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This special story relating to Accounting
Standards and taxation deals with a topic which concerns most of our
readers and members. However, although accounting and taxation both
can claim to have a long history behind them, these two subjects have
developed and evolved almost independent of each other. On the one
hand, accounting as understood today can trace back its ancestry at
least to the double entry system of accounting enunciated by Friar
Luca Pacioli in Italy. However, references in the Arthashastra
indicate a far earlier origin of the science of accountancy. On the
other hand, taxation can claim an even earlier origin and seems to
have been in vogue ever since men came together and formed tribes.
Over the years, the sophistication and the appetite for taxing the
subjects have been refined into an art and a science. Yet interestingly,
the development of accountancy and taxation pursued parallel but unrelated
paths. The traditional distance and the concept of each being independent
and unrelated to the other has been succinctly stated by the Supreme
Court when it observed that "Taxability cannot be decided on basis
of entries which the assessee may choose to make in his accounts."
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The industrial revolution led to
the concentration of economic power in large corporations that became
the powerhouses of the economy. Taxation, which till then had been
primarily on the subjects of the kingdom, shifted its focus to these
corporations in an attempt to maximise revenue collection with least
direct impact on the citizens. Numerous external factors, compelled
these corporations to adopt better, more transparent and refined methodologies
for quantification and measurement of its performance. Along with
this refinement came increased sophistication in reducing the burden
of taxation. On the other hand the appetite of the bureaucracy and
of the rulers for raising and spending more funds has been steadily
increasing and therefore an increasing need was felt to combat sophisticated
methods of accounting which were perceived merely as "colourable devices"
intended to assist in tax evasion.
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It is these developments globally
and more so in the rapidly growing Indian economy in the past
few years that has led to the increasing awareness on part of
the government authorities that accounting has a significant role
to play. Correct accounting practices are imperative not only
in protecting the interest of the stakeholders but also in ensuring
good governance, regulation and tax collection from corporates.
The result of the above referred developments has led to an increasing
awareness among the authorities that accounting practices of corporates
need to be monitored and regulated more carefully.
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The consequences in India of
the realisation mentioned above have been:-
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Section 145 A on the Income
Tax Act recognised and introduced for the first time Two Accounting
Standards in the Income Tax Act.
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Section 211 of the Companies
Act was amended to include therein a Clause making it mandatory
for all companies to prepare their accounts in compliance
with the Accounting Standards prescribed.
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Pursuant to the above amendment,
the Central Government has constituted The National Advisory
Committee on Accounting Standards (NACAS). This Committee
is the apex body to advise the government on Accounting Standards
that it shall notify for compliance by all companies.
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Other regulators such as
SEBI, RBI, IRDA have started laying increasing emphasis on
compliance with the Accounting Standards and practices prescribed.
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The Comptroller and Auditor
General has constituted a Committee to formulate Accounting
Standards that would be applicable to government accounting.
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Along with this, the global and the
Indian economy have suffered the effects of massive scams which have
undermined / shaken the very foundations of the economy. All these
developments have given a boost to the awareness in regard to correct
accounting practices. The Accounting Standards Board constituted by
the Institute of Chartered Accountants of India in 1977, has focused
on introducing members Accounting Standards in the past three years.
During this short period the number of standards prescribed by the
ICAI has gone up from 15 to 29 and as of date the standards are nearly
at par with the standards notified by the International Accounting
Standards Board (IASB).
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All these developments have been
taking place with the active support of the government and as such
it is inevitable that the revenue authorities would also take a serious
look at harmonising the tax laws with these developments. Admittedly,
the gap to be bridged is tremendous as one has centuries of history
to overcome in order to achieve such an objective. However, the Finance
Ministry took the first steps towards this objective by constituting
a Committee (which included representatives of the Institute of chartered
accountants of India as well as industry) to look at the possibility
of introduction of Accounting Standards for the purpose of taxation.
One of the conclusions that this Committee has reached is that there
is no point in reinventing the wheel - and that it would be more appropriate
to prescribe in most cases that the Accounting Standards notified
by the ICAI should be the standards followed by the assessees. ( This
is as yet a mere recommendation which is yet to meet the approval
of the lawmakers) However, the writing on the wall is clear - that
one can no longer ignore the Accounting Standards and claim that taxation
and tax laws function in an environment not affected by the standards.
The change in thinking is also apparent from the change in approach
of the judiciary in its observations on the relevance of Accounting
Standards for the purpose of taxation. The Supreme Court has stated
"the manner of accounting entries passed, though not conclusive may
have persuasive value in deciding the correct income. . [Challapalli
Sugar 98 ITR 167 (SC), CIT vs. Nagarjuna Steels 171 ITR 663.]
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It will thus be clear that the
trend of prescribing certain norms for the purpose of accounting
is gaining ground. Once these norms are universally followed it
is inevitable that the government would have to reduce the divergence
between income computation and profit determination as prescribed
by these norms. Therefore, it is suggested that all tax professionals,
whether or not concerned with the preparation of accounts would
have to be well aware of the developments in accounting thought
and practices that are taking place in the country. The Accounting
Standards as prescribed by the above named authorities contain
the essence of these developments in thought and practice and
therefore it is imperative that the sound knowledge of taxation
is backed by a well informed awareness about the Accounting Standards.
- It is with this intent that
this special story focuses on the Accounting Standards that tax professionals
need to be aware of. It is an accepted fact that despite these trends
gathering force; the gap between the treatment as prescribed in the
Accounting Standards and provisions of the tax laws not only exists
but can have a significant impact. In view of this, the various articles
that follow have tried to focus on bringing to the attention of the
reader the salient provisions of the Accounting Standards and then highlighting
the areas where the tax and accounting treatment diverged from each
other. Over a period of time, these differences would possibly be narrowed.
However, given the fact, that the objectives of the prepare of accounting
statements and the purposes of the revenue authorities are different;
certain divergences are inevitable. It would be useful to know the compulsions
behind these differing objectives and the consequential mismatches that
follow. The articles in this special story tries to focus on these issues
in an attempt to highlight these conceptual differences in each standard
so that a better understanding of these areas and the underlying compulsions
would lead to better application of tax principles to the financial
statements of the assessees.
- In a general sense, the divergences between
the Accounting Standards and tax treatment are inherent because
of the different objectives that underlie the approach adopted by
the accountants and the revenue authorities. I am giving hereunder
the objectives of preparation of financial statements and the objectives
of the revenue authorities and thereafter shall try to identify
the reason for the divergence that appears inevitable.
- The purpose of FS is
stated in the Framework issued in June, 2000:
"12. The objective of financial
statements is to provide information about the financial position,
performance and cash flows of an enterprise that is useful to
a wide range of users in making economic decisions."
The Framework goes on to identify
the basic assumptions underlying preparation of FS: Accrual,
Going Concern and Consistency. These principles were considered
paramount and therefore the concept of substance over form evolved.
Whenever it was necessary to meet the complexities of commercial
reality and where it was felt that straitjacketing all methodologies
into a single option was not possible; alternatives were initially
provided in the Accounting Standards itself. This approach was
backed by the awareness that accounting is not an exact science,
but rather a process of scientific approximation. In the long
run these deviations would cancel out and therefore "in the long
run" the net result by either method would be the same.
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This approach did not find favour
with the tax authorities who want to arrive at a single determinable
figure of taxable income. The intention of the tax authorities
is to determine `income' as is understood under the Income-tax
Act which may not necessarily be the real income. While the income
as computed for the purpose of the tax laws is not entirely divorced
from the concept of "true and fair", the following factors are
considered important by the Revenue Authorities:
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Need to have a method of
computation of income which can be easily verified in most
cases.
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A method which will accelerate
revenue collection.
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A method having least subjectivity
and which involves minimum alternatives - thereby resulting
in a single acceptable treatment.
- In contrast to this,
the objectives of prescribing Accounting Standards is to ensure
that
- the accounts are prepared so as to present
a true & fair view
- The presentation of the state of affairs
as at a particular cut-off date is emphasized rather than determination
of income.
- The income determined is arrived at on a
conservative basis
These differing objectives have
resulted in the inevitable divergence in results, and over the
years there has arisen a deep-rooted suspicion amongst the revenue
authorities that accounting results do not disclose the true taxable
income. Various provisions have been designed to combat these
real and perceived differences. The provisions of S.50C - where
amount is taxed on notional value even though income may not actually
arise and S.115JB whereby set off is restricted to lower of loss
or depreciation irrespective of real loss existing and being carried
forward are illustrations of this mindset. The deep seated divergence
between the approach to depreciation as contained in the accounting
and tax laws as well as the recent amendments regarding year of
allowability in situations where tax is required to be deducted
(Sec. 40(ia)] is in continuation in the same trend and not a very
positive indicator. As a result, the concept of "real income"
which is what is the avowed object of taxation is all but forgotten.
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In fact, if one takes a pessimistic
view one may be justified in concluding that the enactment of
Section 115 JB which brings to tax the book profits in certain
circumstances (where these are higher than the taxable income)
indicates that the tax authorities will always continue to have
the best of both worlds and therefore there will be no impetus
to bridge this gap between Accounting Standards and taxation.
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However, I am a believer in enlightened
administration. Just as the current of the times forces the government
to move in the right direction, (as it happened in the case of
economic liberalisation); so too would be the case in the matter
of accountancy and taxation. Looked at from a macro perspective,
the recognition of revenue in a particular year and the allowance
of deductions in an earlier year can never have an impact in the
long run. On the other hand, the sheer complexity of commercial
transactions, global trade and economic compulsions will make
it un economical for the revenue authorities to continue to prescribe
different rules for determination of income. The increasing relevance
of Double Tax avoidance Agreements (DTAA), the complexity of transfer
pricing mechanisms and the sophistication of corporate accounting
will sooner or later drive the revenue authorities to the view
that it is best to focus on their core competency i.e. revenue
collection and leave the accounting to the accountants. As this
inevitable truth will dawn; the gap between the Accounting Standards
and taxable income determination will close and these two subjects
which we are looking at today in an attempt to integrate them
will become truly harmonised.
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I may mention in conclusion,
that the accounting theory also is constantly evolving. Accounting
Standards prescribed earlier are also being modified and interpreted
to accommodate the commercial and economic realities of the day. As
such, it would be wrong to think that it is only the revenue authorities
that will be changing their approach. The Accounting Standards themselves
are in the continuing state of evolution. It is for this reason that
an important standard like AS 15 - Accounting for Retirement Benefits
in the Financial Statements of Employers, has not been dealt with
in this series of Articles. The other standard which has a significant
impact in regard to the year of charging to revenue, expenditure on
Voluntary Retirement Scheme etc. is under revision. Since the revised
standard is already under consideration, it was felt best not to confuse
the readers. Therefore, although the impact of the revised AS 15 and
modified AS 26 - Intangible Assets, would be significant from a tax
angle also, the same have not been dealt with in the following articles.
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Similarly, another area which
will be seen significant changes is the Accounting Standard dealing
with Investments AS 13. A fresh standard dealing with the Accounting
for Financial Instruments is being drawn up. It is hoped that this
standard would grapple with the numerous issues arising out of the
evolution of the new instruments, derivatives, hedging, swaps etc.
The provision of standard rules in these areas are likely to be on
the lines of International Accounting Standard (IAS 39). I may mention
that this would be at variance with the numerous provision relating
to taxation of capital gains / profits on the share trading etc. Both
the above referred areas are, therefore, not dealt with in the articles
that follow; since it would be premature to deal with these subjects
unless the standards are themselves in place. Suffice it to say that
as mentioned above, both Accounting Standards and Tax laws are not
static and would therefore continue to generate need for study and
updation of knowledge in these areas. I am sure that the focussed
article that follow will provide rich input for the same.
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