Provision for Tax, Sections, Features, Advantages, Disadvantages

Provision for Tax refers to the estimated amount of income tax a company expects to pay on its profits for a given accounting period. Since the exact tax liability is determined after the finalization of accounts and assessment by tax authorities, companies create a provision to account for this future obligation.

It is a liability and shown under “Current Liabilities” in the balance sheet. This provision ensures that profits are not overstated and aligns with the matching principle of accounting, which requires expenses to be recognized in the same period as the related revenues.

The provision is made based on prevailing tax rates and estimated taxable income. Later, when the actual tax is paid, any difference between the provision and actual tax is adjusted.

Creating a provision for tax helps maintain transparency, ensures compliance with laws, and provides a realistic picture of the company’s financial position.

Sections of Provision for Tax in India:

  • Section 139 – Filing of Return

Under Section 139 of the Income Tax Act, 1961, every company is required to file an income tax return for each assessment year, irrespective of whether it has earned income or not. In order to compute accurate taxable income, companies must estimate and account for tax liabilities at the end of the financial year. This estimation is recorded in the books of accounts as a provision for tax. Although the final tax liability is determined after assessment by the tax department, making a provision ensures that financial statements reflect a realistic liability for the period.

  • Section 115JB – Minimum Alternate Tax (MAT)

Section 115JB deals with the concept of Minimum Alternate Tax (MAT). It is applicable to companies whose income tax liability under normal provisions is less than 15% of their “book profit.” In such cases, they are required to pay tax at 15% (plus surcharge and cess) on the book profit. This MAT is also included in the provision for tax if applicable. MAT ensures that companies showing high profits in books but paying little or no tax under the normal provisions contribute a minimum amount to the government.

  • Section 209 – Advance Tax Computation

Section 209 specifies the computation of advance tax for assessees whose total estimated tax liability is ₹10,000 or more in a financial year. Companies are required to pay advance tax in four installments during the year. Provision for tax also includes the estimation and recording of advance tax liabilities. These advance tax payments are adjusted against the total tax liability at the end of the year. Failure to pay advance tax results in interest penalties under Sections 234B and 234C.

  • Section 145 – Method of Accounting

Section 145 of the Income Tax Act mandates that income must be computed in accordance with the mercantile system or the cash system of accounting, as regularly followed by the assessee. Most companies follow the mercantile system, where income and expenses are recognized on an accrual basis. Therefore, the provision for tax is recorded even though the actual tax payment is made at a later date. This ensures that the expenses match the revenues earned during the accounting period in line with the matching principle of accounting.

  • Section 37(1) – General Deduction

As per Section 37(1), expenses that are not specifically covered under any other section and are incurred wholly and exclusively for business or profession are allowed as deductions. However, it is important to note that income tax paid is not allowed as a business expenditure. Although actual tax payments are not deductible, the provision for tax is made in books for accounting purposes only and does not affect taxable profits. This distinction is important for both tax computation and financial reporting.

  • ICDS IX – Provisions, Contingent Liabilities

The Income Computation and Disclosure Standards (ICDS) are a set of standards notified by the Income Tax Department to ensure uniformity in income computation. ICDS IX specifically deals with provisions and contingent liabilities. It outlines how provisions (including provision for tax) should be recognized and disclosed for tax purposes. According to ICDS IX, a provision is recognized only when there is a present obligation resulting from a past event, and the amount can be reliably estimated. This helps in maintaining consistency and compliance in recognizing tax provisions.

  • Section 123 of the Companies Act, 2013

According to Section 123 of the Companies Act, 2013, a company must provide for depreciation and tax before declaring any dividend. This means that the provision for tax must be created and adjusted in the profit and loss account prior to the appropriation of profits for dividend payments. This ensures that dividends are paid only from the net profits of the company, maintaining the integrity of the company’s financial position and protecting shareholder interests.

Features of Provision for Taxation:

  • Estimation of Future Tax Liability

Provision for taxation represents the estimated amount of income tax a company expects to pay for the current accounting year. It is not the exact tax payable but a fair approximation based on taxable income and prevailing tax rates. This provision is made before the final assessment by the tax authorities. Estimating tax in advance ensures that the financial statements show a more realistic picture of the company’s financial obligations, helping in the application of the matching principle in accounting—where expenses are matched with revenues of the same period.

  • Non-Cash, Adjusting Entry

The provision for tax is a non-cash, adjusting journal entry made at the end of the accounting year. Although the actual payment of tax occurs later, the entry ensures that tax expenses are recognized in the financial statements of the relevant period. It does not involve an immediate cash outflow but prepares the business for a future liability. This entry affects the Profit and Loss Account by reducing net profit and is shown as a current liability on the balance sheet, maintaining the accuracy of financial reports.

  • Based on Accounting Profit, Not Taxable Profit

Provision for tax is generally created on the basis of accounting profit and not the actual taxable profit as per the Income Tax Act. Accounting profit is computed according to financial reporting standards (such as Companies Act provisions or accounting standards), whereas taxable profit includes adjustments and disallowances under income tax laws. Therefore, the provision may differ from the final tax liability. Any differences between provision and actual tax are adjusted in subsequent periods, either by creating a tax payable or excess provision account.

  • Helps Comply with Matching Concept

One of the main purposes of creating a provision for tax is to comply with the matching concept of accounting. This principle states that expenses should be recognized in the same period as the revenues they help generate. Since taxes are a result of profits earned during the year, the tax expense (even if unpaid) should be accounted for in the same financial year. Creating the provision ensures that the profit reported is net of estimated tax, giving a more accurate picture of the company’s performance.

  • Shown as Current Liability

Provision for taxation is shown on the liabilities side of the balance sheet under the heading current liabilities and provisions. It represents a legal obligation of the company to pay income tax in the near future. The amount remains as a liability until the tax is paid or assessed. It alerts stakeholders and auditors about the company’s obligations and ensures that the financial position is not overstated. This treatment enhances transparency and reflects the company’s commitment to meeting its statutory obligations.

  • Subject to Adjustments

The provision for tax is not a final amount—it is subject to changes and adjustments once the actual tax liability is computed and paid. If the provision is higher than the actual tax, the excess is written back to profit in the next year. If the provision is lower, the shortfall is recorded as an additional tax expense. These adjustments ensure accuracy in the company’s books and help reconcile the differences between book profit and taxable income over time, aligning with financial and statutory requirements.

Advantages of Provision for Taxation:

  • Ensures Accurate Financial Reporting

Provision for taxation helps in presenting a true and fair view of the company’s financial statements. By recognizing expected tax liabilities in the current period, it prevents overstatement of profits. This aligns with the matching principle and ensures that the expenses related to the current year’s income are accounted for properly. It improves the reliability of financial statements and helps stakeholders make informed decisions based on realistic profit figures after considering expected tax obligations.

  • Facilitates Better Financial Planning

Creating a provision for taxation allows a company to set aside funds in anticipation of future tax payments. This helps avoid sudden cash flow pressure when tax becomes payable. With better foresight into upcoming tax liabilities, the company can plan investments, dividends, and working capital more efficiently. It enables businesses to manage liquidity better and avoid financial disruptions, ensuring that adequate resources are available when the actual tax dues are settled with the tax authorities.

  • Helps in Legal and Regulatory Compliance

Maintaining a provision for taxation ensures that a company complies with statutory requirements, such as the Companies Act and accounting standards. It signals that the company is responsibly planning to meet its tax obligations. Auditors and regulatory authorities often look for such provisions as a sign of good governance. Additionally, accurate provisioning helps in smooth tax assessments and audits, reducing the risk of penalties and interest due to underreporting or delayed recognition of tax liabilities.

  • Enhances Credibility Among Stakeholders

When a company maintains proper provisions for taxation, it boosts the confidence of investors, lenders, and other stakeholders. It demonstrates sound financial management and responsible behavior in anticipating and preparing for tax liabilities. Credit rating agencies and financial institutions often view accurate provisioning as a positive indicator of a company’s discipline and foresight. This can enhance the company’s reputation in the market and improve its ability to attract capital or secure loans at better terms.

Disadvantages of Provision for Taxation:

  • Risk of Over or Under Provisioning

One major disadvantage of provision for taxation is the risk of overestimating or underestimating the actual tax liability. If over-provided, it unnecessarily reduces reported profits, affecting dividend declarations and investor perception. If under-provided, it can lead to future cash flow strain and accounting adjustments. In both cases, the accuracy of financial statements is compromised, which may mislead stakeholders and require restatement of profits in subsequent periods, reducing financial statement reliability.

  • No Tax Deduction for Provision

Although a company creates a provision for taxation in its books, the Income Tax Act does not allow deduction for provisions—only actual tax payments are deductible. This leads to a situation where the expense is recorded in accounting books but not recognized for tax purposes, resulting in deferred tax differences. This creates complexity in tax calculations and reconciliation, and requires maintenance of deferred tax asset/liability accounts, which adds to the administrative and accounting workload.

  • Reduces Available Profits for Distribution

Creating a provision for taxation reduces the net profit of the company for the period, thereby decreasing the profits available for distribution as dividends. This may disappoint shareholders who expect regular or higher dividend payouts. For small companies or those with tight margins, this reduction can significantly impact their ability to reinvest in the business or maintain dividend consistency. It also may affect market perception, as lower profits could be seen as a sign of reduced performance.

  • Complexity in Estimation and Compliance

Accurately estimating the provision for taxation involves a deep understanding of current tax laws, deductions, allowances, and company-specific tax planning strategies. Any error in interpretation or calculation can result in incorrect provisioning. Moreover, changing tax rates, amendments in laws, or new tax regimes add to the complexity. Companies need skilled professionals to ensure compliance and avoid penalties or misstatements. This increases administrative burden and the cost of maintaining proper tax accounting systems.

Interest on Debentures

Interest on debentures refers to the fixed amount of money that a company agrees to pay periodically to its debenture holders for the funds borrowed. It is usually paid semi-annually or annually and is calculated as a percentage of the face value of the debentures. The rate of interest is pre-fixed at the time of issuing the debentures and is stated in the debenture certificate. The interest paid is a financial charge and must be paid even if the company is incurring losses.

Features of Interest on Debentures:

  1. Fixed Rate: The interest is paid at a fixed rate mentioned in the terms of the debenture issue.

  2. Charge on Profit: Interest on debentures is a charge against profits and must be paid regardless of the company’s profitability.

  3. Tax Deductible: Interest paid on debentures is allowed as a tax-deductible expense under the Income Tax Act.

  4. Priority over Dividends: Interest is paid before any dividends are declared to shareholders.

  5. Creditor Relationship: Debenture holders are creditors, not owners, so they only receive interest, not a share of profits.

  6. Obligation: Failure to pay interest can lead to legal action or impact the company’s creditworthiness.

Types of Interest Payments:

  1. Gross Interest: This is the total amount of interest before deducting tax (TDS).

  2. Net Interest: This is the amount paid to debenture holders after deducting tax at source.

TDS (Tax Deducted at Source) on Debenture Interest:

As per the Income Tax Act, companies are required to deduct tax at source (TDS) before paying interest on debentures if the interest amount exceeds a specified limit (₹5,000 for listed companies and ₹2,500 for others). The TDS rate is generally 10%, but it may vary as per applicable tax laws.

Interest on Debentures Issued at Discount or Premium:

When debentures are issued at discount, the interest is calculated on the face value, not on the amount received.

Example:

  • Debentures of ₹10,00,000 issued at 95% (₹9,50,000 received)

  • Interest @10% is calculated on ₹10,00,000 = ₹1,00,000

Accrued Interest on Debentures

If debentures are purchased between interest dates, the buyer compensates the seller for the accrued interest from the last interest date till the date of purchase. This accrued interest is a capital cost for the buyer and is not treated as income in the hands of the seller.

Importance of Interest on Debentures:

  1. Predictable Expense: It allows companies to plan their cash flows effectively.

  2. Investor Confidence: Regular interest payments increase investor confidence and goodwill.

  3. Tax Shield: Being a tax-deductible expense, it helps reduce the company’s taxable income.

  4. Obligation Fulfillment: It reflects a company’s credibility and financial discipline in the market.

Accounting Treatment of Interest on Debentures:

Transaction Debit (Dr) Credit (Cr) Explanation

Interest Due (Accrued Interest)

Interest on Debentures A/c (Expense) Debenture Interest Payable A/c (Liability)

Interest expense is recognized as it accrues, even if not yet paid.

Payment of Interest

Debenture Interest Payable A/c (Liability) Bank/Cash A/c (Asset)

Actual payment of the accrued interest reduces liability and cash.

Tax Deducted at Source (TDS) (if applicable)

Debenture Interest Payable A/c TDS Payable A/c (Liability)

TDS is deducted and withheld for tax authorities.

Transfer to P&L (Year-End)

Profit & Loss A/c (Expense) Interest on Debentures A/c

Interest expense is closed to P&L to determine net profit.

Introduction, Meaning Calculation of Sales Ratio Profit Prior to Incorporation

In the lifecycle of a company, the phase before its legal incorporation is known as the pre-incorporation period. During this phase, promoters often initiate business activities like purchasing assets, hiring staff, and even making sales. However, a company legally comes into existence only after receiving a Certificate of Incorporation from the Registrar of Companies. This creates a distinction between pre-incorporation and post-incorporation periods for accounting purposes.

When a business is taken over by a newly incorporated company, profits earned during the pre-incorporation period are not considered the income of the company. This is because the company did not legally exist at that time. Therefore, such profits are called Profit Prior to Incorporation and are treated as capital profits. Conversely, profits earned after incorporation are revenue profits.

Meaning of Profit Prior to Incorporation:

Profit Prior to Incorporation refers to the profits or losses earned by a business during the period before the company was legally formed. Since the company is not a legal entity during this time, any profit earned cannot be distributed as dividends. Instead, it is transferred to a Capital Reserve.

The business may have been operated by promoters or taken over from an existing sole proprietor or partnership. The financial results for the full accounting period (before and after incorporation) are often given together, so it becomes necessary to apportion the profits between the pre-incorporation and post-incorporation periods.

Necessity of Calculating Profit Prior to Incorporation:

  1. Correct Profit Reporting: Ensures the company’s financials reflect only profits made during its legal existence.

  2. Dividend Distribution: Dividends can only be paid from revenue profits.

  3. Legal Compliance: Prevents distribution of capital profits as dividends, which is prohibited under the Companies Act.

  4. Tax Purposes: Helps determine taxable profits accurately.

Steps to Calculate Profit Prior to Incorporation:

  1. Ascertain Total Profit or Loss: Determine the profit for the entire period (before and after incorporation).

  2. Divide the Period: Identify the number of months before and after incorporation.

  3. Calculate the Sales Ratio: Used for apportioning items related to sales (e.g., gross profit).

  4. Calculate the Time Ratio: Used for apportioning time-based expenses (e.g., rent, salaries).

  5. Allocate Expenses and Incomes:

    • Allocate incomes and expenses between pre- and post-incorporation using appropriate ratios.

  6. Prepare a Statement: Show profit or loss for each period separately.

Calculation of Sales Ratio:

Sales Ratio is used to apportion sales-based items (e.g., gross profit, commission on sales). It is the ratio of sales made during the pre-incorporation and post-incorporation periods.

Formula:

Sales Ratio = Sales in Pre-Incorporation Period / Sales in Post-Incorporation Period

Steps to Calculate:

  1. Find Total Sales: Determine the total sales during the accounting period.

  2. Break Sales Period-Wise: Separate sales into pre- and post-incorporation periods.

  3. Calculate the Ratio: Divide sales of the respective periods to get the sales ratio.

Example:

If total sales from Jan 1 to Dec 31 are ₹12,00,000 and the company was incorporated on May 1:

  • Sales from Jan to April = ₹4,00,000 (Pre)

  • Sales from May to Dec = ₹8,00,000 (Post)

Then,

Sales Ratio = 4,00,000 : 8,00,000 = 1 : 2

Items Apportioned on Time Ratio vs Sales Ratio:

Basis Items
Time Ratio Rent, salaries (if fixed), depreciation, admin expenses
Sales Ratio Gross profit, selling commission, carriage outwards, sales-related advertisement
  • Preliminary expenses: Post-incorporation

  • Director’s fees: Post-incorporation

  • Interest on purchase consideration: Pre-incorporation

Treatment of Profit Prior to Incorporation:

  1. Capital Reserve: Profit prior to incorporation is transferred to Capital Reserve on the balance sheet.

  2. Cannot be Distributed as Dividend: As it is capital in nature.

  3. Can be Used for:

    • Writing off goodwill or preliminary expenses

    • Issuing bonus shares

    • Meeting capital losses

Format of Profit Prior to Incorporation Statement:

Particulars

Pre-Incorporation ()

Post-Incorporation ()

Gross Profit (based on Sales Ratio)

XXXX XXXX
Less: Expenses (allocated) XXXX XXXX
Net Profit XXXX XXXX

Time Ratio Profit Prior to Incorporation

When a newly incorporated company takes over an existing business, it is common for the business to have been operational even before the company was legally formed. In such cases, the total profit or loss for the entire period needs to be split between the Pre-incorporation period and the Post-incorporation period.

The profit earned before incorporation is known as Profit Prior to Incorporation. It is considered a capital profit and cannot be distributed as dividends. For an accurate and fair division of profits and expenses between the two periods, two essential tools are used:

  • Sales Ratio: Used for apportioning sales-related items.

  • Time Ratio: Used for apportioning time-based expenses.

This note focuses on the Time Ratio and how it is used in calculating Profit Prior to Incorporation.

What is Profit Prior to Incorporation?

Profit Prior to Incorporation refers to the portion of the net profit (or loss) earned by a business before it becomes a legally incorporated company. It arises in cases where a business is already operational and later taken over by a company from a specific date.

For example, if a business operates from January 1 and is incorporated on April 1, profits from January to March would be termed as Profit Prior to Incorporation, and profits from April onwards would be Revenue Profits.

Nature and Treatment of Profit Prior to Incorporation:

Capital Nature:

  • Treated as capital reserve, not as distributable profit.

  • Shown on the liabilities side of the Balance Sheet under Reserves and Surplus.

  • Can be used for:

    • Writing off preliminary expenses.

    • Writing off goodwill.

    • Issuing bonus shares.

    • Absorbing capital losses.

Revenue Profits:

  • Arise after incorporation.

  • Can be distributed as dividends to shareholders.

  • Shown in the Profit & Loss Account.

Time Ratio – Meaning and Importance:

Time Ratio is the ratio between the lengths of the pre-incorporation and post-incorporation periods. It is used to apportion time-based expenses and incomes that accrue evenly over time.

  • Formula of Time Ratio

Time Ratio = Number of months (or days) in pre-incorporation period: Number of months (or days) in post-incorporation period

Example:

Items Apportioned Using Time Ratio:

Time-based items that are not directly linked to sales are divided using Time Ratio.

Examples:

Items Apportioned Using Time Ratio
Rent, rates, and taxes Yes
Depreciation (on fixed assets) Yes
General office expenses Yes
Salaries and wages Yes (if fixed monthly payments)
Insurance Yes
Telephone and internet charges Yes
Audit fees Sometimes (if period-based)
  1. Determine Total Profit or Loss for the full accounting period.

  2. Identify the Date of Incorporation and divide the period into:

    • Pre-incorporation period.

    • Post-incorporation period.

  3. Calculate Time Ratio for time-based expenses.

  4. Calculate Sales Ratio for sales-based incomes/expenses.

  5. Classify Expenses and Incomes into:

    • Time-based (use time ratio).

    • Sales-based (use sales ratio).

    • Specific to pre- or post-incorporation.

  6. Prepare a Profit Allocation Statement.

Format of Profit Prior to Incorporation Statement:

Particulars

Pre-Incorporation ()

Post-Incorporation ()

Gross Profit (Sales Ratio)

XXXX

XXXX

Less: Rent, Salaries (Time Ratio)

XXXX

XXXX

Less: Sales Commission (Sales Ratio)

XXXX XXXX
Less: Director’s Remuneration (Post Only) XXXX
Net Profit XXXX XXXX

Weighted Ratio Profit Prior to Incorporation

When a company is formed by taking over a running business, its financial year often spans both pre-incorporation and post-incorporation periods. The profit earned before the date of incorporation is termed “Profit Prior to Incorporation”. This profit is considered capital profit and not available for dividend distribution. To calculate this profit accurately, time ratio and sales ratio are used. However, when expenses and income do not align proportionally with time or sales, the Weighted Ratio is applied for equitable apportionment.

Profit Prior to Incorporation

Profit prior to incorporation is the profit earned by a business before the company is legally formed. For example, if a business is acquired on January 1st but the company is incorporated on April 1st, then the profit from January 1 to March 31 is profit prior to incorporation.

This profit must be calculated separately because:

  • It is capital profit.

  • It is not available for dividend.

  • It is usually transferred to Capital Reserve.

Apportionment of Profit and Expenses:

To determine the correct amount of profit prior to incorporation, the total profit of the period (from acquisition to the end of the financial year) must be split between:

  • Pre-incorporation period: From acquisition date to incorporation date.

  • Post-incorporation period: From incorporation date to the end of the accounting period.

For accurate apportionment of income and expenses, three types of ratios are used:

  1. Time Ratio

  2. Sales Ratio

  3. Weighted Ratio

What is Weighted Ratio?

Weighted Ratio is a more refined method of apportioning expenses, particularly when both time and sales affect the distribution. It assigns weights to both the time and sales factors and then applies these weights to allocate items like salaries, rent, and other semi-variable expenses.

Weighted Ratio = Time × Sales

It is used in situations where neither the time ratio nor sales ratio alone gives a fair distribution.

When to Use Weighted Ratio:

Weighted ratio is used for:

  • Expenses affected by both time and activity level (sales).

  • Semi-variable or mixed expenses like salaries (increased post-incorporation due to more staff), advertisement, and office expenses.

Steps for Calculating Profit Prior to Incorporation Using Weighted Ratio

  1. Determine the total period (acquisition to end of financial year) and divide it into:

    • Pre-incorporation period

    • Post-incorporation period

  2. Calculate Time Ratio = Duration of each period in months.

  3. Calculate Sales Ratio = Sales in each period.

  4. Calculate Weighted Ratio = Time × Sales (for each period).

  5. Prepare a Statement of Profit and Loss:

    • Allocate incomes and expenses using:

      • Time ratio: for fixed expenses (e.g., rent, depreciation).

      • Sales ratio: for variable expenses (e.g., selling commission).

      • Weighted ratio: for semi-variable expenses (e.g., salaries, office expenses).

  6. Calculate Profit Prior to Incorporation: Subtract the pre-incorporation expenses from the pre-incorporation revenue.

  7. Transfer the amount to Capital Reserve.

Items Treated Using Weighted Ratio

Nature of Item Example Basis of Apportionment
Semi-variable expenses Salaries, Office Expenses Weighted Ratio
Fixed Expenses Rent, Insurance, Audit Fees Time Ratio
Variable Expenses Selling Commission, Carriage Outward Sales Ratio

Treatment of Profit Prior to Incorporation

Particulars Treatment
Profit before incorporation Treated as Capital Profit
Use of this profit Transferred to Capital Reserve
Not used for Distribution of dividends

Treatment of Capital and Revenue Expenditure

In accounting, every expenditure incurred by a business must be correctly categorized and treated to present a true and fair view of the financial position. Broadly, expenditures fall into two categories:

  • Capital Expenditure

  • Revenue Expenditure

Correct classification and accounting treatment are crucial because it impacts both the profit and loss account and the balance sheet. Misclassification may mislead stakeholders and lead to incorrect tax computations and profit reporting.

Capital Expenditure

Capital expenditure (CapEx) refers to money spent by a business to acquire, upgrade, or extend the life of long-term assets. These expenditures offer economic benefits beyond the current accounting period and are not incurred regularly.

Examples

  • Purchase of land, building, plant, and machinery

  • Cost of installation or delivery of fixed assets

  • Legal fees on the purchase of property

  • Major improvements or extension of assets

Characteristics

  • Non-recurring and long-term in nature

  • Provides benefit over several accounting periods

  • Increases the earning capacity of the business

  • Capitalized and shown on the assets side of the balance sheet

Revenue Expenditure

Revenue expenditure (RevEx) is the money spent on the daily operational needs of the business. It is incurred to maintain the existing earning capacity of the business and is consumed within the same accounting period.

Examples

  • Salaries and wages

  • Rent, electricity, and water charges

  • Repairs and maintenance

  • Office stationery and administrative expenses

  • Insurance premiums

Characteristics

  • Recurring and short-term in nature

  • Maintains the existing assets, does not increase efficiency

  • Fully charged to the profit and loss account in the year incurred

  • Necessary for the regular functioning of the business

Key Differences between Capital Expenditure and Revenue Expenditure

Particulars Capital Expenditure Revenue Expenditure
Nature Non-recurring, long-term Recurring, short-term
Benefit Duration More than one accounting period Only current accounting period
Impact on Assets Increases asset base Does not affect asset base
Financial Statement Effect Appears in Balance Sheet (as asset) Charged to Profit & Loss Account
Examples Purchase of equipment, land, building Rent, salaries, utilities

The treatment in the accounting books varies significantly based on the nature of the expense. Here’s a table showing the accounting treatment:

Expenditure Type Accounting Entry Impact on Financial Statements
Capital Expenditure Asset A/c Dr.
 To Bank A/c
Asset added in Balance Sheet
Revenue Expenditure Expense A/c Dr.
 To Bank A/c
Charged as expense in Profit & Loss Account
Depreciation (CapEx) Depreciation A/c Dr.
 To Asset A/c
Depreciation charged in P&L A/c, asset value reduced
Deferred Revenue Exp. Deferred Exp. A/c Dr.
 To Bank A/c
Shown as Asset initially, amortized in future P&L A/c

Deferred revenue expenditure is a revenue expenditure in nature but the benefit lasts more than one accounting period. Hence, instead of charging it off in one year, it is spread over several years.

Examples

  • Heavy advertisement for new product launch

  • Preliminary expenses

  • Development costs for new technology

Treatment

Initially shown on the asset side of the balance sheet and gradually written off in the profit and loss account.

At the time of incurring:
Deferred Revenue Exp. A/c Dr.
 To Bank A/c

At the time of amortization:
Profit & Loss A/c Dr.
 To Deferred Revenue Exp. A/c

Capitalized Revenue Expenditure

Certain revenue expenses, when directly related to bringing a capital asset into use, are capitalized.

Examples

  • Wages paid to workers installing machinery

  • Transportation cost for delivering machinery

Though they are revenue in nature, such costs are added to the value of the asset.

Accounting Treatment

Machinery A/c Dr.
 To Bank/Wages/Carriage A/c

Importance of Correct Treatment

Why It Matters

  • Ensures correct computation of profit

  • Proper representation of assets and expenses

  • Compliance with accounting standards (AS-10, AS-26)

  • Affects decision-making by management, investors, and regulators

  • Prevents overstatement or understatement of income

Errors in Classification: Consequences:

Misclassifying Capital as Revenue

  • Understatement of assets

  • Overstatement of current year’s expenses

  • Lower profit shown

Misclassifying Revenue as Capital

  • Overstatement of assets

  • Understatement of expenses

  • Artificially inflated profits

Both types of misclassification violate the principle of prudence and may lead to legal and audit complications.

Accounting Standards Related:

AS-10 (Revised): Property, Plant and Equipment

  • Governs the treatment and recognition of capital assets.

  • Requires capitalization of all costs necessary to bring an asset to working condition.

AS-26: Intangible Assets

  • Applicable to intangible assets like trademarks, patents, and development costs.

  • Clarifies what can and cannot be capitalized.

Special Cases in Treatment

Expense Treatment

Repairs (extensive, long-term)

Capital Expenditure

Ordinary repairs

Revenue Expenditure

Legal charges for buying land

Capital Expenditure

Rent for office

Revenue Expenditure

Renovation increasing asset life

Capital Expenditure

Advertisement (ordinary)

Revenue Expenditure

Advertisement (for long-term impact, e.g., brand building)

Deferred Revenue Expenditure

Ascertainment of Pre-incorporation and Post-incorporation Profits by Preparing Statement of Profit and Loss (Vertical Format) as per Schedule III of Companies Act, 2013

When a company is formed during the course of a financial year, it often takes over a running business. The profits earned before the date of incorporation are termed pre-incorporation profits, and the profits earned after incorporation are known as post-incorporation profits.

✅ Pre-incorporation profit is treated as a capital profit (not available for dividend).
✅ Post-incorporation profit is treated as a revenue profit (available for dividend, subject to law).

To ascertain both, we use the vertical format of the Statement of Profit and Loss as per Schedule III of the Companies Act, 2013 and split items based on Time Ratio, Sales Ratio, or Weighted Ratio, depending on the nature of income or expense.

📊 Format of Statement of Profit and Loss (Vertical Format)

As per Schedule III – Division I of the Companies Act, 2013, applicable to non-Ind AS companies.

ABC Ltd.

Statement of Profit and Loss for the year ended 31st March 2025

(Figures in ₹)

Particulars Total Pre-incorporation Post-incorporation
I. Revenue from operations 10,00,000 2,50,000 7,50,000
II. Other Income 50,000 5,000 45,000
III. Total Revenue (I + II) 10,50,000 2,55,000 7,95,000
IV. Expenses:
(a) Cost of materials consumed 3,00,000 75,000 2,25,000
(b) Purchase of stock-in-trade 50,000 15,000 35,000
(c) Changes in inventories of finished goods 30,000 8,000 22,000
(d) Employee benefit expenses 1,00,000 20,000 80,000
(e) Finance costs (Interest on debentures, etc.) 40,000 40,000
(f) Depreciation and amortisation expenses 60,000 60,000
(g) Other expenses (rent, admin, etc.) 1,20,000 40,000 80,000
Total Expenses (IV) 7,00,000 1,58,000 5,42,000
V. Profit before tax (III – IV) 3,50,000 97,000 2,53,000
Less: Income Tax (only on post-incorp. profit) 65,000
VI. Profit for the year 3,50,000 97,000 1,88,000
Particulars Pre-incorporation Post-incorporation
Classification Capital profit Revenue profit
Transfer to Capital Reserve (in Balance Sheet) Retained earnings / Dividend
Income Tax applicability Not taxable Taxable
Use Cannot be distributed as dividend Can be distributed
Item Basis Remarks
Sales Sales Ratio Based on turnover before and after incorporation
Cost of Goods Sold Sales Ratio Linked to volume of sales
Administrative Expenses Time Ratio Incurred uniformly
Salaries, Rent Time Ratio Fixed and recurring expenses
Selling and Distribution Sales Ratio Sales-based allocation
Depreciation Post-incorporation Applied only after incorporation
Interest on Capital/Debentures Post-incorporation Only after company is formed

Corporate Social Responsibility (CSR), Components, Importance, Stakeholders

Corporate Social Responsibility (CSR) refers to the ethical obligation of companies to contribute positively to society beyond their financial interests. It is a business model in which companies integrate social, environmental, and ethical concerns into their operations, decision-making processes, and interactions with stakeholders, such as employees, customers, investors, and communities. CSR is based on the idea that businesses should not only focus on generating profits but also consider their impact on society and the environment.

The concept of CSR has evolved from a simple philanthropic activity to a comprehensive approach where businesses strive to be responsible corporate citizens. Today, CSR encompasses a wide range of activities aimed at enhancing the well-being of communities, reducing environmental harm, promoting fair labor practices, and ensuring ethical business practices.

Components of CSR

  • Environmental Responsibility:

A significant component of CSR is the responsibility of companies to reduce their environmental footprint. This includes efforts to reduce pollution, conserve natural resources, manage waste, promote sustainable practices, and minimize the ecological impact of their operations. Many companies implement practices such as reducing carbon emissions, using renewable energy, recycling materials, and adopting sustainable sourcing practices to contribute positively to environmental protection.

  • Social Responsibility:

CSR also involves a company’s commitment to society and its people. Social responsibility focuses on improving the quality of life of employees, customers, and communities. This could include providing fair wages, promoting diversity and inclusion, supporting local community projects, and ensuring access to education and healthcare. Social responsibility is about companies engaging in ethical practices that benefit society at large.

  • Economic Responsibility:

CSR extends to ethical business practices, such as ensuring fair trade, avoiding corruption, and providing fair wages to employees. Economic responsibility also involves transparency in financial reporting, paying taxes, and fostering economic development through innovation and job creation. Companies are expected to generate profit in a manner that is ethical, fair, and sustainable for all stakeholders.

  • Ethical Responsibility:

Ethical responsibility in CSR involves conducting business in an honest, transparent, and fair manner. This includes ensuring that products and services are safe, treating employees and customers with respect, and adhering to legal and moral standards. It is also about ensuring that the company’s practices do not harm individuals or communities and that they operate with integrity.

  • Philanthropy:

Many companies engage in philanthropic activities such as charitable donations, volunteering, and sponsoring community development initiatives. While this is just one aspect of CSR, it plays a key role in improving the social and economic well-being of the communities where businesses operate.

  • Stakeholder Engagement:

A key element of CSR is maintaining good relationships with all stakeholders, including employees, customers, suppliers, investors, and local communities. By engaging stakeholders and addressing their concerns, companies can better understand societal expectations and improve their CSR strategies.

Importance of CSR:

  • Building Brand Reputation and Trust:

Companies that actively engage in CSR build a strong reputation as responsible corporate citizens. This enhances their brand image and fosters trust among consumers, investors, and other stakeholders. A positive reputation can lead to increased customer loyalty, improved employee morale, and better relationships with government and regulatory bodies.

  • Attracting and Retaining Talent:

Today’s workforce is increasingly attracted to companies that align with their values. Companies with strong CSR practices are more likely to attract top talent who want to work for organizations that are committed to making a positive impact. Employees who feel that their employer is socially responsible are also more likely to stay with the company long-term, leading to lower turnover rates.

  • Customer Loyalty:

Consumers are becoming more socially conscious and prefer to purchase from companies that share their values and demonstrate a commitment to social and environmental responsibility. CSR initiatives such as ethical sourcing, fair trade, and environmental sustainability can lead to greater customer loyalty and support for a company’s products and services.

  • Financial Performance:

Contrary to the belief that CSR is a financial burden, many studies have shown that companies that invest in CSR programs can achieve better financial performance over time. Engaging in ethical and socially responsible practices can lead to cost savings (e.g., through energy efficiency and waste reduction), enhanced brand value, and increased consumer demand.

  • Risk Management:

CSR can help companies mitigate risks related to their operations. By addressing social and environmental concerns, companies can avoid negative publicity, fines, and legal challenges. Proactively managing CSR helps businesses avoid potential controversies that could damage their reputation and harm their financial stability.

  • Sustainable Development:

CSR plays a crucial role in promoting sustainable development. By taking a long-term view of their impact on society and the environment, companies can contribute to sustainable economic development. CSR initiatives such as promoting renewable energy, reducing waste, and improving labor standards all support the global goal of sustainability.

CSR and Its Stakeholders:

  • Employees:

A company’s commitment to CSR enhances employee morale and job satisfaction. Employees tend to feel proud to work for an organization that is socially responsible and committed to ethical practices. CSR programs can also offer employees opportunities for personal involvement, such as volunteer work or engagement in community initiatives.

  • Customers:

Customers are increasingly seeking products and services that are produced ethically and sustainably. Companies that prioritize CSR are likely to attract socially conscious consumers who care about the origins and environmental impact of the products they purchase. CSR initiatives enhance customer loyalty and retention.

  • Shareholders and Investors:

Investors are placing greater emphasis on companies that adopt CSR practices. Many institutional investors look for businesses that not only promise financial returns but also adhere to environmental, social, and governance (ESG) principles. A strong CSR program can make a company more attractive to investors, leading to increased funding and support.

  • Communities:

CSR helps to improve the social and economic conditions of the communities where a company operates. Whether through donations, community development programs, or local environmental initiatives, businesses can directly contribute to improving the standard of living and well-being in the regions they serve.

  • Government and Regulatory Bodies:

Governments are increasingly requiring businesses to adhere to CSR-related regulations, especially in areas like environmental protection, labor rights, and corporate governance. Companies that proactively adopt CSR policies can reduce their exposure to regulatory risks and improve their relationship with government bodies.

Applicability of CSR as per Section 135 of Companies Act 2013:

Section 135 of the Companies Act, 2013 mandates Corporate Social Responsibility (CSR) for companies meeting specific financial thresholds. The provision applies to every company, including its holding or subsidiary and foreign companies having a branch office or project office in India, that satisfies any one of the following criteria in the immediately preceding financial year:

✅ Applicability Criteria (Any one of the following):

  1. Net worth of ₹500 crore or more,

  2. Turnover of ₹1,000 crore or more, or

  3. Net profit of ₹5 crore or more.

Requirements for Applicable Companies

  1. CSR Committee:
    Companies to whom CSR is applicable must constitute a CSR Committee of the Board with:

    • At least 3 directors (including 1 independent director),

    • (Private companies need only 2 directors; unlisted/public companies with no independent director are exempt from appointing one).

  2. CSR Policy:
    The CSR Committee shall:

    • Formulate and recommend a CSR Policy to the Board,

    • Recommend the amount of expenditure,

    • Monitor the CSR policy implementation.

  3. Minimum CSR Expenditure:
    The Board must ensure that the company spends at least 2% of the average net profits (before tax) made during the three immediately preceding financial years on CSR activities.

  4. Disclosure:

CSR policy and initiatives must be disclosed in the Board’s report and on the company website, if any.

CSR Activities (Schedule VII)

CSR initiatives must fall under activities specified in Schedule VII, such as:

  • Eradicating hunger and poverty,

  • Promoting education and gender equality,

  • Environmental sustainability,

  • Protection of national heritage,

  • Support to armed forces veterans,

  • PM’s National Relief Fund, etc.

Penalty for Non-Compliance (Post Amendment):

As per the Companies (Amendment) Act, 2019:

  • If the required amount is not spent, the company must transfer the unspent amount to a specified fund (like PM CARES) within a stipulated time.

  • Non-compliance attracts penalty:

    • Company: Twice the unspent amount or ₹1 crore (whichever is less),

    • Officers in default: 1/10th of the unspent amount or ₹2 lakh (whichever is less).

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