PROPOSED INVENTORY VALUATION BY COST ACCOUNTANT

[ANIL ANIKHINDI]

Introduction

Probably first time in the history of our profession, an authorized entry to “Aaykar Bhavan” for Cost Accountants is proposed in the Finance Bill presented to the Parliament through Budget 2023. The amendment to the Income Tax Act is proposed for special audit/assignment for Inventory Valuation by Cost Accountant which shall be ordered by the Assessing Officer under the specified situation.

Proposed Amendment to Income Tax Act

Sections 142(2A) and 142(2D) are proposed to be amended as below:

(2A) If, at any stage of the proceedings before him, the Assessing Officer, having regard to the nature and complexity of the accounts, volume of the accounts, doubts about the correctness of the accounts, multiplicity of transactions in the accounts or specialised nature of business activity of the assessee, and the interests of the revenue, is of the opinion that it is necessary so to do, he may, with the previous approval of the Principal Chief Commissioner or Chief Commissioner or Principal Commissioner or Commissioner, direct the assessee to get either or both of the following, namely:––

(i) to get the accounts audited by an accountant, as defined in the Explanation below sub-section (2) of section 288, nominated by the Principal Chief Commissioner or Chief Commissioner or Principal Commissioner or Commissioner in this behalf and to furnish a report of such audit in the prescribed form duly signed and verified by such accountant and setting forth such particulars, as may be prescribed, and such other particulars as the Assessing Officer may require;

(ii) to get the inventory valued by a cost accountant, nominated by the Principal Chief Commissioner or Chief Commissioner or Principal Commissioner or Commissioner in this behalf and to furnish a report of such inventory valuation in the prescribed form duly signed and verified by such cost accountant and setting forth such particulars, as may be prescribed, and such other particulars as the Assessing Officer may require,

Provided that the Assessing Officer shall not direct the assessee to get the accounts so audited or inventory so valued unless the assessee has been given a reasonable opportunity of being heard,

(2B) The provisions of sub- section (2A) shall have effect notwithstanding that the accounts of the assessee have been audited under any other law for the time being in force or otherwise.

(2C) Every report under sub- section (2A) shall be furnished by the assessee to the Assessing Officer within such period as may be specified by the Assessing Officer:

Provided that the Assessing Officer may, on an application made in this behalf by the assessee and for any good and sufficient reason, extend the said period by such further period or periods as he thinks fit;

(2D) The expenses of, and incidental to, any audit under sub-section audit or inventory valuation under sub-section (2A) (including the remuneration of the accountant or the cost accountant, as the case may be) shall be determined by the Principal Chief Commissioner or Chief Commissioner or Principal Commissioner or Commissioner] (which determination shall be final) and paid by the assessee and in default of such payment, shall be recoverable from the assessee in the manner provided in Chapter XVII-D for the recovery of arrears of tax :

Provided that where any direction for audit or inventory valuation under sub-section (2A) is issued by the Assessing Officer on or after the 1st day of June, 2007, the expenses of, and incidental to, such audit or inventory valuation (including the remuneration of the accountant or the cost accountant, as the case may be) shall be determined by the Principal Chief Commissioner or Chief Commissioner or Principal Commissioner or Commissioner in accordance with such guidelines as may be prescribed and the expenses so determined shall be paid by the Central Government.

Explanation –– For the purposes of this section, “cost accountant” means a cost accountant as defined in clause (b) of sub-section (1) of section 2 of the Cost and Works Accountants Act, 1959 and who holds a valid certificate of practice under sub-section (1) of section 6 of the said Act.

Intention of law for this proposed amendment

Explanatory Statement issued with the Finance Bill 2023 specifies the need behind the proposed amendment as below:

Preventing permanent deferral of taxes through undervaluation of inventory

Assessees are required to maintain books of account for the purposes of the Act. The Central Government has notified the Income Computation and Disclosure Standards (ICDS) for the computation of income. ICDS-II relates to valuation of inventory. Section 148 of the Companies Act 2013 also mandates maintenance of cost records and its audit by cost accountant in some cases.

1. 2. In order to ensure that the inventory is valued in accordance with various provisions of law, it is proposed to amend section 142 of the Act relating to Inquiry before assessment to ensure the following:-

1. 1. 1.  To enable the Assessing Officer to direct the assessee to get the inventory valued by a cost accountant, nominated by the Principal Chief Commissioner or Chief Commissioner or Principal Commissioner or Commissioner in this behalf. Assessee is then required to furnish the report of inventory valuation in the prescribed form duly signed and verified by such cost accountant and setting forth such particulars as may be prescribed and such other particulars as the Assessing Officer may require.
      2. To provide that the expenses of, and incidental to, such inventory valuation (including remuneration of the cost accountant) shall be determined by the Principal Chief Commissioner or Chief Commissioner or Principal Commissioner or Commissioner in accordance with the prescribed guidelines and that the expenses so determined shall be paid by the Central Government.
      3. To provide that except where the assessment is made under section 144 of the Act, the assessee will be given an opportunity of being heard in respect of any material gathered on the basis of such inventory valuation which is proposed to be utilized for assessment.
      4. To define “cost accountant” to mean a cost accountant as defined in clause (b) of sub-section (1) of section 2 of the Cost and Works Accountants Act, 1959 (23 of 1959) and who holds a valid certificate of practice under sub-section (1) of section 6 of that Act.

Above proposed amendment is of a nature of Special Audit/Assignment to be ordered by the Assessing officer in specific situation and with prior approval of higher authorities. Whenever the assessing officer faces difficulties in the assessment of business profits for taxation having impact of Inventory valuation and interest of revenue, he may initiate such type of special assignment. Such special audit/assignments are to be carried out by the Cost Accountants nominated by the Income Tax department. The report of such valuation shall be obtained by the assessee and to be submitted by the assessee to the Assessing Officer.  From the above explanation it is seen that the Central Government is aware about the practices followed by the business entities to adjust or reduce profit by managing the valuation of Inventory to avoid or defer tax on business profits.

The cases that may be selected for the special assignment may have any one of the five situations specified in sub-section 2A viz.:

nature and complexity of the accounts,

volume of the accounts,

doubts about the correctness of the accounts,

multiplicity of transactions in the accounts or

specialised nature of business activity of the assessee,

and

the interests of the revenue.

Hence the condition “interest of the revenue” is necessary in the cases to be selected.

There are various mandates already issued by the authorities in relation to the manner and method to be adopted for inventory valuation, such as:

Accounting Standards (AS 2)

Indian Accounting Standards (IND-AS 2)

Income Computation Disclosure Standards (ICDS-II)

Companies (Cost Records and Audit) Rules 2014 (CRA-1)

Cost Accounting Standards (CAS 1 to 24)

Generally Accepted Cost Accounting Principles (GACAP)

Guidance Note on Inventory Valuation issued by ICAI     

The overall theme or the principles lying behind all these mandates are as below:

1. Inventories shall be valued at cost or Net Realisable Value, whichever is lower.
2. The cost of inventories shall comprise of all cost of purchase, cost of services, cost of conversion and other costs incurred, in bringing the inventories to their present location and condition.
3. Interest and other borrowing costs shall not be included in the cost of inventories unless they meet the criteria for recognition of interest as a component of the cost as specified in the ICDS on borrowing cost. Also, selling costs, administrative overheads, storage costs (unless necessary in the production process) and abnormal amounts of wasted material, labour etc. to be excluded from the cost of inventories.
4. Cost of inventories shall be assigned by using First In First Out or weighted average cost formula.
5. Techniques for the measurement of the cost of inventories, such as the standard cost method or the retail method, may be used for convenience if the results approximate the actual cost.
6. Inventories shall be written down to net realizable value on an item-by-item basis. Where 'items of inventory' relating to the same product line having similar purposes or end uses and are produced and marketed in the same geographical area and cannot be practicably evaluated separately from other items in that product line, such inventories shall be grouped together and written down to net realisable value on an aggregate basis.
7. The method of valuation of inventories once adopted by a person in any previous year shall not be changed without reasonable cause.

Above explanation underlines the importance of Cost Records for the business entities. The cost records are required to be properly maintained from time to time so as to determine cost of production for every product on a “true and fair” basis. While determining the cost of production, it is imperative to consider all normal situations such as capacity utilization, wastages, process losses, efficiencies, labour deployment, overhead absorption, fixed costs, input-output norms etc. All abnormalities such as, substantial under-utilization of capacity, abnormal wastages/process losses, Cost of idle assets, inefficiencies, abnormal rejections, irrelevant costs, non-operative nature of costs/incomes etc. are required to be properly treated in the determination of cost of production.

Coverage / scope of proposed amendment

All types of Inventories are covered in the proposed amendment relating to the valuation, such as, Raw Materials, Components, Work in Progress/Process, Finished Goods, Stores & Spares, Packing materials, Power & fuel, Scrap and Wastages, By-products etc. The prescribed method of valuation and mandate has to be applied, as may be applicable, looking to the nature of Inventory and to be followed consistently.

Moreover all types of assessees such as, Individual, Partnership Firms, LLPs, Companies, Co-operatives, AOP/BOI are covered as far as the nature of business of the assessee is concerned.

From the above it is very clear that eventhough every assessee may not be selected for “special assignment” u/s 142 (2A)(ii), it will be always expected that the assessees should take all efforts  and care to properly value the inventory by complying with the applicable mandates.

The cost audit reports (u/s 148 of The Companies Act 2013) submitted to the Central Government includes Annexure (para D-2) which gives reconciliation of Profit/Loss as per Cost accounts and Profit/Loss as per Financial accounts. One of the major reason for difference between the two is “difference between the Valuation of Inventory as per Cost accounts and as per Financial Accounts”. In the cost accounting records the valuation is “at cost” while in financial accounts it is “at lower of the Cost or NRV”. Here “Cost” means always Cost of Production determined as per the applicable accounting standards. Many times it is seen that while finalizing the Balance sheet, the cost is estimated and inventory is valued at such “estimated cost”. But the cost accounting records which are generally compiled on yearly basis, gives “annual average cost of production” used for inventory valuation. This issue now needs to be addressed by following the practice of compiling and finalizing cost accounting records by the entities before finalization of Balance sheet so as to avoid the difference in both sets of valuation. This will definitely avoid the chance of being selected for “special assignment” (as proposed) by the assessing officer.  CMAs have to play a very crucial role in this aspect.

In the case of non-corporate assessees and “no cost audit” cases, the possibility of selection for “special assignment” is much more since the existing audits are not able to detect the improper valuation of inventory resulting into “permanent deferment of tax by undervaluation”. There will be great amount of scope for the CMAs now in such cases to assist such business entities for maintaining proper cost records and determining fair valuation of inventory by complying with the applicable standards.

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CMA (Dr.) Anil Anikhindi