Meaning
of prior period expenses
Prior
period expense are generally those expenses which are relating to the current
year in the sense they are crystalised during the year, though relating to
activities of an earlier year.
For accounting purposes these are
generally known as prior period items and required to be shown separately.
Allowability
of expenditure in year of crystallization
Normally
where mercantile system of accounting is followed, expenses relating to
relevant year are accounted for in that year. However prior period expenses had
to be allowed in subsequent years because the expenses were crystallized only
in that year.
What is a provision?
A provision
is recognized when:
(a) an enterprise has a present obligation as a
result of a past obligating event;
(b) it is probable that an outflow of resources
will be required to settle the obligation;
(c) a reliable estimate can be made of the
amount of the obligation.
If these
conditions are not met, no provision can be recognized. Hence, it is only the
obligation arising from past events existing independently of the future
conduct of the business of the enterprise that is recognized as provision.
What is an obligating event?
A past event
that leads to a present obligation is called as an obligating event. The
obligating event is an event that creates an obligation which results in an
outflow of resources. When there is manufacture and sale of an army of items
running into thousands of units of sophisticated goods, the past event of
defects being detected in some of such items leads to a present obligation
which results in an enterprise having no alternative except to settle that
obligation.
What is a liability?
Liability is
defined as a present obligation arising from past events, the settlement of
which is expected to result in an outflow from the enterprise of resources
embodying economic benefits.
Provision for warranty period expenses
Expenditure
which is contingent on the happening of certain event is not allowable, unless
it meets certain criteria. The provisions of the warranty expenditure is required to be estimated
based on the past experience of the assessee demonstrated on the basis of past
warranty liability on similar type of contracts and further it can be proved by
incurring the warranty expenditure in subsequent period to the sales.
Estimates
of the warranty provision
Estimates
of the warranty provision depends upon a different industry in which assessee
operates. There may be different manner of making a provision because of
warranty services in different industry. There cannot be straightjacket
formulae for warranty provision in each industry alike. Therefore, the reliable
estimate made by the assessee is required to be looked from the perspective of
the industry in which the assessee operates.
Therefore, whether the
provision of the assessee of warranty expenditure is reliable estimate or not
the authorities should have looked into the basis of the estimate made by the
assessee. It is further required to be seen that what kind of expenditure have
been incurred by the assessee in subsequent years that will give the best
picture with the original provision made by the assessee’s reliable estimate or
not.
ICDS vis-à-vis prior period expenses
The notified ICDS does not provide anything on
allowability of prior period expenditure. Hence, it can be presumed that the
treatment of prior period expenditure shall be decided as per judicial
precedents and the provisions of the Act.
Liability in respect of provision for
warranty claims is not a contingent liability
The warranty
provision was computed as a three step process to quantify such provision: (a)
the assessee determines, on the basis explained above, percentage of defects
likely to occur in the product sold by the assessee; (b) the assessee
determines, based on the past experience and the repair cost estimate received
from the vendors, average per unit likely repair costs; and (c) the assessee
determines the likely number of units which are likely to have such defects, by
adopting percentage: (a) to the total units sold, and estimates the provision
required by multiplying the number of units so likely to receive warranty
service, with the average cost incurred on such service as a result of, (b)
above. This method, in our considered view, a fairly scientific basis,
supported by historical data, and it meets the tests laid down by the Hon’ble
Supreme Court in Rotork
Controls India (P) Ltd. v. CIT (2009) 180 Taxman 422 (SC). The
Assessing Officer ought to have reconciled to the fact that, as is the legal
position as on now, the liability in respect of provision for warranty claims is
not a contingent liability but rather a reasonably estimated, to borrow the
felicitous words employed by Their Lordships, “present obligation as a result
of past events (i.e. sale of products) resulting in an outflow of resources (in
future)”. Learned CIT(A) was, therefore, quite justified in granting the
impugned relief. We uphold his action and decline to interfere in the matter. Accordingly, provision for warranty claims made by assessee in
respect of software products on scientific basis and historical data, was to be
allowed as deduction. (Related Assessment year: 2012-13)
[DCIT v.
Elitecore Technologies Private Limited - ITA No.508/Ahd/2016 – Date of
order : 31.03.2017 (ITAT Ahmedabad)]
Where prior period expenses
on account of repair and maintenance were related to earlier years but
crystallized when bills were received during current year, same were to be
treated as current year’s expenses and hence allowable.
[DCIT v. Enercon India Ltd.
(2016) TaxPub (DT) 2867 : 48 ITR 362 (ITAT Mumbai)]
Where
prior period expenses were debited on basis of receipts of bills and were in
the nature of routine expenses duly authorized by company’s authorized body,
the same could not be disallowed on the basis of tax audit report.
[DCM
Limited v. DCIT 2015 TaxPub (DT) 4649 (ITAT Delhi)]
Where from
historical trend it was evident that provision for warranty made by assessee in
respect of after sale services was a fair and reasonable estimate of post sales
expenses to be incurred by assessee in respect of goods supplied by it, same
was to be allowed.
[JCIT v. Mil
India Ltd. (2015) 59 taxmann. com 334 (ITAT Delhi)]
It was held that in the light of the
admitted position that the expenditure in question was wholly and exclusively
for the purpose of business and that the same was genuine, the fact that the
expenditure relates to an earlier period could not be a ground to deny the
deduction, especially when factually crystalisation of liability during the
previous year had not been disputed. Therefore, the expenses claimed by the
assessee were directed to be allowed, as such these expenses were allowed
though related to prior period.
[Bearingpoint Property Services (P) Ltd. v.
DCIT (2014) TaxPub (DT) 4064 : 35 ITR 177 (ITAT Bangalore)]
Information as regards expenses with evidence where
received after closure of accounts
The assessing officer observed that as per audit
report, prior period expenses had been debited to Profit and Loss Account. It
was held that the genuineness of the expenses had not been doubted by the lower
authorities. Thus, these expenses of previous year were allowable in respective
year to which they pertained but information as regards such expenses with
evidence was received by the assessee from the various branches after closing
of books of account. Hence, these expenses are allowable during the year under
consideration.
[State
Bank of Bikaner Jaipur v. ACIT 2014 TaxPub (DT) 4331 : 166 TTJ 244 (ITAT
Jaipur]
It
was held that the real question
concerning us is the year in which the assessee is required to pay tax. There
is no dispute that in the subsequent accounting year…. where that the rate of
tax remained the same in the present assessment year as well as in the
subsequent assessment year. Therefore, the dispute raised by the Revenue is
entirely academic. There was, therefore, no need for the Revenue to continue
with this litigation when it was quite clear that not only was it fruitless (on
merits) but also that it may not have added anything much to the public
coffers. ”
[CIT
v. Excel Industries Limited (2013) 358 ITR 295 (SC)]
In the case of Woodward Governor India Ltd. v. CIT , the Delhi High Court ruled that provision for
warranty made on basis of principle of matching can be allowed but the amount
claimed should have some rational and scientific basis and it cannot be
an ad hoc amount. The matter was
remanded to Assessing Officer for disposal afresh.
[Woodward Governor
India Ltd. v. CIT (2013) 357 ITR 673 : 37 taxmann.com 419
(Del)]
In the case of CIT v. Forbes Campbell Finance Ltd., the Madras High Court found that provision for
service charges payable by assessee by way of warranty provision was not made
on any scientific data but on an ad hoc basis.
Added to that, more than 60 per cent of provision remained unpaid after more
than two years from date of sale. On these grounds, the High Court decided in
favour of the Revenue.
[CIT v. Forbes
Campbell Finance Ltd. (2013) 352 ITR 602 44 taxmann.com 342 (Mad)]
Warranty expenditure - Deduction
allowed if provision made on scientific basis
Assessee had acquired personal computer and
laptops division of IBM India and continued business of trading and manufacture
of PCs and MCs. It provided either 1 year or 3 years warranty on sale of PCs
and laptops made to its customers in India. Assessee debited actual warranty
expenditure incurred during year and also made additional provision on basis of
assessment of warranty liability on sales made for unexpired period to profit
and loss account and claimed it as deduction. It was held that since IBM was
carrying on business in India in earlier assessment years and it was making
provision for warranty on basis of its global data, assessee could use data
used by IBM for past years for making estimation and if assessee had made
provision on a scientific basis, it had to be allowed as deduction.
[Lenovo India (P) Ltd. v. ACIT (2013) 140 ITD
127 (ITAT Bangalore)]
In the case of Mahindra &
Mahindra Ltd. v. DCIT, the ITAT was not satisfied with the explanations of the
assessee of the manner of providing for warranties. Where the provision was
made for Rs.44.20 crores,
the actual amount that was settled in the relevant assessment year was
only Rs.28.19 crores.
In these circumstances, the ITAT after considering a significant amount of case
law was not convinced that the provision was made on a scientific basis
and therefore remitted the matter back to the file of the Assessing Officer to
decide the matter afresh, as per the guidelines laid down in the Rotork Controls
India (P) Ltd. v. CIT (2009) 180 Taxman 422 (SC) case.
[Mahindra
& Mahindra Ltd. v. DCIT (2012) 24 taxmann.com 267
(ITAT Mumbai)]
Expenditure incurred as continuous flow
It was a continuous process to incur expenditure and to account
for in the books of account. Therefore, even though they were treated
technically as prior period expenses, it related to a continuous flow of
expenditure. Therefore, there was no justification in disallowing the
expenditure, otherwise normally eligible for deduction.
[Union Bank of India v. ACIT (2011) 49 SOT 32 (ITAT Mumbai),
Bank of India v. DCIT (2012) 139 ITD 493 (ITAT Mumbai)]
When the department was
taxing prior period income, deduction of expenses, which had crystalized during
the relevant previous year, should have also been allowed to the assesses. In a
going concern, certain bills are received late and pertained to the business
transaction and are crystalized during the relevant accounting period. These
types of expenses are revenue in nature and are allowable in the previous year
in which they are crystalized.
[DCIT v. Khurana
Engineering Ltd. ITA No. 571 (Ahd) of 2010 (ITAT Ahmedabad)]
It was held that a provision is a liability which can
be measured only by using a substantial degree of estimation. A provision is
recognized when: (a) an enterprise
has a present obligation as a result of a past event; (b) it is probable that an outflow
of resources will be required to settle the obligation; and (c) a reliable estimate can be made
of the amount of the obligation. If these conditions are not met, no provision
can be recognized. The apex court went on to say that in order to create a
provision, the appropriate historical trend should be determined. For that,
it is important that the company has a proper accounting system for
capturing relationship between the nature of the sales, the warranty provisions
made and the actual expenses incurred against it subsequently. Thus, the
determination of the amount of provision for warranty should be based on past
experience of the company. In other words, the assessee should create the
provision on a scientific basis based on empirical data, trends, projections
etc. Further, there is a second condition of writing back the unutilized
provision when the warranty period expires.
[Rotork
Controls India (P) Ltd. v. CIT (2009) 180 Taxman 422 (SC)]
The Hon’ble Supreme Court had laid down three conditions for provision
to be regarded as liability. The Hon’ble Supreme Court while answering the
question as to what is a provision opined that a provision is a liability which
can be measured only by using a substantial degree of estimation. A provision
is recognized when:
(a) an enterprise has a present obligation as a result of a past event;
(b)
it is probable that an outflow of resources will be required to settle the
obligation; and
(c)
a reliable estimate can be made of the amount of the obligation.
The
Hon’ble Supreme Court held that if the above three conditions are not met, no
provision can be recognized.
Assessees are
advised caution to ensure that their claims do not fail for want of a
scientific basis and further, to ensure that the unsettled amounts are written
back and offered to tax once the warranty period expires. But before that, one
must ensure that one has a good system of accounting which captures the
required data. Assessees quite often fail on this count.
Where warranty clause is a part of the sale document and it imposes a
liability on the assessee to discharge its obligation for the period of
warranty, the liability could be capable of being construed in definite terms
and therefore could be deducted while working out the profits and gains of
business
[CIT v. Hewlett Packward India Ltd.
(2008) 171 Taxmann 13 (Del)]
Prior period expenses - Held to be not allowable
Since assessee had failed in proving crystallization of prior period
expenditure which included professional fee during the relevant year, assessing
officer was justified in disallowing deduction claimed by assessee.
[Adani Gas Ltd. v. ACIT 2016 TaxPub (DT) 843 (ITAT Ahmedabda)]
Expenditure
to be disallowed where assessee failed to prove as to crystallization in
current year
It was held that while upholding the
disallowance of the expenses, the Commissioner (Appeals) has noted that the
assessee had not submitted any evidence to
prove that the expenses crystallized during the year either before
assessing officer or before the Commissioner (Appeals). The statement of
expenses very clearly indicated that the expenses were related to assessment
year 2000-01. Therefore there was no reason to interfere with the order of the
Commissioner (Appeals) disallowing the prior expenses, after offsetting the
income of earlier year.
[ACIT v. Adani Wilmar Ltd. (2014) TaxPub(DT)
3727 : 64 SOT 122 (ITAT Ahmedabad)]
Assessee claimed deduction in respect of audit
fee and purchase of raw material – Assessing Officer rejected assessee’s claim
holding that said expenses were prior period expenses. Tribunal held that as
regards audit fee, since audit was carried out in earlier years, even if bill
was not received in previous year, expenses should have been considered in
respective year and hence deduction was not allowable in year under
consideration. As regards raw material cost, since assessee failed to bring any
material on record to show in support of its case that there was any dispute
regarding payment to be made to supplier and said dispute was settled in
relevant year, no case was made out for deduction, hence disallowance was held
to be justified.
[Cadila Pharmaceuticals Ltd. v. ACIT (2012) 53
SOT 356 (ITAT Ahmedabad)]
Assessee had failed to
establish that the related expenses were actually crystallised during the year
under consideration. Since assessee was following the mercantile system of
accounting it has to establish that these liabilities pertaining to the previous
year were actually crystallised during the year under consideration. Since the
assessee had failed to do so the order of Commissioner (Appeals) was sustained.
[DCIT v. Cosmo Films Ltd
& Ors. (2012) 13 ITR (Trib) 340 : 139 ITD 628 (ITAT Delhi)]
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