Subject : CORPORATE

 
   Title :        Audit & ASSURANCE - PROBLEMS TO BE FACED BY NON-CORPORATE ENTITIES AFTER APPLICATION OF AS-22 ON ACCOUNTING FOR TAXES ON INCOME
   Author : Deendayal Dhandaria*  
   
 

Introduction: The Accounting Standard 22 - "AS-22" (hereinafter referred to as the "standard") dealing with "Accounting for taxes on income" issued by the Institute of Chartered Accountants of India is mandatory and is already applicable in the case of listed enterprises, listed and unlisted companies, etc. It will become applicable to all other enterprises (including sole proprietary and partnership firms) in respect of accounts commencing on or after 1-4-2003. (AS-22 replaces "Guidance note on accounting for taxes on income" which was recommendatory in nature and was not being followed in most of the cases).

Objective: The objective of AS-22, as set out in its preamble, is "to prescribe accounting treatment for taxes on income". The preamble states that Taxes on income is one of the significant items in the statement of profit and loss of an enterprise. It further states that in a number of cases, taxable income is significantly different from accounting income due to various reasons. The standard attempts to deal with this "divergence between taxable income and accounting income" and adverts to the "matching concept" in which revenue and expenses are attempted to be matched based on the period to which they both relate.

Reasons for differences: Two broad categories of reasons are stated by the Standard due to which differences arise between the taxable and accounting income. Firstly, there are differences between items of revenue and expenses as appearing in the statement of profit and loss and the items, which are considered as revenue, expense or deductions for tax purposes. Secondly, there are differences between the amount in respect of a particular item of revenue or expenses as recognised in the statement of profit and loss and the corresponding amount, which is recognised for the computation of taxable income.

Taxable income is calculated in accordance with the tax laws. In some circumstances, the requirements of these laws to compute taxable income differ from accounting policies applied to determine accounting income. For example, an enterprise may or may not account for depreciation in its books of account or it may account for depreciation at rates, which it finds appropriate. But while computing taxable income, depreciation is allowed as per rates laid down in the Income-tax Act, 1961. The difference in practice for accounting for depreciation results into difference between the taxable and accounting income. There are many such items due to which the taxable and accounting incomes differ.

The standard classifies these differences between taxable and accounting incomes as permanent differences and timing differences.

Permanent difference: Permanent differences are those differences between taxable and accounting income, which originate in one period and do not reverse subsequently. In other words, these differences do not affect the taxable income of subsequent years. For example, say, in assessment year 2003-04 if certain personal expenses, charities and donations, penalties, etc., debited in books of account are not allowed for tax purposes, the taxable income of that year will be higher than that as per accounts. But such disallowed expenses are not allowable in subsequent years as well, and so, these result into permanent differences.

Timing difference: On the other hand, timing differences are those differences between taxable and accounting income which originate in one period and are capable of reversal in one or more subsequent years. In other words, the timing differences affect the taxable income of subsequent years.

Deferred tax assets/liabilities: The standard defines the effect of these differences as deferred tax and classifies them into deferred tax asset and/or deferred tax liability. Permanent differences do not result in deferred tax assets or deferred tax liabilities.

Examples of deferred tax assets/liabilities: An example of tax effect of a timing difference that results in a deferred tax asset is an expense provided in the statement of profit and loss but not allowed as a deduction under section 43B of the Income -tax Act, 1961. This timing difference will reverse when the deduction of that expense is allowed under section 43B in subsequent year(s). An example of tax effect of a timing difference resulting in a deferred tax liability is the higher charge of depreciation allowable under the Income-tax Act, 1961, compared to the depreciation provided in the statement of profit and loss. In subsequent years, the differential will reverse when comparatively lower depreciation will be allowed for tax purposes.

Recognition of differences: The standard stipulates that deferred tax should be recognised for all timing differences, subject to the consideration of prudence in respect of deferred tax assets.

Measurement of differences: The standard further requires that deferred tax assets and liabilities should be measured using the tax rates and tax laws that have been enacted or substantially enacted by the balance sheet date. When different tax rates apply to different levels of taxable income, deferred tax assets and liabilities are measured using average rates.

Transitional provisions: The transitional provisions of the Standard requires that on the first occasion that the taxes on income are accounted for in accordance with this Statement, the enterprise should recognise, in the financial statements, the deferred tax balance that has accumulated prior to the adoption of this Statement as deferred tax asset/liability with a corresponding credit/charge to the revenue reserves, subject to the consideration of prudence in the case of deferred tax assets.

Disclosure requirements: The Standard further requires that deferred tax assets and liabilities should be distinguished from assets and liabilities representing current tax for the period. The deferred tax assets and liabilities should be disclosed under a separate heading in the balance sheet of the enterprise, separately from current assets and current liabilities. Offset of deferred assets and liabilities is permitted.

Practical example: The following practical example will help in understanding the working of the standard:

Mr. A, a sole proprietor, acquired pollution control equipment on 01-04-2003 for Rs. 60,000 on which 100% depreciation is admissible in the first year of use for the purpose of income-tax. Depreciation on this fixed asset is charged in the books under straight-line method assuming the life of 4 years and no scrap value. Mr. A has income of Rs. 1 lakh in all the four years. The tax payable for 4 years on the basis of aforesaid data is computed as follows:

Table A

   

  2003-04   

  2004-05   

  2005-06   

  2006-07

   

 Rs.   

 Rs.   

 Rs.   

 Rs.

Profit before tax   

  100000   

  100000   

  100000   

  100000

Add: Depreciation as per books   

  15000   

  15000   

  15000   

  15000

Total   

  115000   

  115000   

  115000   

  115000

Less: Depreciation as per I. T. Act   

  60000   

  0   

  0   

  0

Taxable income   

  55000   

  115000   

  115000   

  115000

Tax payable for the year* (A)   

  500   

  12000   

  12000   

  12000

*Notes: 1. Though surcharge is required to be considered by the standard, the same is ignored in the example for the sake of simplicity of calculation. 2. Tax payable has been calculated at rates applicable to different slabs of income.

In the above example, the taxable income for the year 2003-04 is lower as compared to other years because excess depreciation of Rs. 45000 was allowed for this year under tax laws, which originated into timing difference, according to the standard. The taxable income for each of the later 3 years, viz., 2004-05, 2005-06 & 2006-07 is more due to lesser allowance of depreciation of Rs. 15000 in each of these three years. This reversal of Rs. 15000 in later 3 years reduced the tax liability of these years. The standard requires recognition of (a) excess depreciation of Rs. 45000 in first year and (b) reversal of Rs. 15000 in each of later 3 years; measurement of tax liability on these amounts for all the four years and separate disclosure thereof.

If there had been no difference between tax laws and accounting practice, the tax payable by the enterprise would have been as follows:

Table B

   

2003-04   

2004-05   

2005-06   

2006-07

   

 Rs.   

 Rs.   

 Rs.   

 Rs.

Profit before tax   

  100000   

  100000   

  100000   

  100000

Add: Depreciation as per books & Income-tax Act (Presumed same)   

  15000   

  15000   

  15000   

  15000 

Total   

  115000   

  115000   

  115000   

  115000

Less: Depreciation allowable   

 15000   

  15000   

  15000   

  15000

Taxable income   

  100000   

  100000   

  100000   

  100000

Tax payable for the year (A)   

  9000   

  9000   

  9000   

  9000

 

By comparing Table A & B, it may be seen that due to tax laws, the tax liability in each of the four years is effected. As shown in Table A, the tax liability in the first year is reduced by Rs. 8500 and the same in later years is increased by Rs. 3000 in each year.

The deferred tax liability arising due to excess allowance of depreciation in the first year and its reversal in later 3 years is required to be measured and disclosed as per the requirements of the standard. This is shown below:

Table C

   

2003-04   

2004-05   

2005-06   

2006-07

   

  Rs.   

  Rs.   

  Rs.   

  Rs.

Depreciation as per I.T. Act   

  60000   

  0   

  0   

  0

Depreciation as per books   

  15000   

  15000   

  15000   

  15000

Originating timing difference   

  45000   

  15000   

  15000   

  15000

Timing difference awaiting reversal in coming years 

45000   

  30000   

  15000   

  0

Closing balance of Deferred tax liability @ 20% (as per rate appli- cable to the slab of income)   

9000   

  6000   

  3000   

  0 

As per the standard, Mr. A should recognise the liability of Rs. 9000 (Rs. 3000 × 3) in its accounts in the first year (i.e., the year of origin) as deferred tax liability so that the principles of matching concept are followed. This liability would be reversed in subsequent years by credit to statement of Profit & Loss. Table C illustrates this.

It is understandable that the standard desires that deferred tax assets/liabilities should be recognised, measured and disclosed so as to take care of the matching concept, but this standard seems to have been prepared by keeping in view the circumstances prevailing in the case of corporate sector. Certain special problems are faced in applying the standard in the case of non-corporate bodies, as stated hereinafter and it seems that the standard does not take care of the same.

Problem of measurement in case of individuals: In case of individuals, the rate of tax depends on the level of income, which ranges from 10% to 30% and is also subject to various rebates and relief under section 88 of the I. T. Act, 1961. The rebates availed of by individuals in different years may not be for the same amounts in different years depending upon the amount of investments made in the eligible financial assets. So, the tax liability may differ from year to year depending upon the level of income and the extent of rebate/relief availed. Even if average rate is calculated (as suggested by the standard), the average rate will differ in different years if the level of income changes and/or the quantum of rebate/relief differ. If in the year in which timing difference originates and the income is in the bracket which is liable to be taxed at 20%, the deferred tax liability will be measured in that year @ 20%. But, say, in the year of reversal, the income rises to the bracket of 30% and the tax benefit is enjoyed against the highest slab of 30%, then the question arises as to at what rate, the reversing entry should be passed. In actual practice, the matters would not be as easy as shown in the example for the sake of simplicity. Every year, new deferred tax liability will originate or reverse and/or new deferred tax assets would be recognised and revalued. It is not necessary that the slab rate and/or the average rate will remain the same year after year. The accounting for taxes on income will have to take into its consideration the effect of change in rates also so as to give a true and fair view of the net balance of deferred tax assets/liabilities in a particular year. From these facts, it is evident that the determination of proper amount of charge/credit to statement of profit & loss would require complex calculations every year.

Problem of disclosure: Para 33 of the standard requires that on the first occasion, the enterprise should recognise, in the financial statements, the deferred tax balance that has accumulated prior to the adoption of this Statement as deferred tax asset/liability with a corresponding credit/charge to the revenue reserves. In case of sole proprietary and partnership firms, there are no such reserve accounts. There are capital accounts of the proprietors or the partners, as the case may be. Then again, the debit and/or credit balances of profit & loss account are not separately shown in the balance sheets of non-corporate entities as is done in the case of corporate sector. If it is opined that instead of revenue reserves, the opening balance of deferred assets/liabilities should be adjusted vide capital accounts, then in case of the partnership firms, the question arises whether such adjustments to partners' capital accounts should be made in equal proportions or according to their profit/loss sharing ratios or in the proportion of their respective capital contributions.

The Institute of Chartered Accountants of India should issue clarifications on the above issues, which arise in case of proprietary and partnership firms.

Propriety of applying the standard to non-corporate sector: It is widely believed that the Institute of Chartered Accountants of India is issuing various accounting standards so as to harmonise the accounting practice prevalent in the country with International Accounting Standards. Harmonisation and comparison may be relevant factors in case of multinational companies and global players. But the accounts of proprietary and partnership firms, being private and confidential documents, are not meant for public and should not be compared. Moreover, the chances of a sole proprietary and/or a partnership firm becoming a global player are remote. So, the application of such a hyper-technical standard as AS-22 to these firms needs to be examined in this context also.

There are yet few more aspects of the matter that deserve mention and attention. Audit is not required in case of all the sole proprietary and partnership firms. The Income-tax Act, 1961 has not yet provided that all the standards issued by The Institute of Chartered Accountants of India should be applicable. Section 145 of the Act prescribes only two standards. By virtue of provisions contained in the Companies Act, 1956, the corporate sector is obliged to comply with the Accounting Standards. But no such legal compulsion/requirement is found in case of proprietary and partnership firms. So, there may be cases where proprietary and partnership firms choose not to comply with AS-22.

As conceded earlier, it may be desirable to advance the theory of "Matching concept". But because of the problems of measurement as stated hereinabove, an element of subjectivity enters into the calculation of reversal of deferred tax assets/ liabilities. It does not seem possible that this exercise will result in accurate measurement of the effect of timing differences and its reversal, which is subject to so many factors and future actions of a proprietor/partnership firm.

Therefore, I conclude by opining that in view of the hyper-technicality of the matter, element of subjectivity, irrelevance of harmonization with International Accounting Standards, inadequate disclosure norms, practical difficulties in accurate measurement of tax effect of timing differences and other problems discussed hereinabove, the standard should not be made applicable to the non-corporate entities in its present form.

________________

*The author is a Chartered Accountant. For any clarification or discussion on this article, the author can be contacted at E-mail : ddhandaria@yahoo.com

   

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