R. Sivakumar

PARAGRAPH 19 of Accounting Standard 22 issued by the ICAI states, "At each balance-sheet date, an enterprise re-assesses unrecognised deferred tax assets. The enterprise recognises previously unrecognised deferred tax assets to the extent that it has become reasonably certain or virtually certain, as the case may be (see paragraphs 15 to 18), that sufficient future taxable income will be available against which such deferred tax assets can be realised. For example, an improvement in trading conditions may make it reasonably certain that the enterprise will be able to generate sufficient taxable income in the future."

It is clear that the thrust of the paragraph is on the recognition of the previously unrecognised deferred tax asset (DTA). The fundamental issue here is how the recognition should be carried out, that is, whether it should be recognised through the profit and loss (P&L) account or can it be recognised through the reserves. This situation holds good more in the case of companies having carry forward losses. The following illustration is considered for the purposes of analysis.

X Ltd has been incurring losses for the past two years and did not recognise the deferred tax asset on the basis of prudence. However, in the current year, it has earned a profit. For simplicity it is assumed that depreciation is the only other timing difference apart from the carried forward losses (see Tables).

From the workings it can be seen that ultimately the net deferred tax liability or asset is on the profit or loss as per book. Further, the carry forward loss envisaged under Para 8 of the Standard is the loss after depreciation for computing DTA. However, the timing differences in depreciation between book and income-tax is separately considered for computing the deferred tax liability (DTL), including the reversal, as this difference affects the carrying value of the fixed assets.

As indicated earlier, the company has not recognised the DTA in the first two years on the basis of prudence. To recognise the DTA in Year 3 the company should be able to demonstrate virtual certainty which again should not be based on future projections as per ASI 9 issued by the ICAI. Hence, on the assumption that there will be virtual certainty as regards future taxable income, the company will have to recognise the DTA in Year 3.

The following situations emerge in terms of the recognition of DTA in Year 3.

Situation 1: The company recognises the accumulated net DTA of Rs 525 as at the end of year 2 and write off Rs 35 in Year 3.

Situation 2: The company recognises the accumulated net DTA of Rs 490 as at the end Year 3.

Situation 3: Though there is virtual certainty, it is restricted to Rs 300 and, hence, it recognises only to this extent.

In all the three situations listed, the basic issue is the manner and nature of recognition of the DTA, that is, whether the DTA should be recognised through the P&L account or through the reserves. If recognised through the P&L account Situations 1 and 2 will lead to the same result. That is, the net credit to the P&L account is Rs 490 and in situation 3 it will be Rs 300.

In situation 1 if the net DTA of Rs 525 is recognised through reserves and the write off takes place through the P&L account the provisions of both Paras 19 and 26 are complied as the reassessment and review is carried out simultaneously.

Para 26 of the standard states is on `review of deferred tax assets'. In situations 2 and 3, if the recognition is carried out through reserves, it will not reflect the utilisation of profits in the Year 3 against the carry forward losses. How should this be viewed is not yet clarified by the ICAI. One view could be that in such situations the profits utilised will take the characteristic of a permanent difference.

Recognition of DTA through the P&L account in all three situations leads to the following key issues:

Issue 1: Whether minimum alternate tax (MAT) has to be paid in Year 3 on the recognition of the DTA since it increases the book profits.

The DTL/DTA is part of the current tax. From the viewpoint of computation of profits for income-tax, current tax should not be considered. Hence, there is no need to pay MAT on DTA. However, opinions are divided on this issue.

Issue 2: Whether such recognition conflicts with the accrual system of accounting.

As per the guidance note issued by the ICAI, accrual basis of accounting is the method of recording transaction by which revenues, costs, assets and liabilities are reflected in the accounts in the period in which they accrue. The accrual basis of accounting includes considerations relating to deferrals, allocations, depreciation and amortisation. This basis is also referred to as 'mercantile basis of accounting'.

Accrual basis of accounting, thus, attempts to record the financial effects of the transactions, events and circumstances of an enterprise in the period in which they occur rather than recording them in the period(s) in which cash is received or paid by the enterprise. It recognises that the buying, producing, selling ant other economic events that affect an enterprise's performance often do not coincide with the cash receipts and payments of the period. The goal of accrual basis of accounting is to relate the accomplishments (measured in the form of revenue) and the efforts (measured in terms of cost) so that reported net income measures an enterprise's performance during a period rather than merely listing its cash receipts and payments. Apart from income measurement, the accrual basis of accounting recognises assets, liabilities or components of revenue and expenses for amounts received or paid in cash in past, and amounts expected to be received or paid in cash in the future.

The essential features of the accrual system of accounting are: i) revenue "earned" is recognised; ii) cost is "matched" to revenue to determine the income of the relevant period; and iii) costs not charged are periodically reviewed and written off as soon as their utility is lost. The emphasis is on the timing of the recording of the transactions which clearly leads to the periodicity concept. In this background, the question before us is whether the recognition of the previously unrecognised deferred tax assets under Para 19 of AS 22 through the P&L account will be proper. If the recognition is carried out in the P&L account it is clearly noticed that the amount of DTA represents the accumulation of previous years.

Hence, it will be against the concept of the accrual system. Accordingly, in each of the situations discussed, it will be proper to recognise the DTA through the Reserves with the write off of Rs 35 in the P&L account under situation 1. According to Para 29, an enterprise should offset deferred tax assets and deferred tax liabilities if: a) it has a legally enforceable right to set off assets against liabilities representing current tax; and b) the deferred tax assets and deferred tax liabilities relate to taxes on income levied by the same governing taxation laws.

(The author is a Chennai-based chartered accountant.)

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