APPLICABILITY OF ACCOUNTING STANDARDS

The standards are developed by the Accounting Standards Board (ASB) of the institute and are issued under the authority of its Council. The institute not being a legislative body can enforce compliance with its standards only by its members. Also, the standards cannot override laws and local regulations. The accounting standards are nevertheless made mandatory from the dates specified in respective standards and are generally applicable to all enterprises, subject to certain exception as stated below. The implication of mandatory status

of an accounting standard depends on whether the statute governing the enterprise concerned requires compliance with the standard.

In assessing whether an accounting standard is applicable, one must find correct answer to the following three questions.

(a) Does it apply to the enterprise concerned? If yes, the next question is:

(b) Does it apply to the financial statement concerned? If yes, the next question is:

(c) Does it apply to the financial item concerned?

The preface to the statements of accounting standards answers the above questions.

Enterprises to which the accounting standards apply

Accounting Standards apply in respect of any enterprise (whether organised in corporate, co-operative or other forms) engaged in commercial, industrial or business activities, whether or not profit oriented and even if established for charitable or religious purposes. Accounting Standards however, do not apply to enterprises solely carrying on the activities, which are not of commercial, industrial or business nature, (e.g., an activity of collecting donations and giving them to flood affected people). Exclusion of an enterprise from the applicability of the Accounting Standards would be permissible only if no part of the activity of such enterprise is commercial, industrial or business in nature. Even if a very small proportion of the activities of an enterprise were considered to be commercial, industrial or business in nature, the Accounting Standards would apply to all its activities including those, which are not commercial, industrial or business in nature.

Implication of mandatory status

Where the statute governing the enterprise does not require compliance with the accounting standards, e.g. a partnership firm, the mandatory status of an accounting standard implies that, in discharging their attest functions, the members of the Institute are required to examine whether the financial statements are prepared in compliance with the applicable accounting standards. (See Scheme of Applicability) In the event of any deviation from the accounting standards, they have the duty to make adequate disclosures in their reports so that the users of financial statements may be aware of such deviations. It should nevertheless be noted that responsibility for the preparation of financial statements and for making adequate disclosure is that of the management of the enterprise. The auditor’s responsibility is to form his opinion and report on such financial statements.

Where the statute governing the enterprise requires compliance with the accounting standards, e.g. companies, mandatory status of an accounting standard implies that the duty of compliance is primarily on the enterprise presenting the financial statement.

Section 211(3A) of the Companies Act requires companies to present their profit and loss accounts and balance sheets in compliance with the accounting standards. (See Note 1) Also, the auditor is required by section 227(3)(d) to report whether, in his opinion, the profit and loss account and balance sheet of the company audited, comply with the accounting standards referred to in section 211(3C). Where the profit and loss account and balance sheet of a company do not comply with the accounting standards, the company is required by section 211(3B) to disclose the deviations from the accounting standards together with reasons for the deviations and financial effect if any arising due to such deviations.

In addition, listed companies are required to comply with the accounting standards issued by The Institute of Chartered Accountants of India, by clause 50 of listing agreement with the stock exchanges.

The above discussion shows that unlike other enterprises, duty to comply with the standards is also on the company, which is presenting the financial statements.

Note 1:

As per section 211(3C), the expression ‘accounting standards’, for the purpose of section 211(3A), means standards of accounting recommended by the Institute of Chartered Accountants of India, as may be prescribed by the Central Government in consultation with the National Advisory Committee on Accounting Standards established under subsection (1) of section 210A. It is also provided that, till the time the Central Government prescribes accounting standards, the accounting standards specified by the Institute of Chartered Accountants of India shall be deemed to be accounting standards for the purpose of section 211(3A). Till date, the Central Government has not prescribed any accounting standards. For the purpose of section 211(3A) and Section 227(3)(d), the institute has specified all mandatory accounting standards. In other words, companies are required to comply with all applicable mandatory standards issued by the Institute of Chartered Accountants of India.

Note 2

Enterprises in insurance business are required to comply with the accounting standards by the Insurance Regulatory and Development Authority (Preparation of Financial Statements and Auditor’s Report of Insurance Companies) Regulations, 2000. The standards to be complied by these enterprises are those, made applicable to them.

Financial items to which the accounting standards apply

The Accounting Standards are intended to apply only to items, which are material. An item is considered material, if its omission or misstatement is likely to affect economic decision of the user. Materiality is not necessarily a function of size; it is the information content if the financial item which is important. A penalty of Rs. 50,000 paid for breach of law by a company can seem to be a relatively small amount for a company incurring crores of rupees in a year,

yet is a material item because of the information it conveys. The materiality should therefore be judged on case-to-case basis. If an item is material, it should be shown separately instead of clubbing it with other items. For example it is not appropriate to club the penalties paid with legal charges.

Conflict between requirements of accounting standard and Court/Tribunal order

On 17 November 2004, the Council of the ICAI has announced that if an item in the financial statement of an enterprise is treated differently pursuant to an Order made by the Court/Tribunal, as compared to the treatment required by an Accounting Standard, following disclosures should be made in the financial statements of the year in which different treatment has been given:

A description of the accounting treatment made along with the reason that the same has been adopted because of the Court/Tribunal Order.

(a) Description of the difference between the accounting treatment prescribed in the Accounting Standard and that followed by the enterprise.

(b) The financial impact, if any, arising due to such a difference.

Accounting Standard and Income Tax Act

Accounting standards intend to reduce diversity in application of accounting principles. They improve comparability of financial statements and promote transparency and fairness in their presentation. Deductions and exemptions allowed in computation of taxable income on the other hand, is a matter fiscal policy of the government. Thus, an expense required to be charged against revenue by an accounting standard does not imply that the same is always deductible for income tax purposes. For example, depreciation on assets taken on finance lease is charged in the books of lessee as per AS 19 but depreciation for tax purpose is allowed to lessor, being legal owner of the asset, rather than to lessee. Likewise, recognition of a revenue in the financial statements cannot be avoided simply because it is exempted under section 10 of Income Tax Act.

As already explained, the Guidance Note on Audit Under Section 44AB of Income Tax Act, requires all financial statements prepared under mercantile system of accounting to comply with all applicable mandatory accounting standards issued by the Institute. The financial statements prepared under cash basis of accounting however, need not adhere to the accounting standards issued by the Institute.

It follows from above, that a member of the Institute reporting for tax audit purposes, is under an obligation to see whether the audited financial statements, if prepared under mercantile system of accounting, comply with all applicable mandatory standards issued by the Institute.

In case of any deviation, the member should consider making qualification/appropriate disclosure in his reports.

It should be noted that the Central Government has notified two accounting standards, viz. AS (IT) 1, Disclosure of Accounting Policies and AS (IT) 2, Disclosure of Prior Period and Extra Ordinary Items and Disclosure of Accounting Policies for the purpose of taxation. Section 145 of Income Tax Act requires all assesses keeping their books by the mercantile system of accounting to comply with these two standards. Also, requirements of AS (IT) 1 and AS (IT) 2 are practically same as the corresponding AS 1 and AS 5 issued by the institute. The mandatory compliance of AS (IT) 1 and AS (IT) 2 are nevertheless required for the limited purpose of income tax.

Mandatory accounting standards issued by the ICAI apply to all financial statements prepared under mercantile system irrespective of the requirements of Income Tax Act. The differences between requirements of Income Tax Act and those of accounting standards cause taxable profit to differ from the accounting profit before tax.