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February 2013

GAP in GAAP? Virtual Certainty vs. Convincing Evidence

By Geeta Jani, Dhishat B. Mehta
Chartered Accountants
Reading Time 7 mins
The principles of virtual certainty continue to remain challenging for many Indian enterprises. Paragraph 17 of AS-22 Accounting for Taxes on Income states as follows: “Where an enterprise has unabsorbed depreciation or carry forward of losses under tax laws, deferred tax assets should be recognised only to the extent that there is virtual certainty supported by convincing evidence that sufficient future taxable income will be available against which such deferred tax assets can be realised.”

Explanation to paragraph 17 states as follows: Determination of virtual certainty that sufficient future taxable income will be available is a matter of judgment based on convincing evidence and will have to be evaluated on a case to case basis. Virtual certainty refers to the extent of certainty, which, for all practical purposes, can be considered certain. Virtual certainty cannot be based merely on forecasts of performance such as business plans. Virtual certainty is not a matter of perception and is to be supported by convincing evidence. Evidence is a matter of fact. To be convincing, the evidence should be available at the reporting date in a concrete form, for example, a profitable binding export order, cancellation of which will result in payment of heavy damages by the defaulting party. On the other hand, a projection of the future profits made by an enterprise based on the future capital expenditures or future restructuring etc., submitted even to an outside agency, e.g., to a credit agency for obtaining loans and accepted by that agency cannot, in isolation, be considered as convincing evidence.

Author’s analysis of virtual certainty

Let us analyse the above requirements of virtual certainty.

1. Virtual certainty has to be supported by convincing evidence of future taxable income. The evidence has to be very strong, such as a non cancellable order, the cancellation of which will result in heavy penalty. The explanation provides non cancellable order as an example. There could be many other examples, which do not entail a non cancellable order, but nonetheless provide virtual certainty. For example, an oil well with proven oil reserves, or FDA approval of a blockbuster drug or a toll road between two very busy cities, for which there is no alternate commute (monopoly situation).

2. Virtual certainty is not a matter of perception, but judgment needs to be exercised. Judgment is based on detailed analysis of facts and circumstances; whereas perception is not based on a detailed analysis or evidence.

3. Mere projections will not suffice. There has to be virtual certainty of future taxable income. Projections would certainly be required to determine future taxable income. However, those projections would have to be supported by virtual certainty of future profits. The virtual certainty could come from non cancellable confirmed orders or other factors.

The Expert Advisory Committee (EAC) has also opined on several occasions on the concept of virtual certainty. Some of the key views of the EAC in addition to those already described above are set out below.

1. An unlimited period of carry forward in respect of unabsorbed depreciation is not a basis for recognising DTA and on its own does not demonstrate virtual certainty.

2. The fact that the company has made book profits (DTA is with respect to tax losses) does not on its own demonstrate virtual certainty.

3. Orders secured by the company, may be considered while creating deferred tax asset, provided these are binding on the other party and it can be demonstrated that they will result in future taxable income. However, mere projections made by the company indicating the earning of profits from future orders, or financial restructuring proposal under consideration or the fact that the books of account of the company are prepared on going concern, or the upward trend in the business or economy, may not be considered as convincing evidence of virtual certainty.

Apparently, the “virtual certainty” criteria laid down in AS 22 for the recognition of DTA is difficult to implement. Given below are the author’s perspectives on some of the key challenges:

(i) The explanation to paragraph 17 gives an example of a profitable binding order for the recognition of DTA and disallows recognition of DTA on the basis of mere projections of future profits based on capital expenditure/restructuring plans.

In practice, there will be many situations that fall between the two scenarios. Let us consider the following scenarios:

(a) A newly set-up entity (New Co) incurred significant losses in the first three years of operations due to reasons such as advertising and initial set-up related costs, significant borrowing costs and lower level of activity in the first two years of operations. Over the years, there has been a significant increase in the operations of New Co and its advertisement cost has stabilized to a normal level. Further, it has raised new capital during the year and repaid its major borrowing. The cumulative effect of all the events is that the New Co has started earning profits from the fourth year. It is expected to make substantial profits in the next three years that will absorb the entire accumulated tax loss of the entity.

(b) A battery manufacturer (Battery Co), which had incurred tax losses in the past, enters into an exclusive sales agreement with a car manufacturer (Car Co). According to the agreement, all the cars manufactured by Car Co will only use batteries manufactured by Battery Co. Though Car Co has not guaranteed any minimum off-take, there is significant demand for its cars in the market.

A perusal of both the aforementioned scenarios indicates that entities have significant additional evidence than mere projections of future profitability to support the recognition of DTA. However, since they do not have any binding orders in hand, or other concrete evidence, it may lead to the conclusion that the virtual certainty criterion laid down in AS 22 for recognition of DTA is not met.

(ii) There are certain sectors such as retail or building material, which generally do not have any binding sale orders. This indicates that these sectors, unless they are monopolies, cannot recognise DTA if they have unabsorbed depreciation and/or carry forward of tax losses. This may not be fair, as the principle of virtual certainty is tilted in favour of entities that work on binding orders such as construction, IT or engineering companies.

(iii) If the intention is that profits are to be virtually certain for the recognition of DTA in case of carry forward losses/unabsorbed depreciation, then it is not clear why the virtual certainty principles are applied only for revenue and not for input costs or availability of inputs.

The virtual certainty principle has a fatal flaw; nothing in this world is virtually certain. Even profitable binding orders could be cancelled without receiving any penalty as the buyer/seller could end up getting bankrupt. Interestingly, both Ind-AS 12 (Ind-AS are notified in the Companies Act, but are not yet applicable) and IAS 12 on Income Taxes lay down the criteria of “probability” to recognise DTA, including on unabsorbed depreciation and/or carry forward of tax losses. However, when an entity has a history of recent losses, it should recognise DTA only to the extent it has convincing evidence that sufficient taxable profit will be available. The principle of convincing evidence under Ind-AS and IAS is not only fair, but is also practical to apply, compared to the “virtual certainty” principle under AS 22. In the two examples referred to in this article, the principles of convincing evidence (under Ind-AS and IFRS) would probably result in recognition of DTA, but under Indian GAAP principles of virtual certainty, no DTA can be recognised.

The ICAI should look into the matter and align the requirement of Indian GAAP with Ind-AS.

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