J.K. INDUSTRIES LTD. & ANR. v. UNION OF INDIA AND ORS.

in the preparation of financial statements. It is a degree of caution in the exercise of judgments needed in making the estimates required under conditions of uncertainty so that assets or income are not overstated and liabilities or expenses are not understated. That, the principles to be followed in the recognition of"assets", "liabilities'', "income" and ''expenses'' require application of the matching concept i.e. matching of costs with revenue, which principle involves combined recognition simultaneous recognition of revenues and expenses that result directly from the same transactions or other events. According to learned counsel, this Comt has always recognized the need for estimation in accrual system of \ accounting. 111.is Court, according to learned counsel, has recognized the accounting concept of matching costs with revenue in preparation of financial statements. In this c01mection, learned counsel placed reliance on the judgment of this Court in Calcutta Company Ltd. v. Commissioner ofIncome Tax, (1959) 37 ITR 1; and Madras Industrial Investment Corporation Ltd. v. Commissioner of Income Tax, (1997) 225 ITR 802. According to learned counsel, at one point of time in the G - ~-__.1, past strict legal concept of "accrual" was laid down in the case of Commissioner of Income Tax v. Tungabhadra Industries Ltd., (1994) 207 ITR 553 Cal. However, according to learned counsel, that strict legal concept is no longer accepted by the Courts and for that purpose learned H - . - --- -

256 SUPREME COURT REPORTS [2007] 12 S.C.R. \

A counsel places reliance on the judgment of this Court on the same issue in the case of Madras Industrial Investment Corporation Ltd. (supra). In short, learned counsel submitted that with globalization and with new concepts coming in, the law is no more confined to the strict legal concept of"accrual" which does not recognize the matching principle.

49Copy pinpoint49. Learned counsel urged that the requirement for "accrual basis of accounting" was introduced in the Companies Act in 1988 through Section 209. Under Section 209(1) every company is required to maintain proper books of account with respect to receipts and expenses, sales and purchases of goods, assets and liabilities of the company, utilization of material or labour and such other items of costs incurred in productio0; process, manufacturing etc. Under Section 209(3) proper books of account shall not be deemed to be kept if such books of account do not give true and fair accounts and if such books fail to explain its transactions further if such books are not kept on accrual basis they have to be rejected for not giving a true and fair view of the state of affairs of the f

company. This position is also reflected in Section 211. Therefore, according to learned counsel, under the scheme-of Companies Act, two requirements have to be. satisfied, namely, ''accrual'' system of accounting and "true and fair" view. Both must read together with each other. E According to learned counsel, the accrual basis of accounting must be applied so that ' 'true and fair ' ' accounts are presented. Indeed, the requirement to present a "true and fair" view precedes the requirement for accrual accounting. The requirement to present true and fair accounts is wider than the requirement of accrual accounting. F Therefore, in a given case it is possible that accounts prepared on I accrual basis may not present true and fair view because of certain deficiencies, however, it is not possible for accounts to be ''true and fair'' unless they are prepared on accrual basis. According to learned counsel, while Section 209(3)(b) mandates the accrual basis of accounting, it does not indicate the amount which should be recognized (accrued) in respect of specific matters. This is left to the judgment of the Accountant. According to learned counsel, accrual basis is a fundamental accounting assumption which means that all Accounting Standards including AS 22 are framed on the basis of accrual system of accounting and, therefore, the question of conflict of an Accounting Standard with the

) J.K. INDUSTRIES LTD. v. UNION OF INDIA 257 I [KAPADIA,].] t >'·~-'I accrual basis of accounting does not arise. That, all Accounting Standards A are framed in order to present a "true and fair" view; that, the primary consideration in the selection of accounting policies is to disclose a ''true and fair" view and, therefore, the purpose of all Accounting Standards including AS 22 is to adopt the accrual basis of accounting in the context of disclosing a ''true and fair'' view and if this principle is kept in mind B -,, then there would be no conflict between AS 22 with accrual basis of accounting. In fact, according to learned counsel, it is significant to not~ that while auditors are required to certify that accounts are true and fair, they are not required to certify that they are prepared on the accrual basis for the simple reason that accounts cannot be true and fair unless the c accrual basis is adopted. For example, a particular liability is not provided for, because it is not legally imminent, it could still be argued that accrual basis bas been adopted in a legalistic sense, but the accounts would nevertheless not represent true and fair view. According to learned counsel, for the aforestated reasons Accounting Standards require that the accrual basis should be adopted in the context of presenting/disclosing a "true anci fair" view. Therefore, the need to disclose a true andfair view is wider then the need for accrual accounts since it automatically includes accrual method of accounting. Learned counsel urged that there is overriding importance for the disclosure of a ''true and fair'' view, since the entire structure of corporate credibility is built on this foundation. Therefore, if any rules for technical disclosure are not consistent with the true and fair view requirement, then the company has to depart from the technical provisions, to the extent necessary, to give a "true and/air" view. '\ That, the disclosure requirements are subservient to the overriding requirement of presenting a ''true and fair'' view. Therefore, in other words, the need to present a ''true and fair'' view should override technical compliance of the law on the basis of true and correct accrual. Therefore, according to the learned counsel, AS 22 goes far beyond technical compliance in order to ensure a ''true and fair presentation 1 ' . G Therefore, according to learned counsel, since Section 211(1) requires • ., true and fair presentation, AS 22, is not beyond the mandate of the Companies Act.

258 SUPREME COURT REPORTS [2007] 12 S.C.R.

50Copy pinpoint50. Coming to the concept of "prudence", learned counsel submitted that when financial statements are prepared, sometimes, the accountant comes across uncertainties that surround many events and in such case caution in exercise of the judgments is required while making estimates, so that assets or income are not overstated and liabilities or expenses are not understated. This is the principle of prudence. The said principle applies in view of uncertainties attached to future events. Profits are not anticipated, but they are recognized only when they are realized. Similarly, Provision is made for all known liabilities and losses, even though the amount cannot be determined with certainty and, therefore, Provision represents only an estimate in the light of available information. The principle of prudence has also been recognized in the Accounting Standard issued by the Central Government under Section 145(2) of the LT. Act through its notification dated 25.2.96 which is required to be followed by all assessees following mercantile system of accounting. In this connection, reliance was placed by learned counsel on the judgment of this Court in the case of Chainrup Sampatram v. Commissioner of Income Tax, (1953) 24 ITR 481 at 485 in which this Court has also underlined the effect that even for income tax purposes profits are to be computed in conformity with ordinary principles of commercial accounting unless such principles stand modified by specific legislative enactments/provisions contained in the Income Tax Law. Similarly, in the case of Commissioner vfIncome Tax v. Duncan Brothers & Co. Ltd., [1996] 8 SCC 31 at 35, this Court has observed that the terms used in the Companies Act should be read in the manner as understood in accounting parlance. F I

51Copy pinpoint51. On the question of alleged conflict between AS 22 and Schedule VI of Companies Act, learned counsel submitted that Accounting Standards, issued by the Institute, deal with recognition, measurement and disclosure and certain elements in financial accounts of every enterprise. That, Schedule VI deals with manner of presentation of financial data in the annual financial statements, namely, the balance- sheet and P&L ale to be drawn by a corporate enterprise at the end of each financial year. That, Part I of Schedule VI lays down the form of balance-sheet whereas Part II lays down the requirements as to the presentation of various financial data in the P&L a.Jc. Part II deals with

j / J.K. INDUSTRIES LTD. v. UNION OF INDIA 259 [KAPADIA,J.] ,.-~-\

interpretation of some of the expressions, namely, "provisions'', A "reserve", "capital reserve", "liability'', "investment" etc. According to learned counsel, except in the case of Depreciation which is provided by every corporate enterprise in accordance with the rates laid down in Schedule XIV of the Companies Act, having regard to the provisions contained in Sections 205, 350 of the said Act, the said Act does not B ---\ lay down the procedure for recognition and measurement of either the income or expenses and or the assets and liabilities. For example, Schedule VI nowhere lays down as to which assets should be recognized as "Investments" and also the method of valuing "Investments". Similarly, AS 6 deals with "Depreciation Accounting", however, except c the statutorily fixed rate of depreciation as laid down in Schedule XIV of the Companies Act, all other aspects relating to recognition and measurement of depreciation are dealt with only in AS 6. They are not dealt with in the Companies Act. Similarly, under Part II of Schedule VI to the Companies Act the manner of presentation of various items of income and expenses in the P&L ale has been laid down. However, the said Act nowhere lays down as to how and when income or expenditure should be measured and/or recognized. This aspect is dealt with by AS 9 alone and not by the provisions of the Companies Act. According to learned counsel, events and contingencies occurring after the balance-sheet date mentioned in AS 4, net profit or loss for a given period, prior period items and changes in accounting policies mentioned in AS 5, Accounting for Construction Contracts in AS 7, Accounting for Fixed Assets in AS 10, the Effect of changes in Foreign Exchaage Rates \ as mentioned in AS 11, Accounting for Intangible Assets contained in AS 26, Accounting for Impairment of Assets in AS 28 are various aspects dealt with only under Accounting Standards and not under the Companies Act. According to learned counsel, since the Companies Act nowhere deals with recognition and measurement of.various items of income and expenses, assets and liabilities, and since it deals with only presentation, there can never be any conflict between the provisions G ~ > ~, of the said Act and the Accounting Standards issued by the Institute in discharge of its statutory obligations under the Chartered Accountants Act, 1949 read with the Companies Act, 1956 which requires that every corporate enterprise must maintain such books H

260 SUPREME COURT REPORTS [2007] 12 S.C.R.

A as are necessary to give a ' 'true and fair '' view of its state ofaffairs and to explain its transactions (See: Section 209(3)), and that every balance-sheet of a company shall give a ''true and fair'' view of the State of affairs of the company at the end of the financial year, and that every P&L ale ofa company shall also give ''true andfair'' view · B of the P&L ale of a company for the financial year (See: Section 21 I (J)(ii)). It is in this context of true and fair view requirement that the Institute has framed Accounting Standards so as to enable proper recognition and measurement of all income and expenses, assets and. liabilities etc. as laid down in Section 209(1) read with Section211(3A), C (3B) and (3C).

52Copy pinpoint52. Coming to the question of true scope and AS 22; learned counsel submitted that AS 22 deals with accounting for taxes on income. According to learned counsel, as far back as in 1991, the Institute had issued the Guidance Note on Accounting for Taxes on Income. This Note D recommended deferred tax adjustments. It also explained the taxes payable method. It also explained the tax effect accounting method. It also explained the methodfor calculating deferred tax adjustments under ''deferred method'' and under "liability method". It recommended l- that till the tax effect accounting method stood developed, it would be E. permissible for an enterprise to follow the taxes payable method as an- altemative. After I 0 years, AS 22 was finally issued by the Institute in 200 I in order to ensure a ''true and fair'' view of the profits earned during a financial year, and the taxes payable with reference thereto, to be presented in the c0rporate accow1ts. That is the reason why, AS 22 leaves ) , F out of account differences between book profits and taxable profits which are of permanent nature. But AS 22 requires that DTLIDTA arising on account of timing differences should be reflected in the corporate accounts through what is called as ''deferred tax account''. According to learned counsel, deferred tax accounting ensures that profits are measured in a real and factual manner. It also ensures that the benefit obtained in one year, which could be reversed in a subsequent year, is duly recognized as a liability. Therefore, according to learned counsel, AS 22 not only complies with the requirement for accrual accounting, but it applies the need for accrual accounting; in the context of presenting a H ''true and fair'' view, rather than purely on the basis of a true and correct

.1 J.K.INDUSTRIESLTD. v. UNIONOFINDIA 261 [KAPADIA, J.] view. Accounting treatments contained in various Accounting Standards A issued by the Institute are. based on accrual accounting and, therefore, these Standards adopt the accounting treatments mentioned therein to ensure that a. company has followed the accrual basis of accounting. According to learned counsel, AS 22, therefore, fulfills, the need for accrual accounting in the context of the true and fair view requirement. B According to learned counsel, there is a difference between accrual accounting on the basis of true and correct view vis-a-vis accrual· accounting on the basis of true and fair view. In the case of former, the profits are likely to be overstated and in which event the investors would be misled. That, the purpose of true and fair accounts is to protect investors and, therefore, the purpose. of AS 22 is to ensure that accrual is made on a. true and fair basis, by reference to the Substance rather than the Form. Learned counsel urged that the very object behind issuance of AS 22 is that in accordance with the matching concept, taxes on income are recognized (accrued) in the same period as the revenue and expenses to which they relate. Matching of such taxes against income/revenue for a period raises problems as taxable income may be different from accounting income significantly. According to learned counsel, para 4 of AS 22 lays down the definitions of various terms used in AS 22. One such term is "current tax" which has been defined to mean the.amount of income tax determined as payable in respect oftaxable income (loss) for a particular period. Similarly, in para 4 the expression "deferred tax" has been defined to mean what is called as "timing differences " which in turn has been defined to mean the differences between taxable income and accounting income for a period. Such ''timing differences'' originates in one period and are capable of reversal in one or more subsequent periods. "Timing differences" arises because the period in which some items of revenue and expenses are included in taxable income which items do not coincide with the period in which such items are included or considered in arriving at accounting income. This difference between taxable income and accounting income arises for two reasons. Firstly, there are differences between items of revenue and expenses, as appearing inthe.P&L a/c, and the items which are considered as revenue, expenses or deductions for tax purposes. Secondly, there are differences between the amount in respect of a H

262 SUPREME COURT REPORTS [2007] 12 S.C.R. \

A particular item of revenue or expense, as recognized in the P&L a/c, and the corresponding amount, which is recognized for the computation of taxable income. This happens in the case of depreciation. The tax laws allow. "incen~ive depreciation" on increased rate, as prescribed in Rule 5 read with.the percentages mentioned in second column of the table in . B . appe~dix I to the I.T. Rules, 1962 on the written down value of the block · of assets, as are used by the assessee for the purpose of the business at any time during the relevant previous year. Depreciation includes amortization of assets whose useful life is predetermined. The commercial accounting principle requires that the original cost of an as..c;et should written off ill the accounts by way of charge against income of each year in such a manner that its entire. cost is debited against the income arising therefrom during life time of such asset. However, the i.T. Act lays down incentive . ra~es of depre~iation. While for accounting purposes, depreciation is provided for on straight line method, the Income Tax Act allows depreciation by way of in~entive ,at much higher rat~ with reference to itS written down value. The tot~l depreciation charged on the plant and machipery for accounting purposes and the amount allowed as deduction for tax purposes ultimately remains constant, but period over which deprecfation is charged in the accounts as compared to the period during which the deductiol\iS allowed under LT. Act, will differ. this is a case E. of timing differenc~: For example, machinery purchased for scientific research is fully allowed as deduction in the very first year for tax pwposes, whereas the same would charged in the P&L a/c, as depreciation, over its useful life of, let us say, 15 years. Unabsorbed depreciation and carry forward oflosses, which can be set off against future taxable income, are J F also examples of timing differences. Such timing differences result in DTAs. According to learned counsel, for the above reasons para 9 of AS 2;2 lays down that tax expense for a given period, shall, therefore, consists of current taxation and deferred tax which included in the determination of the net profit or loss for the period. Similarly, para 10 of AS 22 further G provides that tax effects of timing differences should be included in the tax expense in the P&L a/c and as deferred tax assets or as deferred tax liabilities in the balance-sheet.

53Copy pinpoint53. Learned counsel for the Institute next submitted that para 33 of H AS 22 is Transitional Provisions. According to the learned counsel, it is

i j J.K. INDUSTRIES LTD. v. UNION OF INDIA 263 / [KAPADIA,].] ·~-\ not retrospective as alleged by the appellants. According to learned counsel, under Section 209(3 )(b) of the Companies Act, books of account must be kept on accrual basis and according to the double entry system of accounting. In other words, if a company was maintaining its accounts on cash basis prior to 1988 when the present section came into existence, the said company is required to change the system of accounting from cash to mercantile w.e.f. 15.6.88. However, this would not mean that -~ without maintaining accounts on mercantile basis, the company would not record the opening balances of its assets and liabilities merely because Section 209(3 )(b) does not refer to retrospective application. Learned counsel submitted that, therefore, there is no me1it in the submissions made c on behalf of the appellants that para 33 of AS 22 is ultra vires the provisions of the Companies Act. For the above reasons, learned counsel submitted that AS 22 is in no way contradictory to and/or in conflict of Schedule VI to the Companies Act having regard to the statutory requirement/consideration of presenting the financial statements in ''true and fair" manner as laid down in Section 21 l(l)(ii) of the Companies Act. That, clause (vi) under para 3 of Part II of Schedule VI to the Companies Act reference is made only to presentation of income liability in the P&L ale. It does not refer to the method of its recognition and/or measurement which aspects are considered and dealt with only by AS

22. Therefore, the portion of income tax expenses deferred to future tax returns is required to be credited to a Liability Account called as Deferred Income Tax Account.

54Copy pinpoint54. On behalf of the appellants it was vehemently submitted tliat the ' DTL is a notional and contingent liability and, tlierefore, it is not required F ' to be charged to the P&L ale as per the requirements of the Companies Act. According to the appellants DTL is a future liability and, therefore, it does not exist on the balance-sheet. Appellants have also argued that DTL is a contingent liability because it may or may not arise in future. They have argued that DTL is not in accordance with the requirement of G Section 209(3)(b) of the Companies Act as it does not an10unt to keeping ~ ,\ books of account on accrual basis. In reply, Mr. Poddar, submitted that DTL is not a notional tax liability, but a real liability as it results in future cash outflow in the form of tax payment to tlie Income Tax Department. According to learned counsel, DTL arises in the current year in which H

264 SUPREME COURT REPORTS [2007] 12 S.C.R. i A the timing difference originates i.e. during the year the difference in the tax depreciation and accounting depreciation arises. Therefore, according to learned counsel, DTL exists on the balance-sheet date for the financial year in which it originates and, therefore, it is a real liability. According to learned counsel, the liability which arises in the current year B (i.e. the year in which timing difference arises) and is payable in a future year is not a future liability. According to learned counsel, DTL arises, therefore, in the current financial year in which timing difference arises but is payable in a future financial year. According to learned counsel, the aforestated concept is the essence of the accrual basis of accounting which c has been defined in AS I . Learned counsel further submitted that for the above reasons DTL is not a contingent liability as it actually arises in the financial year in which the timing difference originates. According to learned counsel, a contingent liability becomes a liability on happening or not happening of an uncertain event in future. That DTL is not contingent. D It does not arise in future on happening or not happening of future event. That, there is a difference in the liability arising in future or contingent on a future event taking place and a liability, which exists today, but payment in respect of which is to be made in future. That, any existing liability payable in future is not a future or contingent liability. According to learned E counsel, DTL is an existing liability on the balance-sheet date. According to learned counsel, reversal of timing difference in respect of an asset is definite during the life of an asset. Therefore, there is no uncertainty with regard to the reversal of timing difference in future over the life of the asset. The accounts of a company are prepared under the fundamental accounting assumption of ''going concern" which is defined in AS 1 F under which the enterprise is normally looked upon as a "going concern", >

i.e., continuing in operation for the foreseeable future. Under that assumption it is assumed that the enterprise has neither the intention nor the necessity of liquidation or to reduce the scale of its operations. Therefore, according to learned counsel, the examples, given on behalf G of the appellants. of liquidation or fall in the scale of operations are not apposite illustrations for treating DTL as a notional liability. According to learned counsel. DTL is a liability for the cun·ent period i.e. for the period in which the timing difference originates. on the basis of matching principle also. which is a part of accrual basis of H

J.K. INDUSTRIES LTD. v. UNION OF INDIA 265

/ [KAPADIA, J.] ............ ~ accounting. In the light of the said submissions, learned counsel A contended that the charge in the P&L ale for deferred tax expense is in respect ofa known liability payable in future; and, therefore, it is covered by the definition of the word "Provision" as contained in Part II of Schedule VI to the Companies Act.

55Copy pinpoint55. On the question of ultra vires learned counsel for the Institute B had adopted the contentions advanced by learned Additional Solicitor General on behalf of Union oflndia. Finding:

56Copy pinpoint56. For the follow..ng reasons we hold that the impugned Rule which c adopts AS 22 neither suffers from the vice of excessive delegation nor is the said Rule incongruous/inconsistent with the provisions ofthe Companies Act, 1956. Reasons: D (i) Preface:

57Copy pinpoint57. India is an emerging economy. Globalization has helped India to achieve the GDP rate of around 8 to 9 per cent. However, with globalization, India is required to face challenges in various forms. E Corporate India has been acquiring companies in India and abroad. Indian companies are partners in joint ventures. They are part of international ~ consortium. Therefore, Indian Accounting Standards (IAS) have to harmonize and integrate with International Accounting Standards by which .. harmonization of various accounting policies, practices and principles could F take place.

58Copy pinpoint58. In its 01igin, an accounting standard is the policy document. In matters of recognition of various items of income, expenditure, assets and liabilities, the aim is to achieve standards/norms which would help to reflect "true and fair" view of the accounts of a company. Every Indian and G

< . -~ foreign investor/partner before entering into joint venture agreement(s) with its counterpait exainines the financial statements and tries to asce1tain the real income of the Indian company.

59Copy pinpoint59. With globalization, we have conventional/orthodox system of H

266 SUPREME COURT REPORTS [2007] 12 S.C.R.

' A accounting (recognition. measurement and disclosure) vis-a-vis modem system of advanced accountancy. Therefore, the role of accounting has undergone a revolutionary change with the passage of time. Traditionally, accounting was considered solely a historical description of financial activities. That view is no longer acceptable. Accounting is now considered as a service activity. Its function is to provide quantitative information, primarily of financial nature about the economic entities. Accounting today includes several branches. e.g., Financial Accounting, Management Accounting and Government Accounting. The primary role of accounting is to provide an effective measurement and reporting system. This is possible only when accounting is based on certain coherent set oflogical principles that constitute the general frame of reference for evaluation and development of sound accounting practices. That is why, we have different accounting concepts and fundamental accounting assumptions, such as, separate entity concept. going concern concept, accrual concept, matching concept etc .. Therefore, Accounting Standards are based on a number of accounting principles. For example. the Matching Principle and Fair Valuation principle. Historically, matching principles ensured that costs incurred matched with revenues they generated, though they resulted in assets and liabilities in the balance-sheet at other than fair values. Similarly, they resulted in assets, which were not assets in the real sense, e.g .. E deferred revenue expenditure. However, the matching principles ensured purity of the profit and loss statement. Therefore. matching principles ensure ascertainment of true income. Today under Advanced Accountancy, matching principles recognizes not only costs against revenue but also against the relevant time period to dete1mine the Periodic F Income. Therefore, matching principle today forms an important component of Accmal Basis of Accounting.

60Copy pinpoint60. On the other hand. Fair Valuation principles are important in the context of valuing derivatives and other investments. If one were to G describe one single change in accounting practice over the last few years, it would be the use of Fair Valuation p1inciples. Today. the object behind enactment of A.S .. which are now made mandatory under section 2l1(3A) of the Companies Act, is to shift from historical method of accoLmting to fair valuation. In the case of mergers and acquisitions, which 11 is common today in the world of globalization. fair valuation principles

J.K. INDUSTRIES LTD. v. UNION OF INDIA 267

/ [KAP ADIA,J.] ·~ --1 have important role to play. Mergers and acquisitions are sometimes A undertaken to defer revenue expenditure over future years by invoking the matching concept, which results in putting fictitious assets on the balance-sheet. This is one reason why fair valuation principles are accepted. B

61Copy pinpoint61. A.S. are established rules relating to recognition, measurement and disclosures thereby ensuring that all enterprises that follow them are comparable and that their financial statements are "true and fair". Measurements and disclosures based on fair value are becoming increasingly important. Fair valuation is generally used in valuation and disclosure of financial instruments, derivatives, conversions, C auctions in a bond, business combinations, impairment of assets, retirement obligations, transactions involving exchange of assets without monetary consideration, transfer pricing, etc.

62Copy pinpoint62. In conclusion, the importance of the Preface is to show a D paradigm shift in the thinking of Accountants all over the world, particularly with the coming-in of the abovementioned new concepts. (ii) Doctrine of Ultra vires

63Copy pinpoint63. At the outset, we may state that on account of globaliz.ation and socio-economic problems (including income disparities in our economy) the power of Delegation has become a constituent element oflegislative power as a whole. However, as held in the case of Indian Express Newspaper v. Union of India, reported in [1985] 1 SCC 641 at page 689, subordinate legislation does not carry the same degree of immunity which is enjoyed by a statute passed by a competent Legislature. Subordinate legislation may be questioned on any of the grounds on which plenary legislation is questioned. In addition, it may also be questioned on the ground that it does not confonn to the statute under which it is made. it may further be questioned on the ground that it is inconsistent with the provisions ofthe Act or that it is contrary to some other statute applicable on the same subject matter. Therefore, it has to yield to plenary legislation. It can also be questioned on the ground that it is manifestly arbitrary and unjust. T11at, any inquiry into its vires must be confined to the grounds on which plenary legislation may be questioned, H

268 SUPREME COURT REPORTS (2007] 12 S.'C.R.

A to the grounds that it is contrary to the statute under which it is made, to the grounds that it is contrary to other statutory provisions or on the ground that it is so patently arbitrary that it cannot be said to be inconformity with the statute. It can also be challenged on the ground that it violates Article 14 of the Constitution. Subordinate legislation cannot be questioned on the ground of violation of principles of natural justice on which administrative action may be questioned. A distinction must, however, be made between delegation of a legislative function in which case the question of reasonableness cannot be gone into and the investment by the statute to exercise a particular discretiomuy power. In the latter case, the question may be considered on all grounds on which administrative action may be questioned, such as, non-application of mind, taking irrelevant matters into consideration, failure to take relevant matters into consideration etc .. A subordinate legislation may be struck down as arbitrary or contrary to statute if it fails to take into account vital facts which expressly or by necessary implication are required to be taken into account by the statute or the Constitution. This can be done on the ground that the subordinate legislation does not conform to the statutory or constitutional requirements or that it offends Article 14 or Article 19 of the Constitution. However, it may be noted that, a notification issued w1der a section of the statute which requires it to be laid before Parliament does not make any substantial difference as regards the jurisdiction of the Court to pronounce on its validity.

64Copy pinpoint64. Apart from the grounds referred to by this Court in the above judgment in the case of Indian Express Newspaper, it is important to bear in mind that where the validity of subordinate legislation is challenged., the question to be asked is whether the power given to the rule making authority (in the present case the Central Government tmder section 642(1) of the Companies Act) is exercised for the purpose for which it is given. Before reaching the conclusion that the Rule is intra vires (we have to begin with the presumption that the Rule is intra vires), the comt has to examine the nature, object and the scheme of the legislation as a whole and in that context, the cornt has to consider what is the Area over which powers are given by the section under which the Rule Making Authority is to act. However, the court has to stait with the presumption that the impugned Rule is intra i·ires. This approach means that, the Rule has to

J.K. INDUSTRIES LTD. v. UNION OF INDIA 269

/ [KAPADIA, J.] - ..._ --' be read down only to save it from being declared ultra vires ifthe court finds in a given case that the above presumption stands rebutted.

65Copy pinpoint65. If the impugned rule is a delegated legislation it would follow that the said rule is made in exercise of the power conferred by the statute. Legislature has wide powers of delegation. This, however, is subject to one limitation, namely, it cannot delegate uncontrolled power. Delegation "'J. is valid only when it is confined to legislative policy and guidelines.

66Copy pinpoint66. In the present case, abovementioned guideline is provided by section 211 (1 ), which has brought in a stand-alone concept of ''true and fair'' accounting. The said concept is the controlling consideration. As stated above, delegation is valid when it is confined to Legislative Policy and Guidelines which are adequately laid down and the delegate is only empowered to implement such Policy within the Guidelines laid down by the Legislature (see TlSCO v. The Workmen & Ors., reported in AIR (1972) SC 1917) D

67Copy pinpoint67. In the present case, we are required to consider the scope of section 642(1 ), which refers to the power of Central Government (rule making authority) to make rules vis a vis section 641, which states that subject to the provision of the section, the Central Government may, by Notification in the Official Gaz.ette, alter any of the regulations, rules, fom1s, E tables and other provisions contained in any of the Schedules to the Companies Act (including Schedule VI). This aspect is of some importance. Section 642 is in addition to the powers conferred by section 641, therefore, the two sections form part of the same scheme. However, the scope of section 641 is different from the scope of section 642. Power F to alter any provision of the Schedules and the power to carry out gap- filling exercise are both entrusted to the Central Government. The expression "in addition" to in section 642 indicates that both the above sections constitute one scheme. However, section 642 enables Central Government to provide details and, therefore, under se,ction 642 the rules G contemplated refers to gap-filling exercise.

68Copy pinpoint68. It is well settled that, what is permitted by the concept of ''delegation'' is delegation of ancillary or subordinate legislative fi.mctions or what is fictionally called as "power to fill up the details". The H

270 SUPREME COURT REPORTS [2007] 12 S.C.R. 4

A judgments of this Court have laid down that the Legislature may, after laying duwn the legislative policy, confer discretion on administrative or executive agency like Central Government to work out details within the framework of the legislative policy laid down in the plenary enactment. Therefore, power to supplement the existing law is not B abdication of essential legislative function. Therefore, power to make subordinate legislation is derived from the enabling Act and it is fundamental principle of law which is self-evident that the delegate on whom such power is conferred has to act within the limitations ofthe authority conferred by the Act. It is equally well settled that, Rules c made on matters permitted by the Act in order to supplement the Act and not to supplant the Act, cannot be held to be in violation of the Act. A delegate cannot override the Act either by exceeding the authority or hy making provisions inconsistent with the Act. (See Britnell v. Secretary a/State, (1991) 2 AllER 726 at 730

69Copy pinpoint69. The issue before us in the present batch of civil appeals is whether the Central Government, which is the rule making authority, has overridden the Companies Act, 1956 either by exceeding its authority in adopting AS 22 or by making provisions inconsistent \Vith sections 209 and 211 read with Part I and Part II of Schedule VI to the Companies Act as alleged by the appellants.

70Copy pinpoint70. Since the said issue has two parts, for the sake of convenience, the first point which needs to be decided is as follows: (a) Whether the impugned Rule adopting AS 22 is in excess of the powers conferred upon Central Government under section 642(1) of the Companies Act, 1956 ?

71Copy pinpoint71. In the case of Banarsi Das v. State of MP. reported in AIR 1958 SC 909 the State had issued a Notification under section 6(2) of the Central Provinces and Berar Sales Act, 1947 amending Item 33 in Schedule II by substituting for the words "goods sold to or by the State Government" by the words "goods sold by the State Government". As a result of the said Notification, amending the schedule, the assessee who was entitled for exemption from payment of sales tax in respect of goods sold to the State Government could no longer claim such exemption by H

/ J.K. INDUSTRIES LTD. v. UNION OF INDIA 271 ............. ~ [KAP AD IA,J.] reason of the said Notification. That Notification was challenged on the A ground that it was not open to the Government in exercise of the authority delegated to it under section 6(2) to modify or alter what the Legislature had enacted and, therefore, the said Notification was bad as being unconstitutional delegation oflegislative authority. It was argued on behalf of the assessee that earlier they had been granted exemption under section B l _J 6(1) of the Act which subsisted when the impugned Notification came to be issued and that in consequences, while an exemption under section 6(1) existed any amendment to the Schedule under section 6(2) was bad as it had the effect of deletion of the exemption which had been granted. Section 6( 1) of the Act contemplated exemption to be given by the State c Government on certain types of transactions whereas section 6(2) empowered the State Government to amend the schedule. It is in this context that the question arose as to whether the impugned Notification was bad as being an unconstitutional delegation of legislative authority. The said contention was rejected by this Court stating that the two sub- D sections together constituted integral part of a single enactment. We quote hereinbelow para 11 of the said judgment, which reads as follows: "11. Th~ contention of the appellant that the notification in question is ultra vires must, in our opinion, fail on another ground. TI1e basic assumption on which the argument of the appellant proceeds is that the power to amend the schedule conferred on the Government under section 6(2) is wholly independent of the grant of exemption under section 6(1) of the Act, and that, in consequence, while an exemption under section 6( I) would stand, an amendment thereof by a notification under section 6(2) might be bad. But that, in our opinion, is not the correct interpretation of the section. The two sub-sections together form integral parts ofa single enactment, the object of which is to grant exemption from taxation in respect of such goods and to such extent as may from time to time be determined by the State Government. Section 6(1 ), therefore, G ... _.--'. cannot have an operation independent of section 6(2), and an exemption granted thereunder is conditional and subject to any modification that might be issued under section 6(2). In this view, the impugned notification is intra vires and not open to challenge." (emphasis supplied) H

272 SUPREME COURT REPORTS [2007] 12 S.C.R.

A Applying the tests laid down in the aforestated judgment to the present case, it may be noted that, in this case, we are concerned only with the existence and the extent of the powers given to the Central Government to make rules, both for altering the Schedules to the Companies Act as well as to fill in details. Power to alter the Schedule as well as power to B fill in details are two distinct powers. However, both the powers are entrusted to the same delegate, namely, the Central Government. Furthei, ' ' as stated above, sections 641 and 642 form part of the same scheme, hence, it cannot be said that merely because the impugned Notification has been issued under section 642 and not under section 641 the said C Notification is exhaustive of the powers given to the Central Government to frame rules under the aforestated two sections. Moreover, in the present cas¢, section 642(1) begins with the expression "in addition to the powers conferred by section 641 ", therefore, one has to read section 641 as an additional power given to the Central Government to make Rules, in D addition to its power to alter the schedule by making appropriate Rules under section 641. There is one more way of looking at the arguments. The Companies Act has been enacted to consolidate and amend the law relating to companies and certain other associations. Under section 211(3A) Accounting Standards framed by National Advisory Committee E on Accounting Standards constituted under section 21 OA are now made mandatory. Every company has to comply with the said standards. Similarly, under section 227{3)(d), every auditor has to certify whether the P&L a/c and balance-sheet comply with the accounting standards referred to in section 211(3)(c). Similarly, under section 211(1) the company accounts have to reflect "true and fair" view of the state of affairs. Therefore, the object behind insistence on compliance with the AS. and ''true and fair'' accrual is the presentation of accounts in a manner which would reflect the tme income/profit. One has, therefore, to look at the entire scheme of the Companies Act. In our view, the provisions of the Companies Act together with the Rules framed by the Central Government constitute a complete scheme. Without the Rules, the Companies Act cannot be implemented. The impugned Rules framed under section 642 are a legitimate aid to construction of the Companies Act as contemporanea expositio. Many of the provisions of the Companies Act, like computation of book profit, net profit etc. cannot be put into operation H

/ ,· J.K. INDUSTRIES LTD. v. UNION OF INDIA 273 [KAPADIA,].] without the rules. A

72Copy pinpoint72. In the case of P. Kasilingam and Ors. v. P.S. G. College of Technology and Ors., [1995] Suppl 2 SCC 348 vide para 20 this Court ruled as follows: "20. The Rules have been made in exercise of the power conferred by Section 53 of the Act. Under Section 54(2) of the Act every rule made under the Act is required to be placed on the table of both Houses of the Legislature as soon as possible after it is made. It is accepted principle of statutory construction that "rules made under a statute are a legitimate aid to construction of the statute as contemporanea expositio '' (See : Craies on Statute Law, 7th Edn., pp. 157-158; Tata Engineering and Locomotive Co. Ltd. v. Gram Panchayat, Pimpri Waghere, [1976] 4 SCC 177.) Rule 2(b) and Rule 2(d) defining the expression 'College' and 'Director' can, therefore, be taken into consideration as contemporanea expositio for construing the expression "private college" in Section 2(8) of the Act. Moreover, the Act and the Rules form part of a composite scheme. Many of the provisions of the Act can be put into operation only after the relevant provision or form is prescribed in the Rules. In the absence of the Rules the Act E cannot be enforced. If it is held that Rules do not apply to technical educational institutions the provisions of the Act cannot be enforced in respect of such institutions. There is, therefore, no escape from the conclusion that professional and technical educational institutions are excluded from the ambit of the Act and the High Court has F rightly taken the said view. Since we agree with the view of the High Court that professional and technical educational institutions are not covered by the Act and the Rules, we do not consider it necessary to go into the question whether the provisions of the Act fall within the ambit of Entry 25 of List III and do not relate to G Entry 66 of List I." (emphasis supplied)

73Copy pinpoint73. To the same effect is the judgment of this Comi in the case of TELCO v. Gram Panchayat, Pimpri Waghere, reported in [1976] 4 H

274 SUPREME COURT REPORTS [2007] 12 S.C.R.

A SCC 177 in which the Court was required to consider the definition of the word "house" under the Rules framed in 1934. It was held that the rules provided internal legitimate aid for the interpretation of the words and phrases used in the main enactment.

74Copy pinpoint74. In the present case also even under the Rules impugned herein B AS 22, which is made mandatory, provides an internal legitimate aid to the meaning of the words in the Companies Act, including Schedule VI, ' · namely, liability, provision for taxes on income, book profit, net profit, depreciation, amortization etc .. Therefore, it cannot be said that the impugned Rules framed under section 642(1) constitute an act on the part of the rule making authority, namely, the Central Government, in excess of its powers under section 642(1) of the Companies Act. In our view, the impugned Rule/Notification is valid. It has nexus with the matters entrusted to the Central Government to be covered by appropriate rules. Therefore, in our view, the impugned Rule is valid as it has nexus with statutory functions entrusted to Central Government which is the rule making authority under the Act. It is important to bear in mind that the power to regulate a business or profession implies the power to prescribe and enforce all such proper reasonable rules as may be deemed necessary to conduct business/profession in a proper and orderly manner and the power includes the power to prescribe conditions under which business/ profession can be carried on. (See Deepak Theatre, Dhuri v. State of Punjab and Ors., AIR (1992) SC 1519 at page 1521 ). The Scheme of the Companies Act indicates that Accounting Standards are made mandatory. They have to be followed by the auditors. They have to be followed by the companies. ·n1e Accounting Standards provide discipline. They provide hannonization of concepts. They provide ham10nization of accounting principles. In the past, when Accounting Standards were not mandatory, various companies used to follow alternate system of accounting. This led to overstatement of profits. Therefore, the said Standards have now been made mandatory. In our view, it is the statutory function given to the Central Government to frame Accounting Standards in consultation with the National Advisory Committee on Accounting Standards (NAC) • " under section 211 (3C). It is not necessary for the Central Government to adopt in every case the Accounting Standards issued by the Institute. H Nothing prevents the Central Government from enacting its own

J.K. INDUSTRIES LTD. v. UNION OF INDIA 275

[KAPADIA,].] Accounting Standards which may not be in consonance with the Standards A prescribed by the Institute. Similarly, nothing prevents the Central Government from adopting the Standards issued by that Institute as is the case in the present matter. Therefore, in our view, the impugned Rule is valid as it has nexus with the statutory functions entrusted to the Rule making authority, namely, the Central Government. B (b) Whether the impugned Rule is incongruous/contrary to sections 209 and 211 read with the provisions of Part I and Part II of Schedule VI to the Companies Act, 1956 and whether the said Rule seeks to modify the essential features of the Companies Act ? C (A) Concepts

75Copy pinpoint75. To answer the above question, we need to examine the following concepts prevalent in Accounting. D Accrual System of Accounting

76Copy pinpoint76. In the conventional sense, amounts which become receivables/ recoverable are shown as income actually received and the liabilities incurred are shown as amounts actually disbursed in a given year. Therefore, under the aforestated system of accounting, entries are posted in the books of accounts on the date of the transaction, i.e., on the date on which rights accrue or liabilities are incurred, irrespective ofthe date ofpayment. In such cases, a company has to account for its income or loss as per the above system and not otherwise, if that company has adopted mercantile system of accounting which is also known as accrual system of accounting. However, accrual cioes not mean confinement of items of revenue/expenditure to a given year. As stated above, mergers and acquisitions are undertaken to defer revenue expenditure over future years by invoking matching principles. Therefore, the said principle forms an important part of accrual accounting. G Taxes on Income (TOI)

77Copy pinpoint77. It is an important item of P&L ale. Taxes on income are considered as expenses incurred by a company in earning revenues. It is an expense which is recognized in the same period as revenue and H

276 SUPREME COURT REPORTS [2007] 12 S.C.R.

A expense to which they relate. This is called as matching principle. Such ,.. .. matching, results in what is called as Timing Differences. Tax effects of Timing Differences are included as tax expense in the statement ofprofit and loss and as deferred tax asset (DTA) or as deferred tax liability (DTL) in the balance-sheet. In short, deferred tax should be recognized for timing differences. This is the basic mandate of AS 22. This mandate is based on an important principle of accounting, namely, that every transaction has a tax effect. However, DTA is subject to •• the principle of prudence and certainty that in future the company will have adequate income. This principle of prudence states that DTAs are recognized and carried forward only to the extent of their being a reasonable certainty of their realization, i.e., in future there would be taxable income. Therefore, under the rule of prudence, DTAs are to be recognized only to the extent of their being timing differences, the reversal whereof will result in sufficient taxable income in future against which they can be realized. On the other hand, DTL is to be recognized as liability under the said standard as it results in future cash outflow in the fonn of payments to the Income tax Department in the case ofTOis. Current Tax

78Copy pinpoint78. Current tax has to be measured by using the applicable tax rates. This is because current tax has to be measured at the amount expected to be paid to the Income tax Department by way of tax. Not only the tax rates, but also tax laws constitute the basis for measuring the amount of tax expected to be paid to the Income tax Department. It is important F to note that while measuring current tax, corr.panies have to go by the balance-sheet date. The company has to examine the tax rates and the tax laws on that date. Timing D!lfi:rences

79Copy pinpoint79. They are differences which arises because the period in which some items of revenue and expenses are included in the tawble income do not tally with the period in which items are considered to ,_ .,. compute the Accounting income. In other words, it recognizes expenses against the relevant time period to detennine the periodic income. This H concept has been brought in after the amendment to section 211 ( 1) of

J.K.INDUSTRIESLTD. v. UNION OF INDIA 277

[KAPADIA, J.] the Companies Act which emphasizes that after 2001 the companies shall A prepare their accounts so as to reflect "true and fair" view of the State of Affairs and to obliterate the difference between Accounting and Taxable Income. This concept bridges the gap between accounting income and taxable income. Deferred tax is the tax effect of such differences which are now required to be accounted for. As stated above, B Accounting Standards today constitute a paradigm shift from the conventional system of accounting based on Historical Costs Method towards Fair Valuation Principles. Similarly, in the past, companies used to follow alternate system of accounting. The Accounting Standards today are trying to harmonize different accounting concepts and principles and, c therefore, timing differences play an important role in harmonizing the matching principle under accrual system of accounting with the Fair Valuation Principles. The object is to achieve proper presentation of balance-sheet and P&L ale. The object is to present before the investors, shareholders and other stake-holders the book profits (real income) of the company. The tax effect of timing difference under AS 22 has to be included in the tax expenses in the P&L ale as DTA or DTL in the balance-sheet. Therefore, timing difference is the tax effect which forms part of tax expense in the P&L ale. The primary object of AS 22 adopted by the impugned Rule is to prescribe an accounting treatment for TOI. In accordance with the matching concept, TOis are recognized in the same period as revenue and expenses to which they relate. Matching of TOI against revenue for a period poses problems due to the effect that in a number of cases, taxable income is different from accounting income. This difference arises for two reasons. Firstly, there are differences between items of revenue and expenses in the P&L ale and items considered as revenue expenses or taken for tax purposes. Secondly, there are differences between the amount in respect of a particular item of revenue or expenses as recognized in the P&L ale and the corresponding amount which is recognized for computing taxable income. G Tax Expense

80Copy pinpoint80. As stated above, current tax is the amount of income tax determined to be payable in respect of taxable income for a period. On the other hand, deferred tax is the tax effect of Timing Differences. H

278 SUPREME COURT REPORTS [2007] 12 S.C.R.

A As stated above, Timing Differences are differences between taxable ~ .. · income and accounting income for a given period. Timing Difference originates in one period, but it is capable of reversal in one or more subsequent period(s). As stated above, every transaction has a tax effect, therefore, tax expense is the sum total of current tax + B deferred tax charged or credited to the statement ofprofit and loss for the given period. Therefore, tax expense for that period has to be included in the Net Profit. Therefore, we see no inconsistency between ' · liability as understood in the conventional sense and DTL as submitted on behalf of the appellants. c Assets

81Copy pinpoint81. Assets represent expenditure. When an expenditure is written off for accounting purposes in the year in which it is incurred but is admissible as deduction for tax purposes over a period of time then in such cases, the asset representing expenditure would have a balance only for tax purposes but not for accounting purposes. The difference between the balance of the assets for tax purposes and the balance for accounting purposes would be a timing difference which will reverse in future when the expenditure would be allowed for tax purposes. In such a case, DIA would be recognized in respect of the timing difference, subject to the principle of prudence. This concept is important while deciding the question as to whether para 33 of AS 22 (transitional provision) is or is not inconsistent with the provisions of Schedule VI to the Companies Act. F Matching Principle

82Copy pinpoint82. Matching Concept is based on the accounting period concept. The paramount object of running a business is to earn profit. In order to ascertain the profit made by the business during a period, it is necessary that ""revenues" of the period should be matched with the costs (expenses) of that period. In other words, income made by the business during a period can be measured only with the revenue earned during a period is compared with the expenditure incurred for earning that revenue. However, in cases of mergers and acquisitions, companies sometimes undertake to defer revenue expenditure over future years which brings in the concept

f .i / J.K. INDUSTRIES LTD. v. UNION OF INDIA 279 [KAP ADIA,J.] of Deferred Tax Accounting. Therefore, today it cannot be said that the concept of accrual is limited to one year.

83Copy pinpoint83. It is a principle ofrecognizing costs (expenses) against revenues or against the relevant time period in order to determine the periodic income. This principle is an important component of accrual basis of B I .l accounting. As stated above, the object of AS 22 is to reconcile the matching principle with the Fair Valuation Principles. It may be noted that recognition, measurement and disclosure of various items of income, expenses, assets and liabilities is done only by Accounting Standards and not by provisions of the Companies Act. c Depreciation

84Copy pinpoint84. As stated above, timing difference is the difference between taxable income and accounting income for a period. Depreciation is one of the important items in computation of income, be it taxable income or accounting income. According to Pickles Accountancy, fourth edn., at D page 0518, depreciation is the inherent decline in the value of an asset from any cause whatsoever. The wearing out of a machine is a simple example of depreciation. In double-entry system of accounting, there has to be complete double-entry for depreciation adjustment. The required entry under that system of Depreciation Adjustment is debit Trading and E Profit & Loss account and credit the asset in respect of which depreciation is being recorded. Such an entry conforms with the principles enunciated, namely, that, the debit to Trading and Profit & Loss account is necessary because the amount written-off represents an expense and the credit to the asset is required, as the asset has, pro tanto, reduced in value. F Therefore, from the above point of view in the principles of accountancy, even distribution in certain cases is treated as expenditure paid out over the years. The object of providing for such distribution is to spread the expenditure incurred in acquiring the assets over its effective lifetime. The amount of provision to be made in respect of the accounting period is G .... -1 intended to represent the portion of such expenditure which has expired during the period. Therefore, in that sense, it is money expended which is spread out over the effective life of an asset. Even under the Income tax Act, Parliament has used the expression "allowances and depreciation" in several sections in Chapter IV within which section 44A appears. In H

280 SUPREME COURT REPORTS [2007] 12 S.C.R.

A this connection, reference may be made to section 37 which enjoins that, . ... any expenditure not falling in sections 30 to 36 expended wholly and exclusively or laid out for business purposes should be allowed in computing the business income. Therefore, depreciation and allowances have been dealt with in section 32 and the expression "any expenditure" B in section 37 covers both, allowances and depreciation. [See Commissioner ofIncome-lax v. Indian Jute Mills Association (1982) 134 ITR 68 (Cal)]. Depreciation under Income tax Act is an incentive/ ' . allowance. However, in commercial accountancy, it is reduction/ deduction from the value of an asset on the balance-sheet. c Reserves & Provisions

85Copy pinpoint85. In State Bank of Patiala v. CIT, reported in (1996) 219 ITR 706 substantial amounts were set apart by the assessee-bank as reserves. No amount of bad debt was actually written off or adjusted against the D amounts claimed as reserves. No claim for any deduction by way of bad debts was made during the relevant assessment years. The assessee never appropriated any amount against any "bad and doubtful" debts. The amount remained in the account of the assessee by way of capital and the assessee treated the said amount as "reserves" and not as E "provisions" designed to meet any liability, contingency, commitment or diminution in the value of assets known to exist on the date of the balance- sheet.

86Copy pinpoint86. The question which arose for consideration by this Court was whether amounts set apart in the balance-sheet are ''provisions'' or F "reserves". TI1e matter arose under the provisions of Companies (Profits) Surtax Act, 1964 which levied a charge on every company for every assessment year called as surtax, insofar as the chargeable profits of the previous year exceeded the statutory deduction at the rates mentioned in the Third Schedule. Rule (I) of Schedule II stipulated mandatory that the capital of the company shall be the total of the amounts including reserves. The assessee contended that the amounts set apart in the balance-sheet are reserves. The Department contended that the said amounts were provisions. The assessee succeeded. However, the reasoning given in the judgment is important. It was held by this Court, after referring to the relevant provisions of the Companies Act regarding the form of balance-

J.K.INDUSTRIESLTD. v. UNION OF INDIA 281

[KAP ADIA,J.] sheet wherein the words "reserves and surplus'; and "current liabilities and provisions'' are dealt with, that if any retention or appropriation falls within the definition of "provision" it can never be a reserve but it does not follow that if the retention or appropriation is not a provision it is automatically a reserve. That question has to be decided having regard

. \ to the true nature and character of the sum so retained depending on several factors including the intention with which and the purpose for which such retention has been made because the substance of the matter is to be recorded. In the said judgment, it has been further held that if any retention is made to meet depreciation, renewal or diminution in value of asset, the same is not a reserve. C

. 87. In that case, one of the other questions which arose for determination was whether a fund created or a sum of money set apart by assessee-bank to meet any liability which the assessee-bank can reasonably anticipate on the balance-sheet date is equivalent to the case where the liability has actually arisen. The High Court took the view that since the assessee is the banking company, it would be reasonable and legitimate to assume that the bank was in a position to anticipate any liability by way of bad debt on the balance-sheet date. This Court held that the aforestated assumption made by the High Court was unjustified. According to this Court, the question to be asked in such cases is whether the liability was known or anticipated on the date when the balance-sheet was prepared and not whether the assessee can anticipate on the balance-sheet date the debt and doubtful debts.

88Copy pinpoint88. Applying this test to the facts of the present case, the tax effect of the timing difference was known on the date when the balance-sheet was prepared and, therefore, AS 22 is right in stipulating that the tax effect of such timing differences should be included in the tax expense in the statement ofprofit and loss as DT A/DTL in the balance-sheet.

89Copy pinpoint89. Depreciation in accounting sense is similar to bad and doubtful debts. Provision for bad and doubtful debt like depreciation is not a provision for liability but it is a provision.for diminution in value of assets. Where such provision is made and if that provision is not excessive or unreasonable, it is not a reserve, however, any amount in excess of the requirement can be considered to be a reserve. Thus, H

282 SUPREME COURT REPORTS [2007] 12 S.C.R.

A provision can be made for depreciation, renewal, diminution in the value of an asset or for any known liability. In this case, we are concerned with depreciation mainly because in 99 per cent of the cases the difference between tax depreciation and accounting depreciation results in timing differences.

90Copy pinpoint90. The provision for bad and doubtful debt is always made with reference to debt receivable where there is doubt about full realization of ' . debt. The provision is made in order to cover up the probable diminution in the value of an a~set, i.e., debt which is amount receivable. For example, if the receivable is Rs. 1 crore and the assessee is of the opinion that Rs. C One crore might not be realized and that only 90 per cent of the debt would be realized and, therefore, he makes a provision for Rs. 10 lacs for bad debts. By making the provision, the assessee is valuing his asset, namely, debt, which is the amount receivable, at Rs. 90 lacs as against the book figure of Rs. 1 crore. Thus, the provision for bad and doubtful debt is the provision for diminution in the value of asset, i.e., debt. Such provision is not a provision for liability, because even if a debt is not recovered, no liability would be fastened upon the assessee. The debt is the amount receivable by the assessee. It is not any liability payable by the assessee. Therefore, any provision towards irrecoverabi!ity of debt cannot be said to be provision for liability. It is the provision for diminution in the value ofassets. The expression "reserve" has been defined in a negative manner by clause 7( ! )(b) of Part III of Schedule VI to the Companies Act and it only says that the reserve shall not include any amount written off or retained by way of provision for depreciation, renewal, diminution in value of asset or by way of provision for any known liability. Thus, ifthe provision made by the assessee for depreciation, (diminution in value of the asset) is in excess of the amount which is reasonably necessary for the purpose for which the provision is made, the excess shall be treated as a reserve and not a provision. This aspect is important because the question as to whether the provision made is in excess of the requirement would depend on the facts of each case. This aspect is important also because it has been vehemently argued on behalf of the asscssee that AS 22 requires the assessee to make provision for DTL which, in' fact, should have been treated as a reserve and not as a H provision. Reserve is not a charge to be deducted before arriving at the

J.K. INDUSTRIES LTD. v. UNION OF INDIA 283

[KAPADIA, J.j profit for the period under review. It is appropriation of profit. The A "reserve account" is credited as a result of a debit to the appropriation account and not to the P&L ale or revenue account. In a broad sense, all allocations to reserve represent additions to capital. In the case of a provision, unlike reserves, the charge is created as a result of debit to the P&L ale and not a debit to the appropriation account. B ) ~' Tax Base

91Copy pinpoint91. The tax base ofan asset or liability is the amount attributed to that asset or liability for tax purpose. As stated above, deferred tax has to be recognized/or all timing differences. This is based on C the principle that financial statements for a given period should recognize the tax effect, whether current or deferred, of all transactions occurring in a given period. One more principle needs to be noted that assets represent expenditure. Concept of DTLIDTA D

92Copy pinpoint92. DTLIDTA is recognized for all timing differences. AS 22 requires the companies to make a provision for Deferred Tax Accounting with reference to the difference between accounting income and taxable income. In our view, matching principle is an important component of E Accrual Accounting. The said principle is not in conflict with accrual accounting as vehemently submitted on behalf of the appellants. Accrual Accounting is the concept recognized by sections 205, 209, 211 and Schedule VI to the Companies Act. However, the said provisions of the Companies Act nowhere lays down as to which asset should be recognized as an investment and the method of valuing investments. That exercise is left to the accounting standards. Similarly, the Companies Act nowhere lays down as to how and when income or expenditure should be measured/recognized. That exercise is left to the accounting standards. AS 22 proceeds on the basis that a benefit obtained in one year could be reversed in the subsequent year and, therefore, it has to be recognized as a liability. One more concept needs to be mentioned. Deferred tax is the same as timing difference. It arises on account of the difference between taxable and accounting incomes. This difference arises between items of revenue and expenses as comparing in P & L ale vis-a-vis items H

284 SUPREME COURT REPORTS [2007] 12 S.C.R.

' .. - A considered as revenue, expenses or deduction for tax purposes. Secondly, difference also arises between the amount in respect of an item of revenue or expenses as recognized in the P & L ale and the corresponding amount required in the computation of taxable income. It is the tax effect oftime difference which is required to be included in Tax Expense in the P & L B ale and as DTNDTL in the balance-sheet. Timing difference originates in the year in which difference arises between the tax depreciation and ' ' accounting depreciation. TI1erefore, it is a known liability for the current year, though payable in future period(s). Therefore, tax effect of timing difference is a real liability for which a provision is required to be made c in the P & L ale as well as DTL in the balance-sheet. As stated above, deferred tax is the tax effect of timing difference. It has been vehemently submitted that a provision for Matching Tax is required to be made in respect of accounting income only for accounting period. The emphasis is on the words "only for accounting period". In our view, even under accrual system of accounting, the accounting period need not be confined to one year alone. As stated hereinabove, mergers and acquisitions today are sometimes undertaken by companies to defer revenue expenditure over future period(s) by invoking the matching concept. Historically, it may also be stated that prior to the introduction of AS 22, the companies used to follow what is called as Tax Payable Method. They were put to notice by the Institute that in future the companies shall have to follow what is called as Tax Effect Accounting method. AS 22 introduces tax effect accounting method.

93Copy pinpoint93. Before us, it has been vehemently urged on behalf of the appellants that, unlike U.K., in India, rates of depreciation are statutorily prescribed under the Companies Act and under the Income-tax Act, 1961. According to the appellants, rates of depreciation are not prescribed statut01ily in U.K.. Therefore, in U.K. the tax payer is at liberty to adopt any rate of depreciation and, therefore, there could be justification for invoking the matching principle and for applying AS 22 for deferred taxation. We find no merit in this argument. In our view, on the contrary, since in India we have two separate rates of depreciation statutorily prescribed under two different Acts, introduction of matching principle becomes relevant. Ultimately, AS 22 is for deferred taxation. It brings out for the information of shareholders, investors and stake-holders the

J.K.INDUSTRIESLTD.v. UNIONOFINDIA 285 (KAPADIA,].] hidden liability which earlier could not be brought out. Today, we are living in the world of globalization in which, apart from merger, acquisitions play an important role. The buyer wants to know the income and liabilities of a company. He wants to know the real income of the company, which he proposes to buy. Because of the difference in the rates of depreciation statutorily prescribed under the Income-tax Act and the Companies Act, B the concept of deferred taxation has been introduced in order to obliterate the difforence between accounting depreciation and tax depreciation. (B) Application of above Concepts:

94Copy pinpoint94. As stated above, the power to alter the Schedule is distinct and separate from the power to fill in the details, though both together fonn part of the same scheme. In the present case, under section 641, the Central Government is empowered vide the Notification to alter any of the Regulations, Rules, Forms and other provisions contained in any of the Schedules except Schedules XI and XII. Under section 641 (2), any alteration notified under sub-section (1) has the effect as if the notified alteration stood enacted in the parent Act and shall come into force on the date of the Notification, unless the Notification directs otherwise. In the present case, we are concerned with the provision of section 641 (2) which is not there in section 642. However, as stated above, section 642 E begins with the expression "in addition to the powers conferred by section 641 ''. The point which we would like to stress is that though the Central Government is vested with both the powers, namely, to amend the Schedule and to fill in details, the nature of the rules framed under section 641 (2) continues to have the status of the rules despite the phraseology F used in section 641 (2) which, as stated above, says that "any alteration notified under sub-section (1) of section 641 shall have effect as if enacted in the Companies Act''. To this extent, we are in agreement with the submission made on behalf of the appellants. Our view is supported by the judgment of this Court in the case of ChiefInspector ofMines v. G Karam Chand Thapar, AIR ( 1961) SC 83 8. We quote hereinbelow para 20 of the said judgment, which read as follows: "20. The true position appears to be that the Rules and Regulations do rrot lose their character as rules and regulations, even though they are to be of the same effect as if contained in the Act. They H

286 SUPREME COURT REPORTS [2007] 12 S.C.R.

A continue to be rules subordinate to the Act, and though for certain purposes, including the purpose of construction, they are to be treated as if contained in the Act, their true nature as subordinate rule is not Jost. Therefore, with regard to the effect of a repeal of the Act, they continue to be subject to the operation of Section B 24 of the General Clauses Act."

Therefore, in our view, Rules framed under section 64 l followed by Rules framed under section 642( I) shall continue to be Rules subordinate to the Companies Act though for the purposes of construction, they are to C be treated as forming part of the same scheme.

95Copy pinpoint95. In the present case, the most important question, which we have to decide is whether the impugned Rule adopted AS 22 is contrary to or inconsistent with the provisions of the Companies Act and in that connection our judgment proceeds on the basis that the impugned Rule D is an example of subordinate legislation.

96Copy pinpoint96. As stated above, tax expense or tax income represents total amount included in the determination of net profit or loss for the period in respect of current tax and deferred tax.

97Copy pinpoint97. DTL is a tax payable in future period(s) which arises out of taxable temporary differences.

98Copy pinpoint98. OTA is the tax recoverable in future period(s) which arises out of deductible temporary difference, carry forward of unused tax losses and carry forward of unused tax credits. F

99Copy pinpoint99. Temporary difference is the difference between the carrying amount of an asset or liability in the balance-sheet and its tax base, which is an amount attributable for tax purpose.

100Copy pinpoint100. Taxable temporary difference will result in future period(s) when G carrying amount of the asset or liability is recovered. It will arise when the tax base of an asset/liability is lower than the balance-sheet amount. Tax base of an asset gets reduced by over-charge of depreciation as per the ta"X law. The tax base of a liability gets reduced by over-charge of a liability which is to be written back as income in the future period(s). This H

J.K. INDUSTRIES LTD. v. UNION OF INDIA 287

[KAPADIA,J.] analyses can be explained by the following examples: A Example-] 10 I. A Plant costs Rs. I 00 lacs. Accelerated depreciation is charged on the Plant to the extent of Rs. 70 lacs as per the Income tax Rules. Therefore, the tax base of the Plant is (100 - 70) Rs. 30 lacs. On the B other hand, Accounting Depreciation charged as per the Accounting Standard is Rs. 25 lacs. In such a case, the balance-sheet value or what is called as depreciated book value of the Plant would be (I 00--25) Rs. 75 lacs. I 02. Therefore, a timing difference has arisen, in the above example, c between the depreciated book value (balance-sheet value of the Plant) and its tax base.

103. The principle which emerges from the above example is that when tax base is lower than the balance-sheet value of the asset D (depreciated book value of the Plant) a deferred tax liability emerges.

104. Similarly, the following example will show as to when DTA emerges. Example-2 E

105. Preliminary expenses of Rs. 10 lacs are allowed to be written off over a period of 10 years on a straight-line basis, which are charged to the income statement over a period of 5 years. Therefore, after 3 years from the date the expenses are incurred, book value (the balance-sheet value) of such preliminary expenses would be Rs. 4 lacs (10-6) and the tax base will be Rs. 7 lacs (10-3).

106. In the above example, the tax base of the Plant (asset) at Rs. 7 lacs is higher than the balance-sheet value of preliminary expenses at Rs. 4 lacs. There will, therefore, arise deductible timing difference which gives rise to deferred tax asset (DTA). However, a DTA, as stated above, should be recognized for all deductible temporary difference to the extent it is probable that taxable profit will be available against which the deductible timing difference can be utilized. A DTA should also be recognized for carrying forward the unused tax losses and unused tax H

288 SUPREME COURT REPORTS [2007] 12 S.C.R.

A credits to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilized. It is, therefore, necessary to review DTA at each balance- sheet date.

B l 07. We would also like to give few more examples of DTA and DTL as follows: Example-3

108. Cost of a Plant is Rs. I 00 lacs, its carrying amount is Rs. 80 C lacs whereas its tax base is Rs. 20 lacs. Therefore, the Taxable Timing Difference is (Rs. 80-20) Rs. 60 lacs. In case the tax rate is 25 per cent then the DTL shall be computed as follows: DTL =(Taxable Timing Difference)Rs. 60 lacs x (Tax Rate) 25% DTL = 60 x 25/100 = Rs. 15 lacs D I 09. Similarly, if a company recognizes its liability for Provident Fund in its accounts at Rs. 30 lacs which is not allowed by the Income tax Department unless actually paid and if the tax rate is 30 per cent then the DTA will be Rs. 30 lacs x 30/ I 00 = Rs. 9 lacs as in such a case the tax E base is Nil whereas the carrying amount is Rs. 30 lacs. Example-4 (Matching Concept)

110. A leasing company deducts an amount of lease equalization charges from lease rental income. For that purpose, the company makes F a provision for the said charges in accordance with the guidelines issued by the Institute on ''Accounting of income, depreciation and other aspects for leasing company". This charge is created to equalize the imbalance between lease rentals and depreciation charges over the period of lease. It is based on the rationale of matching costs with revenues so that the periodic net income from a finance lease is true and fair. Such matching is achieved by showing the lease rentals received under finance lease separately under Gross Income in the P&L ale of the relevant period and against such lease rental income, a matching lease annual charge is made to the P&L ale. This annual lease charge represents recovery of the net investment/ fair value of the leased asset over the lease period and is

J.K. INDUSTRIES LTD. v. UNION OF INDIA 289

[KAPADIA,J.] calculated by deducting the finance income for the period from the lease rent for that period. Accordingly, where the annual lease charge is more than the statutory depreciation under the Income tax Act, lease equalization charge account would be debited to that extent; whereas when annual lease charge is less than statutory depreciation under the Income tax Act, a lease equalization would emerge. Therefore, lease equalization charge is created as a result of debit to the P&L ale. It is a charge which has to be deducted to arrive at the true and correct profit of the leasing business and is neither an appropriation of profit nor a reserve. This example indicates applicability of matching concept. (C) Whether AS 22 is contrary to or inconsistent with the provisions of the Companies Act.

111. In the case of Cl T v. Duncan Brothers & Co. Ltd., reported in [ 1996] 8 sec 31 the assessee company submitted that provision for taxation made by it for assessment years 1963-64 and 1964-65 should be treated as a fund and, therefore, it should be deducted from the cost of asset required to be excluded under Rule 1(ii) of Schedule II to the Super Tax Act, 1963 and Rule 2(ii) of Schedule II to the Companies (Profits) Super Tax Act, 1964 respectively. This contention was rejected. This Court held that since Schedule II to both the Acts pertained to computation of capital, the terms used in Schedule II should be interpreted in the context of the balance-sheet of a company and its P&L a/c which will have to be looked at to ascertain the company's capital and its profits. It was held that a provision for taxation of the kind in question was not a fund etymologically in accounting parlance. It was observed that words of accounting language should be interpreted as undersrood in accounting practice.

112. Applying the above test to the present case, we are now required to interpret the words ''the amount of charge for Indian Income tax on profits" in clause 3(vi) in Part II of Schedule VI to the Companies G Act. Similarly, we are required to interpret the words "current liabilities and provisions'' in the form of balance-sheet in Part I of Schedule VI to the Companies Act. Part III of the said Schedule defines the words "provision" as well as "reserve". H

290 SUPREME COURT REPORTS [2007] 12 S.C.R.

A 113. As stated above, the form of balance-sheet is prescribed by Part I of Schedule VI. The Act does not prescribe a proforma of P&L a/c. However, Part II of Schedule VI prescribes the particulars which must be furnished in a P&L ale. As far as possible, the P&L ale must be drawn up according to the requirements of Part II of Schedule VI. As stated above, section 211 (I) emphasizes "true and fair" view in place of "true and correct" view of accounting. As stated above, the legislative policy is to obliterate the difference between the accounting income and the taxable income. As stated above, the accounting income/book profit is the real income. Therefore, section 211 (1) emphasizes the concept of "true and fair" view. As stated above, it is a stand-alone consideration. It is the controlling element underlying the scheme of sections 209, 211 and

227. However, as stated above, the Companies Ac docs not deal with Recognition, Measurement and Disclosure. As stated above, how much amount should be recognized in respect of a specific matter is not covered by section 209(3)(b). Recognition, measurement and disclosure are the three items which can only be done by way of Accounting Standards and not by the provisions of the Companies Act. This aspect is important because under section 642(1) the Central Govenunent is empowered to carry out ancillary/subordinate legislative functions which is also fictionally called as power to fill-up the details. Under section 211(1) Parliament has laid down the controlling consideration in presentation of balance-sheet and P&L ale by companies and it has thereafter conferred discretion on Central Government to work out details within the framework of that Policy. Presentation of balance-sheet and P&L ale is different from recognition, measurement and disclosure of various items of revenue, expenses. assets. liabilities etc.. That part has been left to the Central Government which is empowered to enact Accounting Standards in consultation with National Advisory Committee on Accounting Standards (NAC), which committee is to be established and which has been established under section 21 OA(l ). As stated above, the Central G Government is the mle making authority. As stated above, it is not bound to go by the recommendations of the Institute in the matter of framing of accounting standards. Generally, it follows such recommendations. However, in law nothing prevents the Central Government from enacting accounting standards in consultation with NAC which are in variance from H

J.K. INDUSTRIES LTD. v. UNION OF INDIA 291

[KAPADIA,J.] the Standards prescribed by the Institute. In the present case, we are concerned with the accounting standards prescribed by Central Government in consultation with NAC under section 642(1) of the Companies Act.

114. In the present case, the main objection of the appellants is against paragraphs 9 and 33 of AS 22. Para 9 reads as under: . "Tax expense for the period, comprising current tax and deferred tax, should be included in the determination of !he net profit or loss for the period. "

115. Para 33 of AS 22 reads as under: c "On the first occasion that the taxes on income are accounted for in accordance with this Statement, the enterprise should recognise, in the financial statements, the deferred tax balance that has accumulated prior to the adoption of this Statement as deferred o tax asset/liability with a corresponding credit/charge to the revenue reserves, subject to the consideration of prudence in case of deferred tax assets (see paragraphs 15-18). The amount so credited/charged to the revenue reserves should be the same as that which would have resulted if this Statement had been in effect from the beginning."

116. As regards para 9, the appellants had no objection to the disclosure of DTL/DTA in their financial statements. They object to a charge being created qua P&L a/c for DTL mainly because it results in reduction of reserves and net profits. Therefore. the main contention is that the DTL is a notional concept. According to the appellants, DTL is not a liability. Therefore, according to the appellants, there cannot be a charge for DTL to the P&L ale of the company. According to the appellants, DTL distorts their financial statements. According to the appellants, Schedule VI forms part of the Companies Act. According to the appellants Pait II of Schedule VI contains clause 3(vi). According to the appellants, the said clause 3(vi) refers to the amount of charge for income tax on the profits. According to the appel lai1ts when AS 22 states that tax expense for the period shall consist of current tax and deferred tax and that such tax expense should be included in the detem1ination of H

292 SUPREME COURT REPORTS [2007] 12 S.C.R.

A net profit or loss, it amoill1ts to alteration of clause 3(vi) of Schedule VI to the Companies Act which is the part thereof. According to the appellants, Rules framed by the Central Government as a delegate under section 642 cannot alter the provisions of the Companies Act including Schedule VI. We have dealt with this aspect in the earlier paragraphs. B However, the appellants have further contended that para 9 of AS 22 is inconsistent with the provisions of the Companies Act including Schedule VI and, therefore, void. It is also contended on behalf of the appellants that section 211 deals with P&L ale and balance-sheet. That, para 9 only refers to filling in the details qua items in P&L ale and balance-sheet. c According to the appellants, P&L ale and balance-sheet do not constitute primary books of accounts. According to the appellants, deferred taxation do not form part of accrual system of accounting. According to the appellants para 9 of AS 22 requires the company to make provision for liability for taxation in the balance-sheet and P&L ale, further, according to the appellants P&L ale and balance-sheet do not constitute books of accounts and, therefore, according to the appellants, such a standard brings about inconsistency between maintenance of books of accoill1ts which are primary documents on one hand and balance-sheet and P&L ale on the other hand. According to the appellants, para 9 of AS 22 does not touch the subject " maintenance of books of accounts". That, it only touches the presentation of balance-sheet and P&L a/c. According to the appellants, books of accounts constitute primary documents and if para 9 docs not apply to the maintenance of books of accounts, para 9 cannot be made applicable only to balance-sheet and P&L ale because if it is so pennitted it would bring about inconsistency between "maintenance of books of accounts" under section 209 vis-a-vis presentation of financial statements under section 211. In short, according to the appellants para 9 and para 33 of AS 22 are inconsistent with the provisions of the Companies Act including Schedule VI.

G 117. We do not find any merit in the arguments of the appellants on the point of inconsistency.

118. As stated above, recognition and measurements bring in the concept of fair value. When a financial instrument is measured at fair value it brings transparency in financial reporting. Today, companies undertake H

J.K. INDUSTRIES LTD. v. UNION OF INDIA 293

[KAPADIA,J.] multifarious activities which warrant~ segment reporting. For example in A RIL we have three segments, namely, refining, industry and infrastructure. Similarly, in the case of Sterlite Industries (India) Ltd., it has different segments. Each segment earns its own revenue. For example, revenue from copper, revenue from aluminium and revenue from others. Under clause 3(vi) of Part IT non-provision for taxation would amount to contravention B of the provisions of sections 209 and 211 of the Companies Act. Accordingly, it is necessary for the auditor to say in what manner the accounts do not disclose a ''true and fair'' view of the state of affairs of the company and the P&L ale of the company. AS 22 is mandatory. Therefore, it is the duty ofthe members of the Institute to examine whether c the accounting standard is complied with the said standard in the presentation of financial statement. [see also section 227(3)(d)]

119. In our view, para 9 only provides for details which are necessary for giving effect to the concept of true and fair accrual of accounts contemplated by section 211(1). As stated above, the concept D of ' 'true and correct'' accrual is different from the concept of' 'true and fair' ' accrual. Both the concepts fall under accrual system of accounting. However, there is a difference. Under "true and correct" accrual, the matching principle was always recognized. However, fair valuation principle is the concept which brings out the real income of the company. Para 9 E has been enacted, as stated above, to obliterate the difference between the accounting income and taxable income. Para 9 aims to present the real income to the investors, shareholders and st<ik:e-holders in the company. As stated above, there is also a difference between accounting depreciation and tax depreciation. In order to harmonize these differences, F para 9 has been enacted. As stated above, true and fair view is the basic requirement in the matter of presentation of balance-sheet and P&L ale. Therefore, in order to bring out the tme income of a company, one has to read the provisions of the Companies Act with the accounting standards adopted by the impugned Notification. As held in the judgment of P. G Kasilingam (supra) there are statute under which the rules provide an internal aid to the construction of the words used in the parent Act. The Companies Act uses the words like, provision, reserve, liability etc. in the accounting sense and as held in the case of Duncan Brothers (supra) the words of accounting language should be interpreted as understood in H

294 SUPREME COURT REPORTS [2007] 12 S.C.R.

A accounting practice. Therefore, in our view, para 9 of AS 22 merely provides for details in the matter of provision for liability for taxation.

120. The word ·'tax expense" in para 9 under conservative system of accounting was confined to current tax. However, with para 9 of AS 22 coming into force, the word "tax expense" now includes both, current tax and deferred tax. This inclusion became necessary because of developments not only in concepts but also in accounting practices. This inclusion becomes necessary if one has to go by paradigm shift from historical costs accounting to fair value principles. In our view, with the insertion of the words "true and fair" view in section 211, which is the requirement in the matter of presentation of balance-sheet and P&L ale the rule making authority was entitled to include the concept of '' deferred tax'' in tax expense. It may be stated that under clause 3(vi) of Part II, Schedule VI the charge for tax on profit is contemplated. Provision for liability for taxation is contemplated by the said clause. Para 9 of AS 22 D merely provides for a liability which arises on account of timing difference as explained hereinabove. As stated above, it is known on the balance- sheet date. One has to therefore consider matching principle and fair valuation principles as important concepts in Accrual Accounting. Further, as stated above, recognition and measurement is not covered by the provisions of the Companies Act, therefore, one has to read the presentation of balance-sheet and P&L ale together with recognition and measurements. Therefore, one has to read the provisions of the Companies Act along with the impugned Rule which adopts AS 22 as recommended by the [nstitute. The matching principle recognizes cost against revenue or against the relevant time period to determi.11e the periodic income. Therefore, the said principle constitutes an important component of the accrual basis of accounting. The concept of accrual, in case of mergers and acquisition, is not limited to one year. DTUDTA arises out of timing differences. Therefore, such differences have got to be reflected in G Defe1Ted Tax Accounting. DTL in most cases arises on account of the difference between tax depreciation and accounting depreciation. When on account of over-charging of depreciation under the Income-tax Rules, the taxable income falls below the accounting income, DTL emerges. This is because the rates of tax depreciation are incentive rates whereas accounting depreciation is based on the useful life of the asset. Thus, an

,J J,K. INDUSTRIES LTD. v. UNION OF INDIA [KAP ADIA,J.] 295

asset under Income tax Act would be charged over a much shorter period as compared to the useful life of the asset. If the useful life of the asset is 10 years, for tax purposes it should be written off fully in 4 years. Thus, in the first year in which tax depreciation is higher than the accounting depreciation, the taxable income would be less than the accounting income, which would give rise to DTL on account of the difference between the amount of depreciation, Le., the timing difference, which arises as it relates to the depreciation amounts for that particular year. It would become payable in future years when the timing difference reverses, i.e., when the taxable income becomes higher than the accounting income. Therefore, it is called as DTL. It is so called because it results in future cash outflow c on account of the timing difference.

121. Hereinbelow, we are required to give two illustrations to indicate as to how the DTL emerges out of timing differences and, secondly, the application of Fair Valuation principles in advanced accounting. D

Illustration 1 122, A company, ABC Ltd., prepares its accounts annually on 31st March. On 1st April, 20x 1, it purchases a machine at a cost of Rs.1,50,000. The machine has a useful life of three years and an expected scrap value of zero. Although it is eligible for a 100% first year depreciation allowance for tax purposes, the straight-line method is considered appropriate for accounting purposes. ABC Ltd. has profits before depreciation and taxes of Rs.2,00,000 each year and the corporate tax rate is 40 per cent each year. The purchase of machine at a cost of RsJ ,50,000 in 20x I gives rise to a tax saving of Rs,60,000. If the cost of the machine is spread over three years of its life for accounting purposes, the amount of the tax saving should also be spread over the same period as shown below:

296 SUPREME COURT REPORTS [2007] 12 S.C.R. 1 ,_ A Statement of Profit and Loss (for the three years ending 31st March, 20xl, 20x2, 20x3) (Rupees in thousands) 20xl 20x2 20x3 B Profit before depreciation and taxes Less: Depreciation for accounting Purposes 50 200 200 50 200 50 • .. Profit before taxes 150 150 150 c Less: Tax expense Current tax 0.40 (200-150) 20 0.40(200) 80 80 D Deferred tax Tax effect of timing differences originating during the year 0.40( 150-50) 40 E Tax eflect of timing differences reversing during the year 0.40 (0-50) (20) (20)

Tax expense 60 60 60 F Profit after tax 90 90 90 Net timing differences 100 50 Q Deferred tax liability 40 20 Q

G In 20x 1, the amount of depreciation allowed for tax purposes exceeds the amount of depreciation charged for accounting purposes by Rs.1,00,000 and, therefore, taxable income is lower • than the accounting income. This gives rise to a deferred tax liability ofRs.40,000. In 20x2 and 20x3, accounting income is lower than taxable income because the amount of depreciation charged for