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IFRS: Amoritsed cost and tax implications

on 16 October 2010


Amortized cost basis valuation in IAS-39 with respect to specified financial instruments can be compared to a journey in a passenger train which is either behind or ahead of the schedule and makes lot of discretionary time adjustments (i.e. halts and over speeding) midway to reach the destination at an ‘exact time’. The ‘exact time’ is that which is scheduled, convenient and safe to the passengers.
To have a prelude with the above example, the ‘exact time’ is the maturity date of the financial instrument; the Train is the Financial instrument (the word behind or ahead of the schedule is used to denote that it is artificially priced); Engine is the Effective interest rate which drives the passengers (Company) to their station and lastly the journey being the accounting cycle of the financial instrument.
Abstract thinking apart, amortized cost is considered most appropriate valuation basis that is very much aligned to the market state of affairs. Hence it is an effective tool for dealing with artificial pricing of financial instruments where the prima facie income or expense associated with the instrument does not reflect the true market pattern. It becomes very handy especially in an inter-firm comparison. For the reader’s information, IAS-39 prescribes the amortized cost basis valuation for Loans and receivables and Investments held to maturity for the simple reason that they may be non-current and cannot be carried at Fair values. Effective interest rate is the market driven rate which will normalize the yield of the financial instrument.
Consider Company A which lends Rs.10000/- to its employee at zero percent interest rate for say 3 years. Though the instrument is rated as zero interest, the company cannot avoid accounting an interest income which reflects the market interest. This is a case where the standard presumes an artificial over pricing (premium). Let us assume the market interest rate for similar product to be 5%. For the former case the maturity amount of Rs.10000/- (same as initial amount) has to be discounted at the market rate of 5% which will result in a present value of Rs.8638/-. For simplicity let us assume the Fair value on the date of lending is also Rs.8638/-. The difference of Rs.1362/- (10000-8638) will be incremented to the carrying amount of the asset over the three year period by debiting the asset a/c such that at maturity the asset gets carried at Rs.10000 (recoverable amount) and crediting interest income for a total of Rs.1362/- (actual cash interest receivable from employee being zero). Below is the pattern of debits with reference to the Discount factor (PV) table,
Year 1                   :        Rs. 476
Year 2                   :        Rs. 454
Year 3                   :        Rs. 432
The reader can accordingly visualize the reverse scenario of low pricing where the entries will look vice versa.
Coming up next…………. The probable darker side of this accounting system
  • The interest income credited as above is taxable component if the assessee follows accrual method of accounting. The unfortunate thing about this paradigm is that a part of corpus might have to be offered for income under the tax law. In the above example the amount of Rs.1362/- though forms a part of the capital of Rs.10000/- has to be taxed as interest income. It is apparently ironical since tax law does not allow entering of capital receipts and payments in calculation of income under the head ‘Profits and Gains of Business or Profession’.
  • On the other hand, the employee will also have to offer the interest free portion of the Loan as perquisite offered by the employer under the head ‘Salaries’. Rule 3(7)(1) of the Income tax rules says,
“The value of the benefit to the assessee resulting from the provision of interest-free or concessional loan for any purpose made available to the employee or any member of his household during the relevant previous year by the employer or any person on his behalf shall be determined as the sum equal to the interest computed at the rate charged per annum by the State Bank of India, constituted under the State Bank of India Act, 1955 (23 of 1955), as on the 1st day of the relevant previous year in respect of loans for the same purpose advanced by it on the maximum outstanding monthly balance as reduced by the interest, if any, actually paid by him or any such member of his household”
(Loans below Rs.20000/- are anyway exempted but for simplicity sake a lesser amount is considered). Thus, in our hypothetical example, if we assume the interest rate charged by SBI p.a is 10%, the employee will pay a tax on Rs.1000/- (10000*10%).
This is clearly a case of double taxation where the taxman will pocket a tax revenue on a basis of Rs.2362/- (1362+1000) whereas in the earlier regime the tax basis would have been only Rs.1000/-.
  • Let us consider an interest free loan transaction between associated enterprises which will qualify recording as ‘Financial liabilities measured at amortized cost’. The interest is to be calculated applying the effective interest rate method as above. For the purpose of Sec.115JB relating to calculation of Minimum Alternate Tax, there is requirement inter alia many items the adding back of ‘Provision for unascertained liability’ to the Profit as shown in P&L Account to arrive at Book profits. Will this interest expense be interpreted as the aforesaid provision and be added back because there exists no real liability? It would be unfair to trap the assessee in a labyrinth like this.
Certainly there is an indispensable need to mortise the accounting standards into the tax laws or vice versa to achieve the alignment of objectives.

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