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Supreme Court highlights accounting standards
May, 04th 2009

A paradigm shift in the economic environment in the past decade has led to announcement of several accounting standards. Though, the initiative in setting standards is predominantly led by the The Institute of Chartered Accountants of India (ICAI), enabling provisions under the Companies Act and role of regulators like SEBI, RBI and National Advisory Committee on Accounting Standards (NACAS) is of equal importance.

Role of Standards under Income-tax law
Standards are formulated in general with a view to harmonise varying accounting policies and treatment across a section of businesses. The objective being to reduce the accounting alternatives in the preparation of financial statements within the bounds of rationality, thereby ensuring comparability of financial statements of different enterprises to give a true and fair view of financial position and working results.

While Accounting Standards (AS) issued by ICAI are expected to be complied with as a mandatory requirement for Company law purposes, the Income-tax Act also requires the income to be computed on the basis of a regular method of accounting (Sec 145). Further, both standards prescribed under the Income-tax Act and the company law would require prudence and conservatism to be followed in recognition of income. This has to be understood in the context of wide powers (including power to frame a best judgment assessment) given to the tax officer to reject a tax payers books of accounts and/or disallow a legitimate business claim, should proper and consistent accounting principles not be followed.

Disputes have reached SC
In its first landmark case, the apex court in Challapalli Sugars case put its seal of approval to adopting Accounting Standards for interpretation of terms not defined in the Income-tax law. In 2008, the court upholding the constitutional validity of AS 22 on deferred tax accounting held that the standards are consistent with the Companies Act and well as within the framework of the constitution. While rendering the decision, the Court observed that deferred tax liability is nothing but accrual of tax due to divergence between accounting and tax profits. Further, such disclosure brings out a hidden liability for shareholders and public at large, which otherwise would not have been made.

Last month, in Woodward Governors case, the court affirming the decision of Delhi HC allowed deduction of revenue expenditure resulting from liability due to foreign exchange rates. The court intensively relied upon AS 11 dealing with accounting treatment for effects in foreign exchange rates. It was emphasised in no uncertain manner that profits have to be computed in accordance with the accounting principles. Of course, an important over riding factor is that such principles of commercial accounting should not be superseded or modified by legislative enactments. Though, the law on claiming such deduction was amended in 2002 to provide that deduction shall be allowed on actual payment, the decision nevertheless has laid down important principles.

Importance of standards in the current environment
With growing number of standards in the past few years and more to follow, complexities are bound to grow and with India committing to align itself to international standards, the task for tax payers and tax administration could be daunting. In practice, most provisions for accounting purposes is becoming a subject matter of controversy as the tax administration is prone to take a stand that such provision for expenditure are in the nature of contingent liability. A glaring example is provision for bad and doubtful debts allowed to banks and public financial institutions under the Income-Tax statute, but not admissible for other forms of finance business. Accounting standards on the other hand require reasonable provisioning for all forms of businesses.

The result is that non-banking finance companies are burdened with tax on notional income otherwise not taxed for Indian banks. Though, this inconsistency is the result of a statute, it is nevertheless discriminatory. Similarly, such provisioning is not allowed for foreign bank branches and goes against the grain of non-discrimination clause under the tax treaties.

Similar is the situation with respect to gratuity provision, which is certain, based on actuarial valuation and mandated by statute. However, its deduction is subject to actual payment of awaiting either retirement or death of the employee.

The law on computation of Minimum Alternate Tax (MAT) based on book profits computed as per the accounting principles is similarly riddled with disputes. Another important area of debate is claim of deduction for warranties. Tax payers typically make provision for meeting warranty obligations enshrined in the sale contract and such amounts are based on scientific analysis and past experiences, but, they nevertheless are best estimates. The tax administration has been taking a narrow and conservative view by disallowing such provision on the ground that the liability is contingent in nature. Whilst most tax tribunals and high courts have held it in favour of the tax payers, the apex court would have the final say and as we speak, the court is hearing a batch of appeals on this crucial matter and its verdict would be anxiously awaited.

In conclusion, need of the hour is to establish consistency across accounting principles and statutory tax laws in as many areas as possible. As accounting principles are crystallised into accounting standards which are increasingly being relied upon by the courts for adjudicating tax disputes, it is time that income is directed to be computed in line with accounting standards to reduce controversy and bring reasonableness in our tax systems. With India committed to 2011 deadline for aligning with global accounting standards, it is an opportune time to relook at our Income tax code to avoid disputes.


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