The accounting treatment for DTA is as shown hereunder - (i) Entry to be passed in the year in which timing difference originates - DTA A/c Dr. To Profit and Loss A/c (This is the entry to be passed when the DTA is recognized on meeting the virtual certainty/reasonable certainty criteria, as the case may be. The amount to be debited to

9 Inter-relationship between Accounting and Taxation 12.9 the DTA a/c and credited to the profit and loss A/c is the amount arrived at by multiplying the timing difference with the tax rate applicable for the year) (ii) Entry to be passed in the subsequent years - The carrying amount of DTAs has to be reviewed at each balance sheet date. The carrying amount of a DTA has to be written down to the extent that it is no longer reasonably certain or virtually certain, as the case may be, that adequate future taxable income would be available to realize the DTA. Reversal of a previous write-down may be done to the extent it becomes reasonably certain or virtually certain, as the case may be, that adequate future taxable income would be available. Therefore, in the subsequent years, there should be a review as to whether the recognition criteria is met. If the same is not met, the entire balance should be written off. If the recognition criteria is met, the closing balance of DTA has to be valued applying the tax rate for that year on the unreversed timing difference. The unreversed timing difference is the difference between the timing difference at the beginning of the financial year and the reversal during the year. Profit and Loss A/c Dr. To DTA A/c (This is the entry to be passed in the subsequent years to account for the difference between the opening and closing balance in the DTA a/c which represents reversal of timing difference during the year) Let us understand these entries with the help of an example XYZ Ltd., a domestic company, prepares its accounts on 31 st March every year. The company has incurred a loss of ` 5,00,000 during the year ended and made profits of ` 3,00,000 and ` 3,50,000 during the years and , respectively. The rate of income-tax applicable to the company for all the three assessment years (i.e. A.Y , A.Y & A.Y ) is 30% plus education cess@2% plus secondary and higher education cess@1%. Surcharge is not applicable since the total income does not exceed ` 1 crore. The business loss can be carried forward for 8 years. On , it was virtually certain, supported by convincing evidence, that the company would have adequate taxable income in the future years against which unabsorbed losses can be set-off. You are required to pass accounting entries, assuming that there is no other difference between taxable income and accounting income. Draft Profit and loss account for the years ended Particulars Profit/Loss before giving effect to tax (5,00,000) 3,00,000 3,50,000 Current 30.9% of ` 1,50,000 (46,350) Deferred tax - Tax effect of timing differences 1,54,500 originating during the year [5,00, %]

10 12.10 Income Tax - Tax effect of timing differences reversing during the year ending - (92,700) [3,00, %] (61,800) [2,00, % Profit/Loss after giving effect to tax (3,45,500) 2,07,300 2,41,850 Entry to be passed for the year ending DTA A/c Dr 1,54,500 To Profit and loss A/c 1,54,500 (DTA on account of tax saving due to carry forward of losses) Entry to be passed for the year ending Profit and loss A/c Dr 92,700 To DTA A/c 92,700 (Reversal of DTA on account of set-off of brought forward loss against current year income) Entry to be passed for the year ending Profit and loss A/c Dr 61,800 To DTA A/c 61,800 (Reversal of DTA on account of set-off of brought forward loss against current year income) Accounting treatment for DTL The accounting treatment for DTL is as shown hereunder (i) Entry to be passed in the year in which timing difference originates - Profit and Loss A/c Dr. To DTL A/c (This is the entry to be passed when the DTL is recognized. The amount to be credited to the DTL A/c and debited to the profit and loss account is the amount arrived at by multiplying the timing difference with the tax rate applicable for the year) (ii) Entry to be passed in the subsequent years - DTL A/c Dr. To Profit and Loss A/c (This is the entry to be passed in the subsequent years to account for the difference between the opening and closing balance in the DTL A/c which represents reversal of timing difference during the year. For arriving at the closing balance, the unreversed timing difference should be multiplied by the tax rate applicable for that year)

11 Inter-relationship between Accounting and Taxation Relevance of Method of Accounting under the Income-tax Act, 1961 Having studied the areas of convergence and divergence between Accounting Standards and incometax laws and how income-tax expense is dealt with in the Accounting Standards, let us proceed to study how the method of accounting assumes importance under the Income-tax Act, Section 145 deals with the Method of Accounting. This section provides that the income chargeable under the head Profits and gains of business or profession and Income from other sources have to be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee (It may be noted that the hybrid method is not permitted under the Income-tax Act, 1961). Therefore, the method of accounting is not relevant in computing income under the heads Salaries, Income from house property and Capital gains. The income under these heads have to be computed solely on the basis of the provisions contained in the Income-tax Act, Even in the case of the two heads of income where this section applies i.e., profits and gains of business or profession and income from other sources, wherever specific provisions are made for inclusion of particular income or for disallowance of particular expenditure on cash or accrual basis, then income shall be so computed irrespective of the method of accounting employed. For example, as per section 43B, certain expenditure like taxes, duties etc. are allowable only in the year of payment, irrespective of the previous year in which the liability to pay such sum arose according to the method of accounting regularly employed by the assessee. However, in the case of an assessee following mercantile system of accounting, such expenditure can be claimed as deduction on due basis, provided the payment has been made on or before the due date of furnishing the return of income. The assessee is also required to follow the Accounting Standards notified by the Central Government. The Central Government may notify in the Official Gazette, from time to time, Accounting Standards to be followed by any class of assessees or in respect of any class of income. The Government has, so far, notified two Accounting Standards (TASs) to be followed by all assessees following mercantile system of accounting. Accounting Standard I (TAS I) is on Disclosure of Accounting policies and Accounting Standard II (TAS II) is on Disclosure of prior period and extraordinary items and changes in accounting policies. These standards are more or less on the same pattern as AS 1 and AS 5 issued by the ICAI. 2 TAS I [Disclosure of Accounting Policies]: This standard requires disclosure of all significant accounting policies adopted in the preparation and presentation of financial statements. The disclosure of the significant accounting policies should form part of the financial statements. Further, all significant accounting policies should normally be disclosed in one place. Disclosure of any change in an accounting policy, which has a material effect in the previous year or in the years subsequent to the previous years, is required. Further, the impact of, and the adjustments resulting from, such change, if material, is required to be shown in the financial statements of the period in which such change is made to reflect the effect of such 2 The recently issued Exposure Drafts on Revised AS 1 and AS 5 are, however, different from the existing AS 1 and AS 5. Hence, TAS I and TAS II may not be in tandem with the Exposure Drafts on Revised AS 1 and AS 5.

12 12.12 Income Tax change. In case the effect of such change is not ascertainable, wholly or in the part, the same should be indicated. If a change is made in the accounting policies which has no material effect on the financial statements for the previous year but which is reasonably expected to have a material effect in any year subsequent to previous year, the fact of such change is required to be appropriately disclosed in the previous year in which the change is adopted. Accounting policies adopted by an assessee should be such as to represent a true and fair view of the state of affairs of the business, profession or vocation in the financial statements prepared and presented on the basis of such accounting policies. For this purpose, the significant accounting considerations governing the selection and application of accounting policies are following, namely: (i) Prudence: Provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information; (ii) Substance over form: The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form; (iii) Materiality: Financial statements should disclose all material items, the knowledge of which might influence the decision of the users of the financial statements. If the fundamental accounting assumptions relating to Going Concern, Consistency and Accrual are followed in financial statements, specific disclosure in respect of such assumptions is not required. If a fundamental accounting assumption is not followed, such fact should be disclosed. Meaning of the terms used in this standard (a) Accounting policies means the specific accounting principles and the methods of applying those principles adopted by the assessee in the preparation and presentation of financial statements; (b) Accrual refers to the assumption that revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate; (c) Consistency refers to the assumption that accounting policies are consistent from one period to another; (d) Financial Statements means any statement to provide information about the financial position, performance and changes in the financial position of an assessee and includes balance sheet, profit and loss account and other statements and explanatory notes forming part thereof; (e) Going concern refers to the assumption that the assessee has neither the intention nor the necessity of liquidation or of curtailing materially the scale of the business, profession or vocation and intends to continue his business, profession or vocation for the foreseeable future. TAS II [Disclosure of Prior Period and Extraordinary items and Changes in Accounting Policies]: This standard requires separate disclosure of prior period items in the profit and

13 Inter-relationship between Accounting and Taxation loss account in the previous year, along with their nature and amount, in a manner so that their impact on profit or loss in the previous year can be perceived. Similarly, disclosure of extraordinary items of the enterprise during the previous year as part of the income in the profit and loss account is required. The nature and amount of each such item should be separately disclosed in a manner so that their relative significance and effect on the operating results of the previous year can be perceived. This standard imposes a condition that a change in an accounting policy should be resorted to only if the adoption of a different accounting policy is required by statute or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements by assessee. Any change in an accounting policy which has a material effect is required to be disclosed. The impact of, and the adjustments resulting from such change, if material, has to be shown in the financial statements of the period in which such change is made to reflect the effect of such change. Where the effect of such change is not ascertainable, wholly or in part, the same should be indicated. If a change is made in the accounting policies which has no material effect on the financial statements for the previous year but which is reasonably expected to have a material effect in years subsequent to the previous years, the fact of such change has to be appropriately disclosed in the previous year in which the change is adopted. A change in an accounting estimate that has a material effect in previous year has to be disclosed and quantified. Further, any change in an accounting estimate which is reasonably expected to have a material effect in years subsequent to the previous year shall also be disclosed. If a question arises as to whether a change is a change in accounting policy or a change in an accounting estimate, such a question has to be referred to the CBDT for decision. Meaning of the terms used in this standard (a) Accounting estimate means an estimate made for the purpose of preparation of financial statements which is based on the circumstances existing at the time when the financial statements are prepared; (b) Accounting policies means the specific accounting principles and the method of applying those principles adopted by the assessee in the preparation and presentation of financial statements; (c) Extraordinary items means gains or losses which arise from events or transactions which are distinct from the ordinary activities of the business and which are both material and expected not to recur frequently or regularly. Extraordinary items includes material adjustments necessitated by circumstances which though related to years preceding to the previous years are determined in the previous year; However, the income or expenses arising from the ordinary activities of the business or profession or vocation of an assessee, though abnormal in amount or infrequent in occurrence, will not qualify as extraordinary item; (d) Financial Statements means any statement to provide information about the financial position, performance and changes in the financial position of an assessee and includes

14 12.14 Income Tax balance sheet, profit and loss account and other statements and explanatory notes forming part thereof; (e) Prior period items means material charges or credits which arise in the previous year as a result of errors or omissions in the preparation of the financial statements of one or more previous years; However, the charge or credit arising on the outcome of a contingency, which at the time of occurrence could not be estimated accurately will not constitute the correction of an error but a change in estimate and such an item will not be treated as a prior period item. Therefore, TAS-I and TAS-II have been specifically recognized under the Income-tax Act, These accounting standards have to be followed by all assessees following mercantile system of accounting. Draft Tax Accounting Standards (TASs) recommended by the Accounting Standards Committee for computation of taxable income under the Income-tax Act, 1961 The Accounting Standards Committee, constituted by the CBDT in December 2010, submitted its final report in October, 2012 and recommended the adoption of 14 Tax Accounting Standards ( TAS ) for computing income under the provisions of the Income-tax Act, 1961 in an objective and precise manner. The Committee was set up to study and give its recommendations on: (1) Harmonization of accounting standards issued by the ICAI with the direct tax laws in India and notification of accounting standards to be adopted under section 145(2) with relevant modifications. (2) The method of determining book profit for the purpose of MAT in case of companies migrating to IFRS in the initial year of adoption and thereafter; and (3) Appropriate amendments required in the Income-tax Act, 1961 in view of transition to Ind- AS regime. The Committee, however, focused its recommendations only on harmonization of TAS with the provisions of the Act. The main recommendations of the Committee were: (1) TAS to be made applicable only for computation of taxable income and there should be no requirement to maintain separate books of accounts. (2) TAS to be applicable to all categories of taxpayers (without income/ turnover threshold). (3) TAS to be in accord with the provisions of the Act. In case of any conflict, provisions of the Act to prevail. (4) Transitional provisions, wherever required, to be notified along with the TAS. (5) Appropriate modification in the return of income to ensure compliance with the provisions of TAS by the taxpayer. For tax audit cases, the Form 3CD also to be modified to require a tax auditor to certify that the computation of taxable income is made in accordance with the provisions of TAS. The Committee examined all the Accounting Standards issued by the ICAI and found that some of the accounting standards are not relevant for the computation of taxable income

15 Inter-relationship between Accounting and Taxation under the Act. The Committee noted that some of the accounting standards which were selected for harmonisation with the provisions of the Act mainly relate to disclosure requirements in the financial statements, whilst some others contain matters that are dealt with in the Act. The Committee further noted that the Act already contains detailed provisions on the issues covered by a few accounting standards, for eg. AS 6 Depreciation Accounting. In view of this, the Committee decided that such accounting standards need not be examined for the purpose of harmonisation with the provisions of the Act: The Committee deliberated whether the accounting standards issued by the ICAI could be notified under section 145(2) of the Act without modifications. The Committee noted that the accounting standards to be notified under Section 145(2) would need to be harmonised with the provisions of the Act. Further, the Committee was of the view that the notified accounting standards should lay down the specific provisions, which would enable computation of taxable income with certainty and clarity. To ensure horizontal equity and uniformity, the notified accounting standards should eliminate alternatives, to the extent possible. The Committee, therefore, decided to draft separate accounting standards for the purpose of notification under Section 145(2) and term such separate accounting standards as TAS. The Committee, after due deliberations, formulated the drafts of the Tax Accounting Standards (TASs) on the following issues based on the corresponding Accounting Standard issued by the ICAI after making changes to harmonise the same with the provisions of the Act: 1. Disclosure of Accounting Policies (Corresponding to AS-1) 2. Valuation of Inventories (Corresponding to AS- 2) 3. Events Occurring After the Previous Year (Corresponding to AS-4) 4. Prior Period Expense (Corresponding to AS- 5) 5. Construction Contracts (Corresponding to AS- 7) 6. Revenue Recognition (Corresponding to AS- 9) 7. Accounting for Tangible Fixed Assets (Corresponding to AS- 10) 8. The Effects of Changes in Foreign Exchange Rates (Corresponding to AS-11) 9. Government Grants (Corresponding to AS-12) 10. Securities (Corresponding to AS-13) 11. Borrowing Costs (Corresponding to AS-16) 12. Leases (Corresponding to AS-19) 13. Intangible Assets (Corresponding to AS- 26) 14. Provisions, Contingent Liabilities and Contingent Assets (Corresponding to AS- 29) Best Judgment Assessment Where the Assessing Officer is not satisfied about the correctness or completeness of the accounts of the assessee or where the method of accounting or accounting standards have not been regularly followed by the assessee, the Assessing Officer may make an assessment in the manner provided in section 144. The assessment made under section 144 is known as Best Judgement Assessment as the Assessing Officer, in spite of non-compliance and non-co-operation of the assessee, is expected to make the assessment to the best of his judgement.

16 12.16 Income Tax Bona fide change in the method of accounting: It is open to the assessee to make a change in the method of accounting if the change does not involve any mala fide motive and the assessee regularly follows the changed method of accounting. However, the change should not result in adoption of hybrid method of accounting. The Supreme Court held, by a majority judgment in State Bank of Travancore vs. C.I.T. (1985) 50 CTR 290 (SC), that in the case of a bank following mercantile basis of accounting, it is the income which has really accrued or arisen to the assessee that is taxable. Whether the income has really accrued or arisen to the assessee must be judged in the light of the reality of the situation. The concept of real income would apply where there has been a surrender of income, which, in theory may have accrued but in the reality of the situation no income had resulted because the income did not really accrue. Where a debt has become bad, deduction can be claimed after complying with the provisions of the Act. Where the Act applies, the concept of real income should not be so read as to defeat the provisions of the Act. The conduct of the parties in treating the income in a particular manner is material evidence of the fact whether income has accrued or not. Mere improbability of recovery, where the conduct of the assessee is unequivocal, cannot be treated as the evidence of the fact that income has not resulted or accrued to the assessee. An assessee is entitled to change his regular method of accounting by another regular method [Snow White Food Products Co. Ltd. vs. CIT (No. 2) (1983) 141 ITR 847]. Where it is found that if an assessee has changed his regular method of accounting by another recognised method and has followed the latter method regularly thereafter it is not open to the revenue authorities to go into the question of bonafides of the introduction and continuance of the change. Only in the year where a change in the method of accounting is introduced for the first time, it is to be examined by the revenue authorities, whether the change introduced was meant to be regularly followed. The Calcutta High Court held, in Seth Chemical Works vs. C.I.T. (1983) 140 ITR 507, that where an assessee is allowed to change his method of accounting from an assessment year, he has to compute his income on the changed basis only and not on the old basis. Stock valuation method adopted should not only be consistent but should also be correct for being accepted by tax authorities. The Supreme Court, in CIT v. British Paints (India) Ltd. (188) ITR 44, held that the Assessing Officer is empowered to substitute the correct method in the place of the wrong method adopted by the assessee in valuing closing stock. The Court observed that the wrong method cannot be accepted just because it was consistently followed. Therefore, the Court held that the Assessing Officer was justified in substituting the incorrect method by a correct method. In CIT vs. Carborundum Universal Limited (1984) 149 ITR 759, the company was regularly valuing its stock under total cost method, which excluded certain expenses which were to be included under the former method. The change was bona fide and was intended to be followed by the company consistently in the future. The company wanted to apply the new method in the first year of adoption for the valuation of closing stock only and retain the valuation of opening stock of the relevant year as per the old method. This was of course detrimental to the revenue in that year. The question as to whether the company could do so went before the Madras High Court. It was held that (i) since the change in the method of valuation of stock was bona fide and intended to be

17 Inter-relationship between Accounting and Taxation followed year after year, the company was entitled to change the method of valuation, (ii) merely because the change was detrimental to the revenue, the assessee could not be denied the right to change, since this detriment would be ironed out in the coming years, (iii) if the assessee was forced to apply the new method of valuation to the opening stock then also it will mean change in the valuation of previous year s closing stock and so on necessitating modification of earlier assessments. This in effect would mean that the assessee would not be able to change the method at all, (iv) so long as the method of valuation adopted by the assessee got recognition from the practising accountants and the commercial world, the adoption of that method could not be quashed by the revenue unless the adoption of that method was found to be not bona fide or restricted for a particular year Valuation of Inventory [Section 145A vs. AS 2] As per section 145A of the Income-tax Act, 1961, the valuation of purchase and sale of goods and inventory for the purposes of determining the income chargeable under the head Profits and gains of business or profession has to be- a) in accordance with the method of accounting regularly employed by the assessee; and b) further adjusted to include the amount of any tax, duty, cess or fee, by whatever name called, actually paid or incurred by the assessee to bring the goods to the place of its location and condition as on the date of valuation. The intention of section 145A is to ensure that the sale of goods and purchase of goods are grossed up by including the excise duty, tax, cess, etc., Inventory should also be grossed up in the same manner. However, the CENVAT credit, if any available towards such duty paid should not be taken into account. There are two methods for accounting of tax, duty etc. while preparing accounts. They are the Inclusive method and the Exclusive method. Under the Inclusive method, the amounts are grossed up whereas under the Exclusive method, the figures are shown net of CENVAT credit. Section 145A requires assessees to follow only the Inclusive method, whereas AS 2 on Valuation of Inventories requires adoption of Exclusive method. Let us try to understand the effect of following the inclusive method and exclusive method with the help of an example Particulars Opening stock of raw material Cost of raw material purchased inclusive of CENVAT credit CENVAT credit available Excise duty (Gross) Manufacturing expenses Sale value of finished goods Closing stock of raw material Amount Nil ` 5,00,000 ` 20,000 ` 35,000 ` 15,000 ` 6,25,000 15% of purchases