The amendment to Section 145 of the Income Tax Act, 1961, had empowered the Central Government to notify the accounting standards required to be followed by any class of assessees in respect of any class of income.

Several accounting standards have been notified by the Central Board of Direct Taxes. While company law provides for the accrual system as a mandatory requirement, the tax law has not made the system mandatory. The timing of the accrual of income and of expenditure leaves much scope for tax planning.

Classification of expenses will make the difference regarding admissible and inadmissible expenses. Inventory valuation is a matter of accounting and presents options by offering different methods of valuation of raw materials, work-in-progress and finished products. Potential profits may not be booked while potential losses may be accounted for by taking the market conditions into account. Care should be taken to see that whatever method is followed, there is no distortion of the true profits. Accounting standards are becoming mandatory from year to year. Segment reporting and tax deferment have to take into account the requirements of accounting standards. Accounting for tax on income is concerned with deferred tax. Tax laws influence accounting measurements.

Impending Changes

Corporate houses are concerned about the impending accounting standards and guidance note in the offing.

It has been felt that there is flexibility in the standards issued by the ICAI which makes it possible for an assessee to avoid payment of correct taxes by following a particular system.

The computation of income in a precise and objective manner is rendered difficult by the flexible standards.

The Central Board of Direct Taxes constituted a New Accounting Standard Committee to study the harmonisation of accounting standards issued by the ICAI with the direct tax laws in India and suggests an accounting standard which needs to be adopted under Section 145(2).

The committee has brought out a draft of the tax accounting standards on construction contracts and Government grants. The draft defines terms such as construction contract, fixed price contract, cost plus contract, retentions, progress billings and advances. Contract revenue will comprise the initial amount of revenue as agreed in the contract and variations in contract work, claims and incentive payments to the extent that they are capable of being a reliable measure. Contract costs comprise costs that relate directly to the specific contract and costs attributable to the contract activity. These costs shall be reduced by incidental income, not being in the nature of interests, dividends or capital gains, which are not included in the contract revenue. Costs that are incurred in securing the contract are also included as part of the contract costs.The crucial part of the discussion paper on the subject concerns recognition of contract revenue and expenses.

Recognition is with reference to the stage of completion of the contract activity on the reporting date. This is called the completion contract method.

Contract revenue is matched with the contract costs incurred in reaching the stage of completion, resulting in the reporting of revenue, expenses and profit which can be attributed to the proportion of work completed.

Stage of completion of contract is determined as the proportion that contract costs incurred for work performed up to the reporting date bear to the estimated total contract or completion of a physical proportion of the contract work. Only those costs that reflect work performed are included in costs incurred up to the reporting date.

Costs relating to a future activity and payment made to sub-contractors in advance will be excluded. The early stage of a contract shall not extend beyond 25 per cent of the stage of completion.

The percentage of completion method is applied on a cumulative basis in each accounting period to the current estimates of contract revenue and contract costs. The ICAI is framing rules along with guidance notes to define when and how developers should recognise revenues from a project.

Standards for Developers

The percentage completion method has been recognised by the Courts and even by the department in a number of cases. The completed contract method has resulted in difficulties in fixing the income from year to year (see Sukhdeodas Jalan 26 ITR 617 and Tirathran 186 ITR 428). The Madras High Court had also considered this issue in the East Coasts Constructions case 283 ITR.

The guidance note to be brought out by the institute is expected to define when and how developers should recognise revenues from a project. At present, there are no specific rules on the subject.

This leaves builders and developers much discretion in computing project costs or recording revenues.

It is necessary that while notifying the guidance note, the ICAI takes into account the viewpoints of all those interested in the subject before it becomes law.

(The author is a former Chief Commissioner of Income-Tax.)

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