Ion Of Preliminary Expenses

ACCOUNTING FOR TAXES ON INCOME (AS 22)

Shrikant Jadhav & Gurunath Bhide, Pune

Accounting is the field of worldwide application and having a wide range of diversity in its application. In practical situations, it is many times observed that there is different treatment of accounting for the same event or transaction. Thus it was necessary to give uniform accounting treatment to such transactions so as to attain the objective of at true and fairness of books of accounts . It was also intended to give the best possible treatment to such transactions. Accounting Standards came with this basic objective. In India, The Institute of Chartered Accountants of India being the apex body in the field of Accountancy issues the Accounting Standards for various matters. On the same ground Accounting Standard (AS) 22 was issued by the Institute of Chartered Accountants of India w.e.f. 1.04.2001 Now with this background we can come across the AS 22 for more discussions. Basically one should ask himself, why is this standard? and what this standard means? For such basic knowledge, we should get oneself conversant with the Scope and Applicability of this standard. The scope of the standard as is as follows: It is mandatory in nature for: a.

All the accounting periods commencing on or after 1st April 2001, in respect of the following: i.

Enterprise whose equity or debt securities are listed on a recognized stock exchange in India and enterprises that are in the

process of issuing equity or debt securities that will be listed on a recognized stock exchange in India as evidenced by the board of directors’ resolution in this regard. ii.

All the enterprises of a group, if the parent presents consolidated financial statements and the accounting standard is mandatory in nature in respect of any of the enterprises of that group in terms of (i) above.

b.

All the accounting periods commencing on or after 1st April 2002, in respect of companies not covered by (a) above.

c.

All the accounting periods commencing on or after 1st April 2006, in respect of all other enterprises.

Thus we can now take out the extract as, first clause has been not applicable being the next two are overlapping the first one. Thus we can classify the applicability broadly into two categories as before 1st April 2006 applicable to some selective entities and after 1st April 2006. If the accounting period is commenced before 1st April 2006, the standard is applicable to all the companies. Here "company" means a company defined under companies act, 1956.But for the accounting periods commencing on or after 1st April 2006, standard is applicable to all the Enterprises where enterprise includes partnership firms and sole proprietorship

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concerns also. Thus now the standard is going to cover a large group of entities and job of accountants and auditors is going to be more challenging. Objective: Secondly it is necessary to get conversant with the basic objective of this standard. Its objective is to prescribe accounting treatment for taxes on income. As per the Matching concept of accounting, Taxes on income are accrued in the same period of the revenue and expenses to which they are related. i.e. there has to be a correlation between the revenue for the period and the expenditure incurred for earning the revenue. But it generally observed that there are various counts where accounting income significantly defers from taxable income. This divergence arises due to difference in the Accounting Principles & Tax Laws. The standard helps to explain how to tackle those differences .For Instance we can quote an example as under. There is a deduction available for certain assets such as expenditure on scientific research (capital nature) under section 35 of the Income Tax Act, 1961. Though the benefits of such assets are spread over the economic life of the asset the entity is going to get weighted deduction under the said section after compliance of provisions. This situation is contrary to the Matching Concept of accounting leading towards difference in taxable income & accounting income. We will get due knowledge about this in due course but its important to know basically what is the scope of this standard. As per bare text of the Accounting Standard: 1.

This Statement should be applied in accounting for taxes on income. This includes the determination of the amount of the expense or saving related to taxes on income in respect of an accounting period and the disclosure of such an amount in the financial statements.

2.

For the purposes of this statement, taxes on income include all domestic and foreign taxes, which are based on taxable income.

3.

This statement does not specify when, or how, an enterprise should account for taxes on distribution of dividends and other distributions made by the enterprise.

Thus, this standard has specific scope of application,

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which includes foreign taxes also but excludes taxes on distribution of profits or funds like Dividend Distribution Tax under section 115 O of the Income Tax Act, 1961. We consider Dividend Distribution tax as an appropriation of profit & any appropriation of profit is not eligible for deduction under Income Tax Act. This means it gets automatically escaped from the net of this standard. Before we go for working part of the standard, it will be desirable for us to know the definitions quoted for the purpose of this standard. 1.

Accounting Income (loss): It 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. i.e. it is a book profit arrived at applying the Generally Accepted Accounting Practices.

2.

Taxable Income (Tax Loss): It 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.

3.

Tax Expense (Tax Saving): It is aggregate of current tax and deferred tax charged or credited to the statement of profit and loss for the period.

4.

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

5.

Deferred tax: It is the tax effect of timing differences.

6.

Timing Differences: These are the differences between taxable income and accounting income for a period that originate in one period and capable of reversal in one or more subsequent periods. Timing differences are temporary differences between the accounting income & taxable income, which are capable of reversal in subsequent periods. In short the impact on tax due to the difference originated in one period gets nullified over future period For this purpose we will consider one example:An asset is purchased on 1.04.2001 on which under Companies Act depreciation is to be

charged at 18.91% where as Income Tax Act rate of depreciation is 25%. This leads to Timing Difference as in the initial years the depreciation allowable as per income tax in higher than provided in the books. But in the subsequent years the situation gets reversed as the depreciation allowed as per income tax gets reduced as compared to provided in the books. 7.

Permanent Differences: These are the differences between taxable income and accounting income for a period that originate in one period and do not reverse subsequently.

6.

Net out the aforesaid timing differences resulting towards either net deferred tax asset or net deferred tax liability.

7.

Apply the tax rates & tax law that are enacted or substantively enacted by the balance sheet date on net timing difference. (When tax rates are applied as per slabs of income, then average rate should be used for calculation of deferred tax asset and liability) Deferred tax = Net Timing Difference Tax Rate

8.

Tax expense is an aggregate of current tax & deferred tax. The tax expense is to be shown in the financial statements as a separate disclosure.

Permanent Difference creates a irreversible impact on the taxable & accounting income. e.g. amount deducted under section 80G of the Income Tax Act, which is allowable to the extent of 50% only though the entire amount is debited to profit & loss A/c. once the deduction is allowed to the extent of 50%, the remaining part is not going to be allowed as deduction forever. Now with this much introduction of the standard we will concentrate towards the main part i.e. Computation of Deferred Tax Asset or Liability. Steps involved in recognition of deferred tax asset or liability:1.

Also, the companies act, 1956 allows slight deviation from Schedule VI for presentation of Balance sheet. Therefore, Tax expense for the period = Current tax + Deferred Tax Special points to be kept in mind while computing deferred tax asset or liability:1.

Ascertain the taxable profits: Taxable profit is computed applying the tax laws that are enacted for the relevant assessment year.

3.

Find out the difference in the profit as per books of accounts & taxable income as calculated in above two steps.

4.

Analyse the causes for differences & classify them into "Timing Differences" or "Permanent Differences"

5.

Divide the "Timing Differences" into differences leading towards Deferred Tax Asset and Deferred Tax Liability separately.

Concept of prudence:The deferred tax asset so calculated should be based on concept of prudence i.e. there should be a reasonable assurance that the future profits will be available against which the deferred tax asset can be realized. For example if the company has got a contract for supply of raw material to a foreign buyer, this gives a reasonable assurance about the future available profit to realize the deferred tax asset.

Compute the profit as per books of accounts:Profit as per books of accounts is computed following the Generally Accepted Accounting Practices. i.e. profit is calculated by applying all accounting conventions & principals. E.g. Concept of Prudence, Concept of mutuality, Concept of accrual, etc.

2.

Calculate the tax expense for the period: -

2.

No discounting of deferred tax asset or liability:Deferred tax asset or liability should not be discounted to their present value due to the practical difficulty of keeping the timely record of reversals of the timing differences.

3.

Provisions of Fringe benefit tax under section 115WJ of the Income Tax Act,1961:The Amount of Fringe Benefit Tax is not at all deductible expenditure for computation of Taxable Profits. Hence it leads to Permanent Difference. Hence it should be excluded from the

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ambit of this standard. 4.

From the Assessment Year 2006-07, credit for Minimum Alternate Tax can be carried forward to next five assessment years. Thus now it leads to timing Difference. Hence credit available for Minimum Alternate Tax should be considered for this standard.

Provisions of Minimum Alternate Tax under section 115JB of the Income Tax Act, 1961: In the event of Taxable losses for a corporate assessees Minimum Alternate Tax might be payable as per the provisions of aforesaid section.

Now we will concentrate on issue of determination of timing difference leading to Deferred Tax Asset or Liability. How to decide the deferred tax asset or deferred tax liability:Situation

Tax impact

Def. Tax Asset /Liability

1.

When accounting income is greater than taxable income

Tax on taxable income is lesser than tax on accounting income

Deferred tax liability

2.

When accounting income is lesser than taxable income

Tax on taxable income is greater than tax on accounting income

Deferred tax Asset

3.

When accounting loss is greater than taxable loss

The opportunity to carry forward & set off of losses against future profit gets restricted to the taxable loss and that results in future more payment of taxes.

Deferred tax Liability

4.

When accounting loss is lesser than taxable loss.

Enterprise is in a position to carry forward & set off more loss against the future profit and that leads to lowering the future payments of taxes

Deferred Tax Asset.

5.

When there is loss as per books but taxable income is computed.

Enterprise will have to pay tax on taxable income though its books of accounts are showing loss

Deferred tax asset

6.

When there is profit as per books but taxable loss

Enterprise will not have to pay tax though there is profit in books

Deferred tax liability

Some examples of Timing Differences:-

Some examples of permanent differences:-

1.

1.

Donations given under section 80G

2.

Tax Holiday benefits

Depreciation provided in books & allowed by the Income tax act

2.

Disallowance under section 43B of the income tax act

3.

Taxable income on presumptive basis under section 44AD, 44AE, 44AC

3.

Amortization of preliminary expenses under section 35D

4.

Standard deduction under section 24(a)

4.

Provision for doubtful debts

5.

Capital gain indexation

5.

Municipal tax paid are allowed as deduction only when payment is made during the pervious year

6.

Weighted deduction under section 35

7.

Income exempt from tax & expenses relating there to under section 10

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We will now go for one example to get ourselves more clarified with the above issues.

The co. has purchased following Plant & Machinery:Date of purchase

Purpose

Amount (Rs.)

ABC Co. Ltd. started business on 1/04/2001. Following information is available from records of the ABC Co. Ltd.

1/04/2001

General

30000

1/04/2002

Research

25000

Profit before depreciation, amortization of preliminary expenses & taxes: -

1/11/2004

Research

36000

Illustration:

Year

Rs.

2001-02

100000

2002-03

150000

2003-04

250000

2004-05

300000

Company charges depreciation on plant & machinery @ 15% on Straight Line Method where as the rates of depreciation as per Income Tax Act for general machinery @ 25% on Written Down Value Method & for research purpose @ 100% The tax rates for relevant years were 45%, 40%, 35% & 35.875% respectively. During the year 2001-02 Company has written off Rs. 30000/- preliminary expenses to Profit & Loss A/c. Under Income Tax Act the qualifying sum for amortization for 5 years is Rs. 25000.

During 2003-2004 payment of Rs. 140000/- made by bearer cheque, which will be disallowed @ 20 % under section 40A(3). Prepare Profit and Loss Statement using AS 22. SOLUTION: PARTICULARS

YEAR ENDING 31.03.2002

31.03.2003

31.03.2004

31.03.2005

100000

150000

250000

300000

1. depreciation

4500

8250

8250

10500

2. preliminary expenses

30000

-

-

-

Profit before Tax

65500

141750

241750

289500

Current Tax (note 1)

39375

45750

94073

91781

Deferred Tax (note 2)

(7650)

10950

339

12077

Sub total

31725

56700

94412

103858

Profit Carried to Balance Sheet

33775

85050

147338

185642

Profit before depreciation and amortisation of expenses Less :

Less : Tax Expense

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Note 1: Computation of current tax. PARTICULARS

YEAR 2001-02

2002-03

2003-04

2004-05

65500

141750

241750

289500

1. Depreciation. as per books

4500

8250

8250

10500

2. Preliminary Expenses

30000

-

-

-

3. Disallowed u/s 40A(3)

-

-

28000

-

100000

150000

278000

300000

7500

5625

4219

3164

-

25000

-

36000-

Amount of Preliminary. Expenses

5000

5000

5000

5000

Sub total (B)

12500

35625

9219

44164

Taxable Profit (A-B)

87500

114375

268781

255836

Tax Rates

45%

40%

35%

35.875%

Current Tax

39375

45750

94073

91781

Profit before tax Add back/add:

(A) Less: Depre. As per IT Act R&D Expenditure u/s 35

Calculation of depreciation as per Companies Act, 1956:Method:- Straight line Method Rate of Depreciation: - 15%

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Year (1)

Cost at the beginning (2)

Depreciation on opening balance (3)

Acquisition during the year (date) (4)

Cost of Acquisition (5)

Depreciation on addition (6)

Total Rs. (3+6) = (7)

2001-02

--

--

1/04/2001

30000

4500

4500

2002-03

30000

4500

1/04/2002

25000

3750

8250

2003-04

55000

8250

---

---

---

8250

2004-05

55000

8250

1/11/2004

36000

2250

10500

Calculation of depreciation as per Income Tax, 1961:Method:- Reducing Balance method Rate of Depreciation:- 25% for general purpose machinery on W.D.V.. Year

Opening balance

Additions during the year

Deduction during the year

Depreciation for the year

Closing Balance

2001-02

--

30000 (1/04/2001)

Nil

7500

22500

2002-03

22500

Nil

5625

16875

2003-04

16875

Nil

4219

12656

2004-05

12656

Nil

3164

9492

2001-02

2002-03

2003-04

2004-05

Profit as per books

65500

141750

241750

289500

Taxable Profit

87500

114375

268781

255836

Difference (absolute terms)

22000

(27375)

27031

(33664)

a. Disallowance u/s 40A(3)

-

-

28000

-

b. Non qualifying amount of Preliminary Expenses

5000* (27375)

(969)

(33664)

Nil

Note II: Computation of Deferred Tax Asset or Liability:Particulars

Segregation in 1. Permanent Difference.

2. Net Timing Difference

17000

Prima-facie Classification of Timing Differences :Year

Timing Difference

Rate of Tax

Deferred Tax

Whether Deferred Tax Asset or Liability should be created

2001-02

17000

45%

7650

Deferred Tax Asset

2002-03

27375

40%

10950

Deferred Tax Liability

2003-04

969

35%

339

Deferred Tax Liability

2004-05

33664

35.875%

12077

Deferred Tax Liability

*Rs.30000 Written off to Profit & Loss A/c -- Amortization Allowed Under Income Tax Rs.25000 = Nonqualifying Amount Rs.5000

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Presentation and Disclosure Requirements:1.

it should give the separate identification.

Deferred Tax Asset or Liability should be distinguished from assets & liabilities representing current tax for the period. It should be separately in the balance so as a distinguishing from current assets & liabilities. Though the standard requires separate disclosure for the Deferred Tax Asset or Liability, it does not specify the place in the Balance Sheet. It is at the discretion of the Management but provided

2.

The major components in the Deferred Tax Assets or Liabilities should be disclosed separately. This means that the items contributing toward recognition of Deferred Tax Asset or Liability should be clearly spelt out in the notes to accounts.

3.

The nature of evidence supporting the recognition of Deferred Tax Asset or Liability should be spelt out in the Notes to accounts.

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