AS 22 permits set-off of deferred tax assets against similar liabilities

Jayant M Thakur

This is the concluding part of the series of three on accounting standard 22, which deals with accounting for taxes on income. The first part discussed that the AS classifies differences in accounting and taxable income into permanent differences and temporary differences. The timing difference between accounting and taxable income would get reversed in the future and therefore should be accounted for so that a true and fair picture is presented. However, permanent differences are to be ignored since there would be no future impact of such differences.

The accounting standard does not seek to even out the impact of income and expenditure accounting - it only seeks to even out the tax implications of this. It also points out that deferred tax assets are illusory unless one is certain that the company will earn profits that are taxable and against which such losses can be adjusted.
Thus, the accounting standard emphasises prudence. It states that such assets should be recognised only if there is “reasonable certainty” that there would be future taxable income for such purposes. It also requires that deferred tax assets should be reviewed at the end of each year.

there are some issues relating to putting an amount on the amount of deferred tax assets and liabilities. The first issue is of tax rates. Deferred tax assets and liabilities are clearly to materialise in the future. For example, when depreciation claim is available in the future, the tax rate at that time can be higher or lower and the actual tax rate would determine the amount of the asset or liability. Clearly, one cannot predict certainly the tax rate and the accounting standard therefore provides that the tax rates existing as at the balance sheet date should be adopted or those provided as per laws “substantively enacted” by the balance sheet date.

The accounting standard does not expressly clarify here whether the changes introduced by a Finance Bill in February of a year for the purposes of the accounts closing in March which are adopted and approved after March can be taken into account. While the words “substantively enacted” may support to some extent such an interpretation, an express clarification may be necessary.

The accounting standard also provides that if tax rates change as per levels of income, (ie, differing tax slabs) the deferred tax assets and liabilities should be measured using average rates. Here again, expediency has conquered logic. One could argue that if one is making estimates of profits, etc. of the future, is it appropriate not to use actual tax amounts. After all these are estimates but still should not one carry the logic to its end result?

What is meant by the words “average rates”? Is it meant that the average rate applicable to that entity? For example, an individual may have a tax of, say, Rs 60,000 on an income of, say, Rs 3,00,000, thus giving an average rate of 22.50 per cent. The three tax rates applicable at different slab levels are 10 per cent, 20 per cent and 30 per cent. The simple average of these three tax rates is 20 per cent. Will this average of 20 per cent be taken or the actual average of 22.50 per cent?

While on this, it is very likely that the deferred tax liabilities and assets would affect only the last tax slab which usually would be the highest one. In the above example, suppose the item resulting in a tax deferral is Rs 20,000. If this item gets added or deducted in the future at the same income levels, the tax impact would be @ 30 per cent only. In which case, is it appropriate to compute the deferred tax at the average rate? Incidentally, surcharge has to be taken into account while computing the tax and it would be a part of the tax rate itself.

The accounting standard then makes one more requirement that may not once again be logical but it is expedient and in fact also sensible. Clearly, the very concept of deferred tax talks of benefits or liabilities in the future. However, the accounting is done of such amounts today. Clearly, the further in the future such benefits or liabilities are expected to occur, the lesser is the impact considering interest. In other words, in the normal course, one should discount benefits or liabilities occurring in the future, if one has to be realistic about them.

The accounting standard, however, specifically requires that no discounting shall be carried out. In other words, a deferred tax benefit of Rs 20,000 in the next year is place at par with a benefit of the same amount expected to realise 10 years hence. Apart from the fact that both these figures are unrealistic once discounting is applied, putting them at par is compounding it. The reason offered by the accounting standard for this is that once the concept of discounting is required, it would mean making of detailed and precise estimates of year to year reversal of such timing differences and for this the projections of income, profits, etc. year to year would have to be made. This, the accounting standard states, is in most cases “impracticable or highly complex”. Thus, the accounting standard concludes that such discounting is not permitted nor is required.

One could argue particularly that when an entity is making an estimate of deferred tax assets, it is required to have a certain level of certainty (ie, “reasonable” or “virtual”, as the case may be).
Under certain circumstances, “convincing evidence” is also required before such assets are booked. In such case, surely, the estimates may have been made with more precision including precision for years. In which case, is it not appropriate to take discounting into account. Nevertheless, this is a debate that has some thing to say for both sides and the accounting standard has adopted that alternative that is expedient and which involves lesser complication as also lesser possibility of misuse but perhaps at the cost of accuracy and reasonableness.

The accounting standard permits set off of deferred tax assets and liabilities provided some conditions, which are fairly obvious, are satisfied. It appears that the concept of set off is of two types. The first type of set off means that a liability may never arise because an asset may arise in the same year. Hence the liability is netted out. Another concept is that liability may arise in one year and the asset may arise in another. However, still the entity is sure of both and hence the net amount would be the same. Detailed disclosure is also required, particularly of breakup of the deferred tax assets. accounting entries are also provided by way of an example.

Finally, let us come to perhaps the most far reaching requirement of the accounting standard. It is provided that in the first year of application of this accounting standard, calculation and provision of all past differences should be made.

In other words, the cumulative timing differences, so long as they are live and available for the future, should be computed and provided for by way of a charge or credit to the retained earnings.
To conclude, a very useful accounting practice that is prevalent abroad is now required to be applied in India. Better disclosure and presentation would certainly follow.