STOCK VALUATION - No real and substantial impact on revenue over two years hence additions are not result oriented and assessee should not be forced to pursue litigation

[C.A. DEV KUMAR KOTHARI]

Provisions of sections 28, 29, 145 and 145A of the Income-tax Act, 1961

CIT v. Punjab State Industrial Development Corpn. Ltd. 2002 (2) TMI 78 (HC)

CIT v. B. Amrithalakshmi 2007 (6) TMI 164 (HC)

Sarupchand v. CIT 1936 (3) TMI 1 (HC)

Indo-Commercial Bank Ltd. v. CIT 1961 (3) TMI 77 (HC);

Forest Industries Travancore Ltd. v CIT 1963 (8) TMI 31 (HC); (iii)

New Victoria Mills Co. Ltd. v. CIT 1965 (7) TMI 39 (HC);

Dr. Ishwari Prasad v. CIT 1982 (11) TMI 37 (HC)

CIT v. Shriram Associated Bearing (P) Ltd. [1984] 150 ITR (St.) 77 (SC);

CIT v. Hind Lamps Ltd. [1987] Taxation 85 (3) 225 (All);

CIT v. Mopeds India Ltd. 1988 (3) TMI 34 (HC)

CIT v. Bikaner Trading Co. 1989 (3) TMI 73 (HC)

CIT v. Hollungooree Tea Co. 1990 (2) TMI 11 (HC)

CIT v. Corpn. Bank Ltd. 1988 (8) TMI 90 (HC)

CIT v. Dalmia Cement (Bharat) Ltd. - 1995 (5) TMI 22 (HC)

Reform Flour Mills (P) Ltd. v. CIT 1978 (3) TMI 80 (HC)

Snow White Food Products Co. Ltd. v. CIT 1981 (11) TMI 27 (HC)

Snow White Foods Products Co. Ltd. v. CIT 1981 (11) TMI 26 (HC)

CIT v. Modi Rubber Ltd. 1998 (1) TMI 68 (HC)

CIT v. Punjab State Industrial Development Corpn. Ltd. 2002 (2) TMI 78 (HC)

 CIT v. Indo Rama Synthetics Ltd. 2009 (1) TMI 522 (HC) Sahara India Mass Communication Ltd. v. Asstt. CIT [IT Appeal No.522 (Mum.) of 2006 dated 28-4-2011]

Ajanta Raj Proteins Ltd. v. Dy. CIT  2009 (6) TMI 122 (Tri) is not applicable to the assessee's case as in that case Tribunal dealt with the change of method of accounting of closing stock which was earlier valued at cost and subsequently valued at net realizable value. Hence, in that case, the method was changed from 'At cost' to 'Net realizable value'. He pleaded that no such circumstances exist in the present case. The assessee continues to value the inventory at cost only.

Stock valuation have only effect for one year on revenue:

Stock valuation is an important aspect for the purpose of ascertaining true and fair view of the state of affairs and also profit or loss for a particular period for which final accounts are drawn. Closing stock as on end of any  year is reflected on credit side of the Profit and Loss account as an item of income the same stock value   is reflected on debit  side of the Profit and Loss account as an item of  expenditure in just the next year. Therefore, if the valuation of stock as on end of first year results into some tax saving, if at all, such tax saving is very temporary as the same stock is taken as opening stock and the amount of income reduced on valuation becomes part of income of next year. For example:

In first year stock is valued on some basis adopted by the assessee and as per other basis (as per AO) the valuation should be higher by say Rs. one crore, thus the AO takes view that income is reduced by Rs. one crore. AO makes addition and suppose the same is accepted by the assessee.

In the next year the stock valuation adopted by AO in first year will have to be considered as value of opening stock for tax purposes. Therefore, in next year the AO will have to allow a further deduction of Rs. one crore.

Thus we find that addition made in first year is deductible in the next year.

Impact for assessee may be perceptible but not for revenue:

Now let us see the impact. For an assessee retention of cash by way of tax saving for few months can be very vital as he may be able to face difficult financial times. By saving tax in first year he only improves cash availability temporarily. He has to pay tax in next year, and in case of company assessee payment of tax starts from 15^th June by way of 1^st installment of advance tax. However, deferment of tax payment of say about Rs.35 lakh may be an important decision to survive in competitive business. The savings made in first year will improve capital bases and profitability of assessee in next year and he may be able to earn better profit to pay higher tax.

For the revenue as a whole such deferment of tax collection hardly makes any impact in overall context of revenue collection. In fact, improved capital base of assessee in first year will offset the loss of revenue in next year by higher profit and higher tax in next year. Therefore, revenue is not loser at all in long term and not in any significant manner in short term. If at all there is some loss in first year, it improves chances of better tax in future.

Therefore, there should not be litigation on the aspect of stock valuation. Unfortunately we find that revenue is indulging into lot of litigation on the issue of stock valuation. Cases have been noticed in which additions to stock is made, although there is no tax liability of assessee due to losses brought forwarded and / or carried forwarded in such circumstances revenue is not at all loser and there is not even deferment of tax.

Additions beneficial to assessee in case of losses carried forward:

Cases have also been noticed in which additions on account of stock valuation is made and loss is reduced in say first year and consequently in second year loss is increased. In such cases, assessee is in fact gainer because eligibility period of loss, to the extent of loss increased in second year is increased because loss of first year is reduced and loss of second year is increased.

Assessee is forced to contest and litigate and the revenue also contest even without meaningful purpose:

Assessee has to contest the additions because otherwise the AO may impose penalty and open another area of litigation will start. Thus even in case where losses are accumulated and are likely lapse without set off, assessee has to contest addition on account of stock. When assessee contest, the revenue has also to contest appeals of assessee and if assessee wins at one stage the revenue goes in further appeal to contest its stand though it may be neutral so far revenue collection is concerned.      

Avoidable litigation:

The above discussion shows that so far revenue is concerned, there is ether no loss to the revenue or even if there is loss it is not material. Therefore, it is desirable that the revenue should not indulge into litigation on account of stock valuation. For this purpose the CBDT can issue guidelines to the Assessing Officer to consider the assessment records of assessment year and the next assessment year, and if there is only deferment of tax it should be accepted as a measure of strengthening capital base of assessee and also to avoid un-necessary litigation.

Stock valuation and basic accounting theories:

The stock valuation basis also need to satisfy concepts of prudence, conservative theory, booking all losses, matching principals etc. Therefore, a lower stock valuation is generally accepted in due course if the assessee is able to satisfy the prudence aspect.

As per Boards Circulars on accounting standards vide NOTIFICATION NO. S.O.69 (E)  DATED 25-1-1996 the assessee has to follow rules of a. reasonable estimate as per prevailing facts and circumstances, b. rule of matching, c. prudential estimates for expenses or losses. In this regard relevnt portion of the notification is reproduced below with highlights by way of underlining and red colour:

NOTIFICATION NO. S.O.69 (E) DATED 25-1-1996

In exercise of the powers conferred by sub-section (2) of section 145 of the Income-tax Act, 1961 (43 of 1961), the Central Government hereby notifies the following accounting standards to be followed by all assessees following the mercantile system of accounting, namely :

 A. Accounting Standard I relating to disclosure of accounting policies :

Xxx:

 (3) Any change in an accounting policy which has a material effect in the previous year or in the years subsequent to the previous years shall be disclosed. The impact of, and the adjustments resulting from, such change, if material, shall be shown in the financial statements of the period in which such change is made to reflect the effect of such change. Where the effect of such change is not ascertainable, wholly or in part, the fact shall be indicated. If a change is made in the accounting policies which has no material effect on the financial statements for the previous year but which is reasonably expected to have a material effect in any year subsequent to the previous year, the fact of such change shall be appropriately disclosed in the previous year in which the change is adopted.

(4) Accounting policies adopted by an assessee should be such so as to represent a true and fair view of the state of affairs of the business, profession or vocation in the financial statements prepared and presented on the basis of such accounting policies. For this purpose, the major considerations governing the selection and application of accounting policies are the following, namely :--

(i) Prudence.--Provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information;

 (iii) Materiality.--Financial statements should disclose all material items, the knowledge of which might influence the decisions of the user of the financial statements.

 (6) For the purposes of paragraphs (1) to (5), the expressions,--

(a) "Accounting policies" means the specific accounting principles and the methods of applying those principles adopted by the assessee in the preparation and presentation of financial statements ;

(b) "Accrual" refers to the assumption that revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate ;

(c) "Consistency" refers to the assumption that accounting policies are consistent from one period to another ;

B. Accounting standard II relating to disclosure of prior period and extraordinary items and changes in accounting policies :

9) A change in an accounting policy shall be made only if the adoption of a different accounting policy is required by statute or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements by an assessee.

(10) Any change in an accounting policy which has a material effect shall be disclosed.  …

 (11) A change in an accounting estimate that has a material effect in the previous year shall be disclosed and quantified. Any change in an accounting estimate which is reasonably expected to have a material effect in years subsequent to the previous year shall also be disclosed.

(12) If a question arises as to whether a change is a change in accounting policy or a change in an accounting estimate, such a question shall be referred to the Board for decision.

Observations of author:

On reading of the above notification we find that a change in method of accounting is permissible and it is not a case that there cannot be any change in method of accounting. Valuation of stock is an important aspect in  accounting method. Valuation of stock should be such that it consider that all possible losses are accounted for and that any probable or contingent profit is not considered as income.

On reading of paragraph  B. 9 of the notification we find that change in method of accounting is mandatory in some situations such situations are as follows :

1. when adoption of a different accounting policy is required by statute and
2.  if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements by an assessee.

General aspects about change in accounting methods:

Change in accounting method is permissible when one recognized method is substituted by another recognized method, the change is to be followed in future and there is not a casual departure due to such change, and when circumstances exists which shows need for such a change and also bonafide for a change, mere reduction of tax liability or deferment of tax liability will not affect permissibility of change in method of accounting. Therefore, the assessee should prepare a note about these aspects , keep supporting documents ready and in case of an institutional assessee like company or co-operative society, society  and even in case of a partnership firm appropriate resolution should be passed by the Board of Directors, Executive committee or the partners to show that a conscious decision was taken in view of prevailing circumstances to change the method of accounting.

Cost or market values whichever is less:

The generally accepted meth of stock valuation is ‘Cost or market value whichever is less’. This method is based on the theories which reflect conservative theory, reasonable estimate ,  prudence, and matching principal to ensure that stock is valued in such a manner that all possible losses are accounted for and probable income is not credited in form of stock valuation.

Meaning of cost:

In context of stock valuation meaning of cost of stock may differ in different situations. Whatever, basis of cost be adopted, it will have not much impact and whatsoever impact is found will have a temporary impact because closing stock of any year is opening stock of the next year.     

From http://www.fasab.gov/pdffiles/costacc_glossary.pdf  we find some of relevant definitions of cost as follows:

Actual Cost - An amount determined on the basis of cost incurred including standard cost properly adjusted for applicable variance.

Avoidable Cost - A cost associated with an activity that would not be incurred if the activity were not performed.

Common Cost - The cost of resources employed jointly in the production of two or more outputs and the cost cannot be directly traced to any one of those outputs.

Cost - The monetary value of resources used or sacrificed or liabilities incurred to achieve an objective, such as to acquire or produce a good or to perform an activity or service.

Differential Cost - The cost difference expected if one course of action is adopted instead of others.

Direct Cost - The cost of resources directly consumed by an activity. Direct costs are assigned to activities by direct tracing of units of resources consumed by individual activities. A cost that is specifically identified with a single cost object.

Estimated Cost - The process of projecting a future result in terms of cost, based on information available at the time. Estimated costs, rather than actual costs, are sometimes the basis for credits to work-in-process accounts and debits to finished goods inventory.

Full-Absorption Costing - A method of costing that assigns (absorbs) all labor, material, and service/manufacturing facilities and support costs to products or other cost objects. The costs assigned include those that do and do not vary with the level of activity performed.

Full Cost - The sum of all costs required by a cost object including the costs of activities performed by other entities regardless of funding sources.

Standard Costing - A costing method that attaches costs to cost objects based on reasonable estimates or cost studies and by means of budgeted rates rather than according to actual costs incurred. The anticipated cost of producing a unit of output. A predetermined cost to be assigned to products produced. Standard cost implies a norm, or what costs should be.

Standard costing may be based on estimate.

There can be different basis of ascertaining cost of stock and in different circumstances different composition of cost and method of ascertaining cost may be appropriate. With changes in circumstances, the basis of ascertainment of cost can also undergo a change.

Method of ascertaining cost:

Cost of stock can be ascertained in different manner and on different basis. Some of recognized methods are Average cost, weighted average cost, FIFO method, LIFO method, base stock cost etc.  Changes in circumstances may require to change in basis also.

Computerization with standard ERP packages:

Computerization of accounts with standard accounting package or ERP package is a situation in which assessee may have to change the basis of determining cost of stock. The change will be once and it will be followed. Therefore, if there is some impact on profit or loss in one year, it will be offset in next year.

Recent case decided by Tribunal: 

In case reported as Luxor Writing Instruments (P.) Ltd. Versus Deputy Commissioner of Income-tax, Circle 4(1), New Delhi 2012 (6) TMI 477 (Tri) arising out of IT APPEAL NO. 3816 (DELHI) OF 2011 decided on Dated - 29 February 2012 we find a case in which assessee was forced to pursue appeal due to addition made by the AO in stock valuation and unfortunately the same was confirmed by CIT(A) and now Tribunal has also confirmed the addition. The counsels of assessee has tried their best to argue the case with help of decided cases however, honorable Tribunal was not convinced with the same and Tribunal took very narrow view and confirmed the addition. In this case there was change of method of accounting by change in basis of ascertaining cost of stock due to shifting to a new ERP package by assessee. The new ERP package worked out the value of the stock at cost in different manner which caused reduction in the valuation of the stock and the difference was added by the AO. The Tribunal observed and held that “once the method has been chosen it should be employed regularly by the assessee and assessee may not be permitted to change it in the subsequent years. The assessee was regularly employing the method of valuation for valuing the stock at cost or net realizable value whichever is less. By shifting to a new ERP package, for example, SAP 2 worked out the value of the stock at cost, any reduction in the valuation of the stock is not permitted in law. The assessee's claim that the regularly employed method means change method should be adopted in subsequent years is also untenable. The regular employed method by the assessee must have been followed in the past years which is continued to be followed in the subsequent years. Considering the totality of the facts of the case and considering the case laws relied upon, we find no fault in the orders of the authorities below.”

Hence the appeal of the assessee was dismissed.

Observations of author:

In this case there was in fact no change in method of stock valuation. The change was only in formula for ascertaining cost of stock. Such change in formula was due to change in circumstances and assessee was permitted to do so in view of notification on Accounting standards as discussed earlier. Change in formula for computation of cost say from   actual cost or average cost to weighted average cost or moving average basis, or from FIFO to LIFO or base stock cost etc. really does not amount to change in accounting policy, The policy remains to be at cost or at cost or market value whichever is less.

Furthermore, by adopting ERP the assessee has been able to ascertain cost on more scientific basis and it provides more prudential method. Therefore, it should have been accepted.   

It appears that some of vital contentions as discussed in this article were not raised by the counsels before the CIT(A) and Tribunal. If those contentions were raised, to support that a change is permissible in changed circumstances, and such change is also permissible as per the notified accounting standards, perhaps the Tribunal would have deleted the addition.

 The decision of the Tribunal is likely to cause intense litigation on account of stock valuation due to adoption of standard accounting and enterprise resource planning packages (ERP). The decision of tribunal need to be reconsidered in proper proceedings. It is a fit case for appeal before the High Court.

On reading of the reported judgment we find no information about real impact on revenue by way of tax saving or tax deferment. The case involves addition of just Rs. Rs.11,60,494/- even if we assume that the assessee has gained tax saving of say @30%  on the amount of addition  revenue loss would be less than Rs. 3,50,000/- in the assessment  year 2008-09. In AY 2009-10 assessee would be allowed further deduction and the revenue collection will be reduced. Just there will be some impact due to timing differences in payment of advance tax etc. Thus at most revenue will gain on account of interest of few thousand rupees.

A circular from CBDT is desirable:

As discussed earlier, the CBDT should also adopt reasonable and purposive approach. Every and all accounting adjustments should not be discarded. The approach of assessee should be considered from point of view of ground realities, facts and circumstances. If there is mere deferment of tax collection, the revenue should not indulge into litigation and should not force assessee to pursue litigation due to additions made. The purpose seeking and result oriented  approach can be to consider that an assessee  need to have maximize profit after tax to have  have stronger capital base which  is likely to pay much higher taxes in future. 

Section 145 and 145A:

Both sections speaks about method of accounting regularly followed. Prior to insertion of S.145A stock valuation was also considered u/s 145. S. 145A is about valuation of purchase, sale and inventory of goods. This section was specifically inserted to make mandatory inclusion of tax, duty, cess or fees paid on goods in valuation. This section also prescribes that assessee has to follow accounting method regularly. Section 145A stipulates some adjustments in stock valuation which are mandatory. Except that section provide that the valuation of purchase and sale of goods and inventory shall be in accordance with the method of accounting regularly employed by assessee. Thus on the aspect of ‘regularly followed’ the judgments rendered in context of S.145 are equally applicable.

 There is no bar in choosing a proper method to ascertain cost of stock. The method may have to be changed if there are circumstances suggesting such change. For example, on standardization of ERP packages by others or possible use of similar ERP packages by others it becomes necessary to adopt method of costing based on formulae inbuilt in ERP packages. To make inter-firm comparison also it becomes necessary to change the formulae.

It is felt that the learned Tribunal has taken a very static approach that once a method is adopted it cannot be changed. The counsels before Tribunal also did not point out that there was no significant revenue implications. At most the revenue will earn some interest if addition is confirmed.

Luxor Writing Instruments (P.) Ltd. Versus Deputy Commissioner of Income-tax, Circle 4(1), New Delhi 2012 (6) TMI 477 (Tri)