Valuation of stocks and particularly scrap and obsolete stock much disputes about almost nothing- revenue should adopt a purpose seeking approach in overall context.

[DEV KUMAR KOTHARI]

Scrap and obsolete stock

Scrap means such stock or items, which are generated in the course of manufacturing or producing goods and things.  The extent of scrap and its value may vary from product to product and process to process.  In some cases, the value of scrap generated may be insignificant whereas in some other cases, it may be significant.  However, in the overall context of the business and as a percentage of total value of production, the scrap value is generally not significant so as to apply to many checks, balances and restrictions or to ask for too much of reporting.

Obsolete stock

Obsolete stocks are different from scrap.  Obsolete stock includes such items which have become unusable due to certain reasons like outdated medicines and chemicals, spare parts of machines which have been discarded and similar machines have not been acquired again, stores and materials becoming obsolete due to change in machines, manufacturing process, raw materials, finished goods and other technical factors.  An example of scrap and obsolete material, worn out tires and tubes of vehicles may be considered as scrap material.  Whereas new tires and tubes kept in stores may become obsolete if the vehicles for which they are kept as spares it is discarded.  The worn out tires and tubes arose or became scrap in the course of use of vehicles whereas discarding of particular vehicles resulted into itself spares becoming obsolete.

Computation of income and scrap and obsolete items

As indicated earlier scrap and obsolete items are not substantial in value.  However, unfortunately, there is lot of emphasis on these petty items by our taxation authorities as well as certain regulatory authorities.  In audit report of companies there is specific requirement to report about scraps and obsolete items.  This type of requirement for petty items takes away from the attention the major item that is the raw materials and finished goods.  In the income tax assessment also, many times we find that there is lot of enquiry and also additions and disallowances about these petty items whereas major items may not find adequate attention of the authorities.

Valuation is really neutral over a period of two years:

So far valuation of any inventory is concerned, it is generally revenue neutral over a period of time.  The impact of valuation on taxable income can at best be a temporary deferment of tax liability.  It may make some  difference when the rates of tax are different in two accounting periods.  This can be illustrated as follows:-

Example A

Value of scrap and obsolete item in first year       -       Rs.2,00,000

Sale of the above item in second year                   -       Rs.2,05,000

Total credit for these items in two years               -       Rs.2,05,000

The closing stock of the first year is taken as opening stock of the second  year at Rs. 2,00,000,and it is debited in the profit and loss account.  Therefore, in the first year there is a credit of Rs.2 lakhs and in the second year, net credit is only Rs.5,000. Overall credit in two years is Rs. 2,05,000

Example B

Value of scrap and obsolete item in first year       -       Rs.1,50,000

Sale of the above item in second year                   -       Rs.2,05,000

Total credit for these items in two years               -       Rs.2,05,000

The closing stock of the first year is taken as opening stock of the second  year at Rs. 1,50,000 and it is debited in the profit and loss account. The sale of the same at Rs.2,05,000 results into profit of rs.55,000 in second year. However, in the first year there is a credit of Rs.1.5  lakhs and in the second year, net credit is only Rs.55,000, therefore total credit in two years is Rs.2,05,000/-.

On analysis of the above two examples, we find that in the first year, income was Rs.2 lakhs and in the second year Rs.5,000 i.e. total Rs.2,05,000.  In the same example, on different valuation in the first year, income or credit was Rs.1,50,000 and in the second year net credit was Rs.55,000. Therefore the total credit or income in two years offered was Rs.2,05,000.  Therefore, when we considered the two years we find that there is no impact on the income disclosed. In view of this it can be said that there should not be much hue and cry by revenue authorities about valuation of stocks.

Now suppose in second year rate of tax is reduced by 5% then there will be a tax saving in first year when estimate of scrap value in second method  is Rs.1,50,000  instead of Rs.2,00,000 under first method. However, in second year there will be larger income offered to tax. In net result tax @5% on Rs,50000 is saved on consideration of both years and this is only because of lower rate of tax in second year.  Such situations arise very occasionally and not on regular basis.

Therefore so far revenue is concerned, taking an overall view the implication will be not significant. However, unfortunately overall view is not considered instead of that very temporary view is considered and un necessary litigation takes place.

Recent case before Supreme Court

In CIT v. Alfa Laval (India) Ltd. [2007] 295 ITR 451 (SC) = [2009 -TMI - 32446 - SUPREME Court], the matter relating to valuation of obsolete stock was under consideration.  The assessee had valued certain obsolete stocks at 10% of their stocks.  Such valuation was also supported by audit report and in subsequent year, the actual price realized on sale of such items was less than 10% of the cost that means in the next year, the assessee had a loss as the sale was less than  opening value of such stocks. In the first year that is the year in which the dispute of valuation arose, the assessing officer took the realizable value of obsolete item at 50% of the cost on the ground that assessee had neither furnished the list of obsolete items nor produced any records to show that the items were not moving.  The Commissioner (Appeal) deleted the addition.  However, on appeal by the assessing officer, the Tribunal set aside the order of the Commissioner (Appeal) and restored the order of the assessing officer on the ground that assessee had failed to produce the necessary evidence in support of its claim.  Therefore, the assessee preferred appeal before the High Court and the High Court in this regard held as follows:-

That the duly certified auditor's report placed before the Assessing Officer clearly justified valuation of obsolete items at 10 per cent of cost.  There was no dispute that the assessee is entitled to value the closing stock at market value or art cost whichever is lower.  It was also not in dispute that the value of the closing stock had been taken as the value of the opening stock in the subsequent year.  Moreover, it was also not disputed that the obsolete items were in fact sold in the subsequent year at a price less than 10 per cent of the cost.  In the absence of any basis for valuing the obsolete items at 50 per cent of the cost, the Tribunal could not have upheld the findings of the Assessing Officer.

There was no under-valuation of stock, where the assessee had valued its obsolete stock at 10 per cent. and had sold it in the next year at less than that value - Alfa Laval India Ltd. v. Deputy CIT [2004] 266 ITR 418.

Thereafter the revenue preferred appeal before the Supreme Court and the Supreme Court taking into account that the valuation was supported by audit report and stock was actually sold at a lesser price in subsequent year held that there was no under valuation of stock.

An observation on ALFA Laval's case:

We find that the A.O. took value of such stocks @ 50% of cost at about Rs.15.16 lakh. The assessee had taken it at 10% of cost that means the addition was of about Rs.12.12 lakh, which cannot be considered as significant by any standard. In this case the stock was sold in next year even below 10% value taken by assessee, therefore, in fact assessee had shown excessive income in the relevant year and suffered loss in next year when stock was sold. Therefore, the A.O. and Tribunal did not take a rational approach in the matter. The sale value realized in next year is a perfect evidence of fall in valuation. Furthermore, the A.O. took value at 50% without any basis. Suppose in next year value realized was higher than value shown in first year, still there would be not much revenue impact. Therefore, in such cases revenue is not at all justified in indulging into litigation which serves hardly any meaningful purpose. 

A purpose seeking and liberal approach is required regarding stock valuation which is neutral over a period:

It appears that there are a lot of litigations on the valuation aspect.  Whereas there should not be litigation considering the point that over a period of two or more years, the valuation makes no difference.  As on a particular last day of previous year, there may be certain circumstances relating to market condition which may suggest that the stock value is low and if the stock is sold immediately, the value realized may even  be lower than the book value and in fact, one has to value his stock at such price which the stock will realize if sold in open market on the closing day and if entire stock is put to sell on a particular day, the value shall definitely fall down.  However, generally that is in more than 95% of cases, the stocks are valued at cost.  The valuation of outdated or obsolete stocks, scrap stocks is to be on different footing than the normal stock and total impact of reduced valuation, if at all, in the overall context of the turnover of a particular assesses and in the context of all the assesses taken together is really immaterial.  Furthermore, the lowered stock valuation gives the benefit to the revenue in next year when this stock is sold at higher price.  For example, in case when the market value of stock increases in the next year, the assessee will have higher profit in the next year.  If the valuation is higher in the first year and the price realized is lower in the next year, as the case was in the case of Alfa Laval (supra), the revenue looses in the subsequent year because there is a loss, which is allowable.  Therefore, applying the principle of always better control, the authorities should not make unnecessary issues about stock valuation and generally it should be left to the businessman / assessee to decide what is the valuation of stock to be undertaken in particular circumstances.  Particularly, when the accounts are governed by the provisions of Companies Act, accounting standards and audit standards, the same should be relied on. 

Why changes are made in method of valuation:

Change in method of stock valuation may be required for several reasons like (a) change in market conditions and marketing policies, ( b) requirement of presentation of state of affairs in a more suitable manner ( c) changes in legal provisions and accounting standards (d) financing requirements ( e) inter-firm comparison (f) industry wide policy decisions affecting market parameters  (g) change in rate of tax etc.

A bona fide change in method of accounting from one recognized method to other recognized method is permissible provided it is regularly followed. A casual departure may not be considered as a bona fide change unless there are compelling reasons requiring even casual change.

In case of change in method of accounting also there is lot of litigation having hardly any impact.

Revenue effect is almost neutral in overall context:

For an assessee a small sum of money saved in one year  may be meaningful and in fact may be some time like a life saving blood, however, in the case of revenue, such small sums makes hardly any difference in the overall context. Furthermore in case of revenue there will be found balancing when allover review is made. This is because the revenue collection is concerned with all industry and economy and not with a particular industry or business. some assesses might have deferred payment of some tax by adopting typical method of stock Valuation in first year, but in second year they will be required to pay tax on higher income because opening stock value is low so profit in second year is higher. In second year some other assessee may have adopted some method to defer tax but that is compensated by higher tax collection from assesses who deferred some tax in first year.

Revenue's long-term outlook is desired:

As discussed above, impact on revenue in overall context will not be significant and over a period of time there will be hardly any impact. Therefore, there should not be litigation by the revenue on stock valuation aspect. However, we find a lot of litigation going on. This is really against purpose seeking and result oriented approach. We find that even when an assessee has larger amount of losses carried forward, which are likely to be lapsed, still the revenue indulge in litigation on petty issues and matters like stock valuation. The revenue should take into consideration long-term aspects and accept stock valuation as per normally followed accounting policies by assessee. Because it really makes not much difference in the context of revenue.

Some instances of stock additions:

When Section 145A was inserted w.e.f. 01.04.1999 to prescribe inclusion of  duties, cess , fees etc in stock valuation, lot of litigation has taken place by way of re-assessment, rectifications and revision proceedings. There have been cases wherein in one year stock addition has been made but correspondingly in next year addition has not been allowed by way of increasing value of opening stock as taken value of closing stock in earlier year. In some cases while making stock adjustment in one year duty etc. has been included in opening as well as closing stock. Therefore, value of opening stock has been increased and an allowance has been allowed, however, in immediately preceding year closing stock value remained unchanged. Therefore, some assesses got extra benefit. Thus we find that there has been un-necessary proceedings having hardly any benefit to the revenue in overall context and over a period of time.

In relation to inclusion of tax , duty etc. it is also worth to mention that generally goods are sold by the due date for filing of return. Therefore, a major part of addition made is allowable as per proviso to S. 43B. However, on consideration of some cases law is amended without consideration of overall context, implications and revenue effect. 

On change in method of accounting, generally the A.O. makes addition in one year and disputes are raised, though the effect of lesser stock valuation in one year is neutralized in very next year when the same value of stock is taken as an item on debit side of the profit and loss account thus in next year income is increased. The assessee has to establish bona fide, and continuity to changed method and generally the addition made by the A.O. is deleted.

 

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CIT v. Alfa Laval (India) Ltd. [2007] 295 ITR 451 (SC) = [2009 -TMI - 32446 - SUPREME Court]

Valuation of stock - valuation of obsolete stock at 10 per cent. of cost - valuation supported by audit report - stock actually sold at less than that value in subsequent year - no under-valuation of stock in relevant year - Income-tax Act, 1961.

Business expenditure - investment deposit account - recomputation of depreciation in accordance with circular of company law board - amount credited to profit and loss account consequent on such recomputation - amount not deductible from eligible profits - Income-tax Act, 1961, s. 32AB.

Export - special deduction - computation of special deduction - interest and sales tax set off assessed as business profits - amounts includible for computation of special deduction - Income-tax Act, 1961, s. 80HHC.

From the decision of the Bombay High Court in Alfa Laval India Ltd. v. Deputy CIT 2003 -TMI - 11336 - (BOMBAY High Court), holding that : (i) there was no under-valuation of stock, where the assessee had valued its obsolete stock at 10 per cent. and had sold it in the next year at less than that value, (ii) the amount written back in the profit and loss account by way of adjustment on a recomputation of the depreciation on the basis of a circular of the Company Law Board could not be reduced from the profit eligible under section 32AB, and (iii) interest from customers and sales tax set off received by the assessee, being profits of the business under the head "Profits and gains of business or profession", could not be excluded whiled calculating the deduction under section 80HHC, an appeal was taken to the Supreme Court by the Department.  The Supreme Court dismissed the appeal, leaving the question of law open.

Decision of the Bombay High Court in Alfa Laval India Ltd. v. Deputy CIT 2003 -TMI - 11336 - (BOMBAY High Court) affirmed.

Alfa Laval India Ltd. v. Deputy CIT 2003 -TMI - 11336 - (BOMBAY High Court)  referred to.

Order

On the facts of the case, we do not wish to interfere.  The appeal is dismissed, leaving the question of law open.

Alfa Laval India Ltd. v. Deputy CIT 2003 -TMI - 11336 - (BOMBAY High Court)

Valuation of stock - valuation of obsolete stock at 10 per cent of cost - valuation supported by audit report - stock actually sold at less than that value in subsequent year - no under-valuation of stock in relevant year - Income-tax Act, 1961.

Business expenditure - investment deposit account - recomputation of depreciation in accordance with circular of company law board - amount credited to profit and loss account consequent on such recomputation - amount not deductible from eligible profits - Income-tax Act, 1961, s. 32AB.

Export - special deduction - computation of special deduction - interest and sales tax set off assessed as business profits - amounts includible for computation of special deduction under section 80HHC - Income-tax Act, 1961, s. 80HHC.

For the assessment year 1989-90, the assessee had valued the closing stock of obsolete items at 10 per cent of the cost.  The Assessing Officer held that the assessee had neither furnished the list of obsolete items nor produced any records to show that the items were not moving.  The Assessing Officer took the realizable value of obsolete items at 50 per cent of the cost and accordingly added back Rs.15,15,656.  On appeal filed by the assessee, the Commissioner of Income-tax (Appeals) deleted the additions made by the Assessing Officer by taking into account the fact that the actual realization of the obsolete items in the subsequent year was less than 10 per cent of the cost.  On further appeal filed by the Revenue, the Tribunal set aside the order of the Commissioner (Appeals) and restored the order of the Assessing Officer on the ground that the assessee had failed to produce the necessary evidence in support of its claim.

In order to comply with the instructions contained in a circular of the Company Law Board dated December 31 1986, the assessee during the year had changed the basis of working out depreciation and on account of such reworking Rs.81,33,607 was credited to the profit and loss account.  This was done by way of adjustment of the current period's depreciation charge in the profit and loss account.  The assessing Officer took the views that for working out relief under section 32AB of the Income-tax Act, 1961, depreciation written back had to be reduced from the profits.  This order was upheld by the Tribunal.

The assessee made a claim of Rs.1,20,51,817 under section 80HHC of the Act, based on the profits as per the return of income.  The profits computed under the head "Profits and gains of business or profession" at Rs.7,06,26,746 included "othe4r income" of Rs.4,33,56,007 comprising interest from customers, income from investments, export incentives, sales tax set off, claims, refunds, etc.  The Assessing Officer treated the export incentives under the caption "Other income" amounting to Rs.2,42,66,453 as part of business profit and excluded the balance amount of rs.1,90,89,554 (Rs.4,33,56,0076 - Rs.2,42,66,453) from the profits of business as if the same were not part of business profits and accordingly reduced the amount of Rs.1,90,89,554 from the business income for computing deduction under section 80HHC. The Tribunal confirmed the order.  On appeal to the High Court :

Held, (i) that the duly certified auditor's report placed before the Assessing Officer clearly justified valuation of obsolete items at 10 per cent of cost.  There was no dispute that the assessee is entitled to value the closing stock at market value or art cost whichever is lower.  It was also not in dispute that the value of the closing stock had been taken as the value of the opening stock in the subsequent year.  Moreover, it was also not disputed that the obsolete items were I fact sold in the subsequent year at a price less than 10 per cent of the cost.  In the absence of any basis for valuing the obsolete items at 50 per cent of the cost, the Tribunal could not have upheld the findings of the Assessing Officer.

(ii) That as per the circular issue by the Company Law Board, it was necessary for the assessee to rework the depreciation.  As a result, increased profits to the tune of Rs.81,33,667 had to be written back by way of adjustment in the profit and loss account.  Therefore, no fault could be found with the adjustment made by the assessee in the profit and loss account.  For working out relief under section 32AB(3) of the Income-tax Act, the profits of the business are required to be reduced by an amount or amounts withdrawn from reserves or provisions, if such amounts arte credited to the profit and loss account.  In the present case, there was no withdrawal of amount from reserves or provisions and, therefore the amount written back and credited to the profit and loss account on account of reworking of the depreciation, as per the circulars of the Company Law Board, could not be reduced from the profits eligible for relief under section 32AB.

(iii) That the interest form customers and sales tax set off received by the assessee being assessed as part of the business profits under the head "Profits and gains of business or profession" the same could not be excluded while calculating deduction under section 80HHC.

Cases referred to :

CIT v Bangalore Clothing Co. 2003 -TMI - 12071 - (BOMBAY High Court).

CIT v K. K. Doshi 2000 -TMI - 15032 - (BOMBAY High Court)

CIT v Pink Star 2000 -TMI - 15012 - (BOMBAY High Court)

CIT v S G Jhaveri Consultancy Ltd. 2000 -TMI - 15033 - (BOMBAY High Court)

CIT v Sudarshan Chemicals Industries Ltd.[2000] 245 ITR 769(Bom)

Kinetic Motor Co. Ltd. v. Deputy CIT 2003 -TMI - 11824 - (BOMBAY High Court)