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TMI Blog1995 (6) TMI 41X X X X Extracts X X X X X X X X Extracts X X X X ..... from its inception, was charging in the books only the actual consumption of consumable stores and machinery spares to the profit and loss account. In this accounting year, that is 1977, a change was made. The change was that the entire purchase was charged in the books and this also included the opening stock of that year. A reason offered for the method newly adopted was that inconvenience was being experienced in accounting innumerable items involved in consumable stores and machinery spares. To obviate the difficulty, the assessee, it was stated, switched over to the new method stated above which was also a recognised method in accountancy. It was claimed that the switch-over was bona fide. 4. Parallel with issue No. 1 we may also consider the second question which relates to valuation of finished goods. For valuing the finished items, overhead expenses were being reckoned. What they did in this year (1977) was to value the goods on " prime cost " instead of " on cost " basis. To say this in a simple way, earlier, the closing stock of finished goods were being valued on cost which included many items other than raw material cost and direct labour. Under the changed system on ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e a few authorities were cited by Shri Puniha in support of his submissions. And they are : the decision of the judicial committee of the Privy Council in the case of CIT v. Sarangpur Cotton Mfg. Co. Ltd [1930] 6 ITR 36 ; the decisions of the Supreme Court in the case of Chainrup Sampatram v. CIT [1953] 24 ITR 481 ; the case of S.N. Namasivayam Chettiar v. CIT [1960] 38 ITR 579 ; the case of CIT v. A. Krishnaswami Mudaliar [1964] 53 ITR 122 ; and the case of CIT v. British Paints India Ltd [1991] 188 ITR 44. 9. Shri Soli E. Dastur, the learned senior advocate for the assessee, replied that so long as the newly adopted system has sanction from accountancy and the change is bona fide, the revenue cannot refuse to accept the changed system merely because it results in loss of revenue in the year of change. His further submission was that in a case of this type, the loss of revenue is one-time affair and the question has to be seen only from the point of bona fides. To establish that, he stated that the changed method is continuously being adopted by the assessee till this year and that the revenue has not taken objection in any subsequent assessments. He made a special mention to th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ls Many hand tools and other portable tools may last for years, or they may break or be worn out, lost or stolen almost as soon as they are put to use. Therefore, accounting form them as property, plant and equipment to be capitalized and depreciated is often considered too difficult or impracticable. Some companies take physical inventories of tools periodically and adjust the accounts accordingly. Others treat small tools as supplies inventory and record their costs as expenses when they are put into use, considering as assets only new tools that have not been placed in service. Others charge all tool costs to expense as incurred. Still others capitalize all tool costs and depreciate them over a short period, such as two or three years. All methods are sanctioned by long-standing practice ; the first method of periodic physical inventories is most likely to reflect actual cost of tools consumed. " Following is the extract from the Handbook of Modern Accounting by Sidney Davidson (pp 17 - 32) : " Minimum capitalization amount In practice, strict observance of capitalization principles would require intolerable attention to detail in regard to minor items, such as the subs ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... advertently followed the earlier method though inconvenient, inconvenience felt in 1977 would not constitute a reasonable explanation. The company, it is true, had a different practice right from the inception in 1954 up to 1977. The organisation had grown from year to year and the items of manufacture had increased. The company had taken up manufacturing new items which were earlier not there. Naturally, the number of small items would have gradually increased and at some stage difficulty would be felt acutely. There could be no surprise about it. 14. The items of consumable stores which are charged off irrespective of consumption are : (i) High Speed Diesel Oil, (ii) Light Diesel Oil, (iii) Generator Lubrication Oil, (iv) Trichloroethylene, (v) Tempering salt, (vi) Emulsifiable (without EP characteristics), (vii) Hydraulic oil, (viii) Petrol, (ix) Cutting oil, (x) Kerosene, (xi) Transformer oil. The items of consumable stores were about twenty one thousand in number. None of these items had gone into manufacturing articles. There is a certificate issued by the Deputy General Manager (Finance) of the assessee to show this fact. The consumable spares were ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the earlier method of " on cost " several items which did not directly relate to the manufacture were also being included. They were : (1) Consumable tools and stores, (2) Depreciation, (3) Repair/maintenance of buildings and machinery, (4) Salaries and wages of Foreman, Supervisors, Setters, etc. (5) Provident Fund, gratuity, leave wages etc., relating to direct and indirect labour, (6) Machine shifting and re-arrangement, (7) Power, water, compressed air, etc. The above overheads have no direct relation to production. In case of supervising staff, salary would have been paid even during the time the factory was under lock-out or closed on account of labour strike. Expenditure on machine shifting or re-arrangement has nothing to do with the manufacturing cost. It is only to make re-arrangement in the factory working. Consumable stores and tools are those required for operation of the plant. 18. We must make a special mention to power, water and compressed oil. They are directly used in the manufacture, and, hence, should have been added to the cost just like labour. 19. Power and water are also used outside the factory, such as maintenance, canteens, offices. A ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the declaration of dividend. This is no doubt true. Further, the note given in the Audit Report is not a criticism. It is only a statement of fact. In the Annual Report of 1979 it is mentioned that the changed system which is in accordance with the normally accepted accountancy principles has been followed in that year also. So, consistency is demonstrated. 21. Another submission of Shri Puniha was that the picture is made to appear attractive on the premise that the changed method is also a well recognised method ; but a method which would substantially detract the real profit would be unacceptable to the revenue and the assessor has always the power to deduce the true income for tax purposes and, on this account, additions could be justifiably made. To put his submission in another way, it was his point that the profits of the year would have been far in excess of what is declared had there been no change in the method of accounting and that bona fides cannot be considered in a vacuum when the true profits of the year is sought to be kept out of reach. The accounting practice is not determinative if only it is contrary to the provisions of the IT Act and Shri Dastur stated tha ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Sarangpur Cotton Mfg. Co. Ltd. in support of the submission that " the ITO was not entitled to take the profit shown in the balance sheet as the real income but was bound to consider whether the true income could be deduced from the account of the assessee and to proceed, according to his judgment, on this question ". The facts of this case are different. The assessee who was regularly following the method of valuation of the stock by taking some price under both cost and market price with the object of creating a " secret reserve " which involved the retention of profits and was not included in the profits shown to the shareholders. As the method involved concealing true income on account of " secret reserve " made, their Lordships held that the ITO was entitled to deduce the true income according to his own judgment. This is not a case comparable on facts. It is one thing to say that true income is concealed and quite another to say that income is altered by the way as a consequence of change in the method of accounting. 27. In the case of S.N. Namasivayam Chettiar, from the method of accounting adopted, the correct profits of business were not deductible. Therefore, the ITO a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s who had reviewed the entire case law found that there was no decision in support of the practice adopted by the assessee. The assessee's method was, therefore, rejected and the exercise made by the ITO in deducing the true profits of the year was upheld. 31. The decision of the House of Lords in Duple Motor Bodies Ltd [1961] 1 WLR 739 was examined by the Supreme Court and their Lordships recognised the direct cost (also called the prime cost) method which the assessee, in that case, was following proper on the facts of that case. The observation of Dr. T. Kochu Thommen, J. is that there is much uncertainty in the ' on cost ' method compared to direct cost (or prime cost) method which takes into consideration only labour and raw-materials which is far more accurate in respect of goods which have insignificant market value. It seems to us that in this case the ITO had made addition expressly in terms of the proviso to section 145. 32. Another point, put alternatively, was that the ITO had not resorted to proviso to section 145 and when the method of accountancy adopted by the assessee was not rejected as one unknown to accountancy principles, the additions cannot be justified. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nal practice. If that is allowed to stand in this year it would upset the opening balance of the next year which is not disturbed as we have found. 36. It is apposite to quote the following observations of the Bombay High Court in Melmould Corpn. v. CIT [1993] 202 ITR 789 : " Whenever there is a change in the method of valuation, there is bound to be some distortion in the calculation of profits in the year in which the change takes place. But, if the change is brought about bona fide and is in accordance with the normally accepted accounting practice, there is no reason why such a change should not be permitted. The change has to be effected by adopting the new method for valuing the closing stock which will, in its turn, become the value of the opening stock of the next year ................................ If, instead, a procedure is adopted for changing the value of the opening stock, it will lead to a chain reaction of changes in the sense that the closing stock value of the stock of the year preceding will also have to change and correspondingly the value of the opening stock of that year and so on. This was pointed out by the Madras High Court in the case of CIT v. Carb ..... X X X X Extracts X X X X X X X X Extracts X X X X
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