Accounting Rules & Taxation FRS 12

Interaction of accounting rules and taxation

FRS 12 Provisions, Contingent Liabilities and Contingent Assets

FRS 12 applies as regards accounts for periods ending on or after 23 March 1999. The new standard applies to all financial statements intending to provide a true and fair view, subject to a number of exceptions set out in the FRS. In particular, the FRS does not apply to financial statements covered by more specific requirements in another FRS or a SSAP. This article deals with the interaction of the new FRS with tax computations.

Background note on FRS 12

The objective of FRS 12 is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount.

The Standard replaces SSAP 18, Accounting for Contingencies, and makes a minor amendment to FRS 3, Reporting Financial Performance. It was developed as part of a joint project with the International Accounting Standards Committee, who produced IAS 37 on the same topic.

The Standard attempts to produce a consistent method of accounting for provisions, contingent liabilities and contingent assets while also applying the fundamental accounting concept of prudence to the recognition of contingent liabilities. It does this by requiring that a provision should be recognised only when the following conditions are satisfied:

• an entity has a present obligation (legal or constructive) as a result of a past event;
• it is probable that a transfer of economic benefits will be required to settle the obligation; and
• a reliable estimate can be made of the amount of the obligation.

A clear distinction is drawn between an intention to incur expenditure and an obligation to do so. The mere intention to incur expenditure is not sufficient to justify the making of a provision.

In a number of situations where, in the past, provisions were made on the basis of potential or even probable future losses, such provisions must now be written back. Unless the entity can clearly prove that an obligation exists, such provisions are in contravention of FRS 12. This change may entail a change in accounting policy [e.g. where no provision was previously required but one is required under FRS 12 or vice versa] or a change in an accounting estimate [i.e. where the amount of a provision requires to be recalculated].

General rule as regards provisions

Apart from Section 81(2)(i) TCA 1997 which deals with the allowance for doubtful debts, the Tax Acts are silent as regards the question of provisions. Accordingly, the allowability of a provision will depend on whether the provision is necessary in ascertaining the full profits for tax purposes.

Revenue has up to now treated a provision as allowable for tax purposes if

• The provision did not seek to anticipate a loss i.e. the provision did not refer to expenditure which had not been incurred [see paragraph 12 of the Revenue Commissioners' memorandum (April 1975) to the Accountancy Bodies on SSAP 9 - the text of paragraph 12 is set out at the end of this article].
• The expenditure in respect of which the provision was made would be an allowable deduction in computing profits for tax purposes - for example, the expenditure would not be capital expenditure
• It is made in accordance with the correct principles of commercial accounting
• It can be estimated with a reasonable degree of accuracy n It is made to correctly ascertain the full profits for tax purposes, being the receipts during the year and the expenditure laid out to earn those receipts

New Revenue approach to provisions

In the light of a number of recent UK court decisions, Revenue is prepared to accept that there is no longer any rule of tax law which prohibits a provision for future losses, where such a provision is required in accordance with a system of commercial accounting which correctly ascertains the full profits for tax purposes of the trader. Revenue accepts that a provision made in accordance with generally accepted accounting practice [GAAP], including a provision make in accordance with FRS 12, is made in accordance with such a system. Revenue also accepts that a provision for a loss on a contract, made in accordance with paragraph 9 of Part 1 of SSAP 9, is no longer precluded on the basis that the provision takes account of expenditure which has not yet been incurred. The other requirements governing the allowability of a provision, which are listed above, continue to apply.

Where there is a doubt as to whether a provision is allowable for tax purposes, taxpayers should avail of the expression of doubt facility in section 955(4) TCA 1997.

An examination of the facts supporting provisions is a normal part of Revenue's audit programmes.

Prior year adjustments arising from FRS 12

FRS 12 introduces a more stringent test as regards the making of provisions in accounts. Where provisions have been made in previous years, an accounting adjustment may be required to the first accounts for periods ended on or after 23 March 1999. FRS 12 states that any such adjustment should be made by restating the comparative figures for the preceding year and adjusting the opening balance of the reserves for the cumulative effect.

The treatment, for tax purposes, of such an accounting adjustment will depend on whether the provision was allowed for tax purposes for the period in which it was made.

• If the provision was allowed for tax purposes for the period in which it was made, the accounting adjustment should be included in the profits for tax purposes of the period in which the change in accounting policy took place.

Provisions disallowed for tax purposes in the past

Where a provision was previously disallowed on the basis that it anticipated a loss, the earlier year will not be re-opened. The return of income for these periods, which would have taken account of such an adjustment, would have been prepared in accordance with the practice generally prevailing at the time. Accordingly, error or mistake claims under section 930 TCA 1997, will not be admitted in respect of such adjustments. The provision, calculated in accordance with FRS 12, may be claimed in the first open accounting period ending on or after 23 March 1999.

Provisions which should have been diallowed for tax purposes in the past

Where a provision had been claimed for tax purposes for accounting periods ending before 23 March 1999 and allowed under the self-assessment system, Inspectors will not now seek to disallow the provision on the grounds that the provision anticipates a loss.

Where provisions which are not allowable for some other reason [e.g. because they are capital in nature] had been claimed for tax purposes in the period in which they were made, taxpayers should contact their local Inspector to agree the adjustment due for the earlier period together with any interest and penalties which may arise.

[References to the period in which a provision was made include a reference to basis periods for years of assessment.