Income computation and disclosure standards (ICDS)

1 Background 2 General principles 3 Key Areas of Impact 4 Hierarchy of Act, ICDSs and ASs 5 ICDS I: Accounting Policies 6 ICDS II: Valuation of Inventories 7 ICDS III: Construction Contr

RAO & KUMAR Chartered Accountants Income Computation And

Disclosure Standards (ICDS)

1) Background

2) General principles

3) Key Areas of Impact

4) Hierarchy of Act, ICDSs and ASs

5) ICDS I: Accounting Policies

6) ICDS II: Valuation of Inventories

7) ICDS III: Construction Contracts

8) ICDS IV: Revenue Recognition

9) ICDS V: Tangible Fixed Assets

10) ICDS VI: The effects of changes in foreign exchange rates

11) ICDS VII: Government Grants

12) ICDS VIII: Securities

13) ICDS IX: Borrowing Costs

14) ICDS X: Provisions, Contingent liabilities and Contingent assets

Background of ICDS…

 Section 145(1) of the Income-tax Act, 1961 (Act) stipulates that the method of accounting for computation of income under the heads

“Profits and gains of business or profession” and “Income from other sources” can either be cash or mercantile system of accounting

 Section 145(2) of the Act states that the Central Government may notify the accounting standards to be followed by any class of assesses or in respect of any class of income

 Accordingly, two tax accounting standards had been notified until now:

1.Disclosure of accounting policies

2.Disclosure of prior period and extraordinary items and changes in accounting policies

General principles

 Applicable to all tax payers (Corporate and Non-corporate) following mercantile system of accounting including non-resident tax payers

 ICDS applies to income computed under the head “profits and gains of business or profession” and “income from other sources” and not for

maintaining books of accounts

 In case of conflict between the provisions of the Act and ICDS, the provisions of the Act shall prevail to that extent

 No impact on computation of book profits for the purpose of MAT The Provisions of sec-115 JB(1) shall continue to apply

Expected Losses/Mark to Market losses will not be recognized unless permitted by specific ICDS Not Clarity w.r.t MTM Gains.

New formula for capitalization of Borrowing Costs is introduced

Applicable for all open Construction Contracts as at 31.03.2015

All Service contracts shall be valued at POC for Revenue Recognition

Key Areas of Impact…

Hierarchy of Act, ICDSs and ASs

Income Tax Act, 1961

Income Tax Rules, 1962

Income Computation and Disclosure Standards – (Ultra-vires Sec-145)

Accounting Standards

Accounting Policies

• No concept of materiality in ICDS unlike, AS-1

• No likely significant tax impact

• In absence of materiality concept, considerable time and cost will be involved making trivial adjustments in net profit as per books of accounts to arrive at PGBP since authorities may insist on strict application of ICDS even on small value items

Prudence

• Based upon the concept of ‘prudence’, AS-1 precludes recognition of anticipated profits and requires recognition of expected losses

• However, ICDS provides that expected losses or mark to market losses shall not be recognized unless permitted by any other ICDS to

avoid differential treatment for recognition of income and losses

• However, ICDS is silent on MTM gain

Prudence

• In the absence of prudence as a fundamental assumption, there could be several situations which could result in earlier recognition

of income or gains or later recognition of expenses as compared to that under AS E.g provision for warranty expenses on sales made

• An ambiguity would arise on deductibility of losses which are not covered in any specific ICDS E.g Currently no specific proposed ICDS dealing with MTM loss on derivatives

Valuation of Inventories

Value of opening inventory

• Value of opening inventory should be same as preceding year’s closing inventory

• In case of a newly commenced business, the value of the opening inventory shall be the cost of the inventory

• Cases of conversion of capital asset into stock-in-trade with intent to commence business may remain unaffected due to overriding provisions of Section 45(2) of the Act

• If business is commenced with acquisition of running business on slump sale, price paid will be ‘cost’ of opening inventory

Method of Valuation

• ICDS does not permit standard cost method for the purpose of inventory valuation.

• The same will have an impact on taxpayers following standard cost method for valuation of inventory for accounting purpose, who will need to adopt FIFO or weighted average cost formula for tax purposes

• Further, as per ICDS, method of valuation once adopted shall not be changed without reasonable cause It would not have a significant impact since bonafide change may constitute reasonable cause

Valuation of inventories in case of service providers

• AS-2 does not include work in progress (WIP) arising in the ordinary

course of business of service providers.

• Specifies that it does not apply to WIP which is dealt with by other ICDS

• Valuation of service inventory to be the lower of cost or NRV.

• Cost to include labor and other costs of personnel directly engaged in providing services including supervisory personnel and attributable overheads.

• Difficulty would arise in case of services whose chargeability depends on the success of the service.

Construction Contract

- Cost allocated to the contract

- Cost specially charged to the customer under the terms of the contract

The scope of the Contract Cost has been widened to include “Allocated Borrowing Cost” in accordance with ICDS on Borrowing Cost.

Construction Contracts

 Recognition of Contract Revenue

Contract revenue to be recognized if it is possible to reliably estimate

the outcome of a contract.

The criteria “if it is possible to reliably measure the outcome of a contract” has been omitted Contract revenue to be recognized when there is reasonable certainty of its ultimate collection.

Impact: The recognition of contract revenue may be preponed under ICDS.

 It lays down the conditions to estimate the outcome of

construction contract in case of

: Fixed Price Contract

-Cost plus Contract

 ICDS is silent on the same

Construction Contract

 Situation when outcome of contract cannot be reliably estimated

Contract revenue and contract costs to be recognized as revenue or expenses by reference to

the POCM if the outcome of the contract can be estimated reliably; else, revenue should be

recognized only to the extent of contract costs incurred.

No quantitative threshold laid down for determining the stage of completion, until when, the

outcome of a contract cannot be reliably measured.

ICDS provides that early stage of a contract shall not exceed 25% of the stage of completion.

In other words, upto 25% of the stage of completion, if the outcome of construction contract cannot be reliably measured, contract revenue is recognized only to the extent of cost incurred.

Impact: Under ICDS, profit recognition has to start compulsorily once 25% stage is completed but the same is not the case currently under AS – 7.

Construction Contract

 Retention Money

Contract revenue shall comprise:

The initial amount of revenue agreed in the contract

Contract revenue shall comprise:

The initial amount of revenue agreed in the contract, including retentions.

Impact Analysis: There are various judicial precedents like Angelique International Ltd vs Department of Income Tax [ITA No.4085/DEL/2011] which does not recognize retention money as

income for tax purpose if there is no enforceable debt ICDS leads to deviation from the settled judicial position.

 Incidental Income

Any incidental income, not included in the contract revenue, shall be deducted while

computing construction cost.

Contract cost shall be reduced by any incidental income, not being in the nature of interest, dividends or capital gains, that is not included in the contract revenue Therefore, those interest income, dividend income and capital gains shall be taxed as income in accordance with the applicable provisions of the Act.

Construction Contract

 Recognition of foreseeable losses

It permits to recognise immediately the foreseeable losses on a contract regardless

of commencement or stage of completion of contract.

ICDS does not permit recognition of the foreseeable/expected losses on a contract ICDS on accounting policies also does not permit recognition of foreseeable loss.

Impact: ICDS deviates from the present legal settled position in the case of CIT V/s Triveni Engineering & Industries Ltd (49 DTR 253) (Del) & CIT v Advance Construction

Co (P) Ltd (275 ITR 30) (Guj)) in which foreseeable losses on construction contracts were allowed as a deduction for tax purpose.

Construction Contract

 Recognition of incentive payments

Incentive payment to be recognised only when (i) probability exists that specified

performance standards would be met or exceeded (Guidance para in ICAI AS, links probability

to contract progress upto sufficiently advanced stage); (ii) incentive is reliably measurable.

Requires recognition under POCM if incentive reliably measurable and it is probable that it will result in revenue In absence of further guidance, ambiguity may arise if the requirement

of “sufficiently advanced stage of contract” is deleted/diluted.

 Recognition of claims

Claims against customers to be recognised when (i) probability exists that the customer will

accept the claim (Guidance para in ICAI AS, links probability to negotiation progress upto

advanced stage); (ii) amount is reliably measurable.

Requires recognition under POCM if claims are reliably measurable and it is probable that it will result in revenue In absence of further guidance, ambiguity may arise if the requirement

of “advanced stage of negotiation” is deleted/diluted.

Revenue Recognition

AS - 9 ICDS

 It does not apply to companies engaged in insurance

business

ICDS is silent on same

Revenue from service transactions are recognised as

percentage completion method or by the completed service

ICDS requires application of ICDS on construction contracts for recognition of revenue on mutatis mutandis basis.

• Threshold of 25% stage of completion for recognition of income

• No recognition of the foreseeable losses on a contract However, AS-7 permits immediate recognition of the foreseeable losses on a contract regardless of commencement or stage of completion of contract

• Stage of completion can be determined with reference to (a) total estimated costs v/s cost incurred till balance sheet date;

or (b) survey of work performed; or (c) completion of physical proportion of work

Tangible Fixed Assets

AS- 10 ICDS

 It applies to tangible fixed assets as well as goodwill  It applies to only tangible fixed assets

 Cost of fixed asset comprises its purchase price, non refundable taxes

and any directly attributable cost of bringing the asset to its working

condition for its intended use

 It has similar definition to AS 10 but the words used are actual cost as compared to cost in AS -10

Impact:

The Act provides for the definition of the term ‘actual cost’ and it is again repeated in the ICDS but it does not modify the concept of actual cost However when there is conflict in interpreting the abovementioned term under ICDS and Act, the Act will prevail over ICDS Such a narrow definition in ICDS might encourage the taxpayer to contend that expenditure on acquisition which is not part of actual cost should be deductible as revenue instead of capitalising

AS- 10 ICDS

 AS 10 read with guidance note on Machinery for Spares provides

for charge to P/L, however spares to specific asset should be

capitalised and shall form part of that Asset

 It provides that machinery spares which can be used only in connection with an item of tangible fixed asset and their use is expected to be irregular, shall be capitalized

Impact:

ICDS specifies that machinery spares dedicated to a tangible fixed asset should be capitalized, it does not provide any further guidance on subsequent treatment that whether it will form part of the block of the asset However, in absence of such clarification spares would form part of the block and once the principal asset is put to use, the spares shall qualify for the depreciation at the same rate

Assets acquired against non-monetary consideration

 When a fixed asset is acquired in exchange or in part exchange for another

asset, the cost of acquired asset should be recorded either at FMV or NBV of

asset given up, adjusted for any balancing payment or receipt of cash or other

consideration

 When a tangible fixed asset is acquired in exchange for other asset, the fair value of the tangible fixed asset so acquired shall

be its actual cost

 Fixed asset acquired in exchange for shares or other securities in the

enterprise should be recorded at its FMV, or the FMV of the securities issued,

whichever is more clearly evident

 When a tangible fixed asset is acquired in exchange for shares or other securities, the fair value of the tangible fixed asset so acquired shall be its actual cost

Usual Practice: Concept of cost should normally relate to what is given up.

Assets acquired for a consolidated price

 Para 15.3 says that when several assets are purchased for consolidated price,

the consideration is apportioned on fair basis as determined by competent

valuers

 When several assets are purchased for a consolidated price, the consideration shall be apportioned to the various assets on a fair basis

Impact: In absence of determination by registered valuers in ICDS words “fair basis” becomes subjective and might be prone to litigation.

The Effects of Changes in Foreign Exchange Rates

Revenue monetary items (like trade receivables, payables, bank balance, etc.)

 Reported using the closing rate

 Exchange difference recognised in P&L A/c

 Allowed under the Act also

 Converted into reporting currency by applying the closing rate

 Recognised as income or expense subject to provisions of Rule

115

Impact: No change in tax position

Capital monetary items – Relating to Imported assets

 Requires recognition in P&L A/c

 Option of capitalization u/s 211(3C) of companies Act, 1956 as per which (Para 46 & 46A)

exchange differences arising in case of long-term foreign currency monetary items shall be

either adjusted to capital asset or accumulated in FCMITDA

 Requires recognition in P&L A/c subject to provisions of Section 43A

 No Para 46 & 46A exists

Impact:

 Presently, Section 43A permits capitalization on payment basis of exchange differences relating to asset acquired from a country outside India

 Hence, there would be no change in the tax position

Capital monetary items – Not relating to Imported assets

 Requires recognition in P&L A/c

 Option of capitalization u/s 211(3C) of companies Act, 1956 as per which (Para 46 & 46A)

exchange differences arising in case of long-term foreign currency monetary items shall be

either adjusted to capital asset or accumulated in FCMITDA

 Requires recognition in P&L A/c subject to provisions of Section 43A

 No Para 46 & 46A exists

Impact:

 Section 43A does not apply since it applies only if it relates to the imported assets

 Presently, such FE differences are not recognized for tax purposes i.e gain is not taxable, loss is not deductible/ allowable