Wednesday, April 26, 2006



Surely accountants not lawyers ought to decide what are the principles of commercial accountancy! This remark is prompted by the mess that a succession of lawyers seem to me to have made in the related cases of Small v Mars Ltd and CIR v William Grant & Sons Ltd. These both relate to the inclusion of depreciation in stock. Take William Grant for example. In the year to 28 December 2002 it depreciated land and buildings by £1.585m and plant, vehicles and casks by £5.120m, a total of £6.705m. The accounting entries were debit profit and loss account £5.010m, debit stock £1.695m and credit depreciation £6.705m.

The tax legislation disallows a deduction for depreciation in calculating taxable profits. So how much of the £6.705m was deducted in the profit and loss account and falls to be disallowed? Surely all accountants would say £5.110m. Indeed so would some lawyers. It is what the two Special Commissioners who heard the case, Dr Nuala Brice and John Walters QC thought. It is also what Lord Reed thought in a thoughtful and compelling judgement in the Court of Session. Sadly it is not what Mr Justice Lightman thought when hearing the Mars case in the High Court not what Lord Penrose and Lord Osborne thought in their majority decision in William Grant in the Court of Session. They all felt that somehow £6.705m had been deducted in the profit and loss account and therefore fell to be disallowed.

The fallacy of this view is well brought out by Lord Reed when he asks what would have happened in year 1 if no stock were sold. The profit and loss account would show a break even position but the tax computation would show £1.695m profit if his colleagues view was correct. It is difficult to see how even an eminent lawyer can justify such a result.

Mr Justice Lightman’s judgement is difficult to follow. He starts by affirming that the issue turns on whether the calculation of profits is a question of law or to be determined in accordance with current accepted principles of commercial accountancy and comes down firmly in favour of the latter. He next held that under such principles “there is no notional purchase of opening or sale of closing stock, the stock is merely carried forward”. He then somehow held that what had really happened (using the above William Grant figures for illustration rather than the Mars ones) was that as the balance sheet showed £6,705m depreciation this figure should somehow have been charged to the profit and loss account and the £1.695m credited against it to arrive at a net charge of £5.110m – so the whole of £6.75m had been deducted and falls to be added back. This seems to be a complete non sequitur. It flies in the face of both the evidence and of his own conclusion that “the stock is merely carried forward”.

Lord Penrose took as his starting point a 1925 tax case, Whimster & Co v CIR, which did not involve stock (it involved the anticipation of losses on ship charters), was decided by the Commissioners on the basis of agreed facts, and in which it does not appear that accountancy evidence was called by either side. “Arithmetically the operating profit is precisely the same as it would have been if a trading and profit and loss account had been prepared in traditional form. [by which he seems to mean if opening stock had been debited to profit and loss account and closing stock credited to profit and loss account instead of merely “cost of sales” being debited in the account]. But the omission of opening and closing stock is not simply a short cut. It reflects a difference in understanding of what is required by GAAP to arrive at a proper statement of operating profits from that which would have been reflected in accounting evidence in 1925 when Lord President Clyde went on to say [in Whimster] “For example, the ordinary principles of commercial accounting require that in the profit and loss account of a merchant’s or manufacturer’s business the values of the stock-in-trade at the beginning and at the end of the period covered by the account should be entered at cost or market price, whichever is the lower; although there is nothing about this in the taxing statutes”. At that stage in the development of accounting practice it is difficult to envisage any other approach”.

He attributes the change to computer power. “However”, he goes on to say, “it is important to note that, whatever development had taken place…the focus remains the same: adjusting for stock at the beginning and end of the accounting period at cost or market value. The alternative was, and in my view remains, important. The required adjustment has at no time been confined to an adjustment related to cost…It is clear that the net realisable value alternative involves the recognition as an expense, in a period during which the goods in question have not been sold, of costs that have not been incurred in generating the receipts of that period. That, in my view, suggests that one must be slow to reduce the issue of principle in this case to one of accounting for cost or for expense…It is immaterial that a trader…could apportion the reduction over cost headings as a matter of bookkeeping. The recognition that the corporeal stock had a value derived externally from market conditions would be an inescapable part of the process of computing the amount of the reduction.”

Most accountants would find two fallacies in this argument. Reducing stock to market value is not anticipating a loss; it is recognising that the value has fallen while the stock is being held and that fall ought properly to be regarded as a result of the activity in the accounting period of holding the stock. Secondly, reflecting that fall in value does not of itself involve recognising the stock itself as a cost or expense (or a credit) in the accounts. The basic accounting principle of matching costs and receipts requires the exclusion of costs that do not relate to the period concerned, not their initial inclusion followed by a credit to exclude them.

Lord Penrose then follows the Lightman approach of looking at the Companies Act requirement to show depreciation separately on the balance sheet and concluding from this that the balance sheet figure must have been credited to profit and loss account and part then removed by capitalising it.

He then decides that Whimster (and some later cases in which accountancy evidence was again not called) “provide support for the view, on which the Revenue relied, that there is a rule of law requiring the computation of profits for corporation tax purposes on a basis that explicitly brings into account opening and closing stock figures ascertained at the lower of cost and net realisable value. In terms of current GAAP that accounting procedure would require now to reflect depreciation applied in ascertaining stock figures to be included. To that extent there has been development of the accounting practices employed to measure stock, but no change in the asset whose cost is to be measured”.

This seems a quite extra-ordinary approach. It basically says accountants try to match costs and income. They do this by by-passing from the accounts costs that do not relate to the year. But lawyers think that is unreasonable. The accountants need to recognise both the cost of opening stock and the cost of closing stock to prepare proper legal accounts. Accordingly as, contrary to the facts, that is what William Grant ought to have done its accounts need to be rewritten to bring in opening and closing stock so that the depreciation figure in the profit and loss account conforms with that in the balance sheet and can therefore be disallowed for tax purposes.

It is likely that both of these cases will go to the House of Lords. It is to be hoped that their lordships will be convinced by the argument of Lord Reed, which is the only of the judgements that, to an accountant, accords both with the facts and with the logic of the accounting principles.

Robert W Maas


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