D. Subhashchandra & Co. v. ACIT
ITA No. 2805/Ahd/2006
JANUARY 4, 2008

7. We have carefully considered the rival submissions along with the order of the tax authorities. This is an undisputed fact that the auditor who carried out the audit u/s 44AB has qualified the auditreport in respect of valuation of closing stock. The audit report has been issued subject to the following note:
“in view of the nature of variation in the values of individual diamonds and the differential in their processing costs, it is not practicable to compute the cost of polished diamonds using either FIFO or weighted average cost. In view of the numerous grades, it is not practicable to use specific costs. The method of valuation used is to that extent a departure from that prescribed AS2 issued by theICAI. Finished goods are valued at estimated net realizable value.Closing Stock is taken, valued & certified by Partner. Though it ismerely technical matter, we had relied upon it.”

The learned AR before us vehemently argued that the stock has beenvalued in accordance with Item No.14 of AS-2 issued by the ICAI. Wehave gone through Item No.14 of AS-2. This states as under:-

“The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated forspecific projects should be assigned by specific identification oftheir individual costs.”

This stipulates for a specific projects. Specific identification ofcost means that specific costs are attributed to the identified items of inventories. When there are large numbers of inventorieswhich was ordinarily interchangeable specific identification of costis inventoried and this fact has been mentioned in Item No.15 of AS-2. The assessee in fact has valued the stock on the basis of estimated net realizable value. The submissions made by the learnedAR are contrary to the facts on record, item No. 14 of AS-2 dealswith the determination of the cost of inventory. The assessee hasnot valued the closing stock of polished diamonds at cost.Therefore, we do not agree with the submissions of the learned ARthat there is no departure of AS-2 in the case of the assessee andthe assessee’s case is covered under Item No.14 of AS-2. Had theassessee assigned the cost to each piece of diamond, it could havebeen said that the assessee has valued the inventories in accordancewith Item No.14 of AS-2.

The CBDT has notified two accounting standards vide notification dated 25.1.1996 on the basis of the power entrusted u/s 145(2) ofthe income tax act. The Accounting standard no. 1 and accountingstandard no.2. These Accounting standards are mandatory to befollowed in view of Section 145(3). We noted that clause 4 onaccounting standard no. 1 lays down as under:“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. Forthis purpose, the major considerations governing the selection andapplication of accounting policies are 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;

(ii) Substance over form: The accounting treatment and presentationin financial statements of transactions and events should begoverned by their substance and not merely by the legal form;

(iii) Materiality : Financial statements should disclose allmaterial items, the knowledge of which might influence the decisionsof the user of the financial statements.”

From the above, it is apparent that the accounting standard no.1recognize “Prudence” to be one of the major consideration for applying accounting policies. It requires that provision should be made for all known liabilities and losses even though amount cannotbe determined with certainty and represents only a best estimate inthe light of the available information. In other way, it recognisesthat anticipates all the losses but not provide for the profit untiland unless it is not realised. Valuing the closing stock at cost ormarket value whichever is lower is a well established method ofaccounting. This method is based on the principle of prudence.Hon’ble Supreme Court in the case of Chainrup sampatram vs CIT 24ITR 481 accepted this principle. We noted from this decision thatthe Hon’ble Court explained the reasons for the said practice atpage 485 which is reproduced as under:-

“It is wrong to assume that the valuation of the closing stock at market rate has, for its object, the bringing into charge any appreciation in the value of such stock. The true purpose of crediting the value of unsold stock is to balance the cost of those goods entered on the other side of the account at the time of theirpurchase, so that the canceling out of the entries relating to thesame stock from both sides of the account would leave only thetransactions on which there have been actual sales in the course ofthe year showing the profit or loss actually realised on the year’strading. As pointed out in paragraph 8 of the Report of theCommittee on Financial Risks attaching to the holding of TradingStocks, 1919.

‘As the entry for stock which appears in atradingaccountis merelyintended to cancel the charge for the goods purchased, which havenot been sold, it should necessarily represent the cost of thegoods. If it is more or less than the cost, then the effect is tostate the profit on the goods which actually have been sold at theincorrect figure…. From this rigid doctrine, one exception is verygenerally recognised on prudential grounds and is now fully sanctioned by custom, viz., the adoption of market value at the dateof making up accounts, if that value is less, than cost. It is of course an anticipation of the loss that may be made on those goodsin the following year, and may even have the effect, if prices riseagain, of attributing to the following year’s results a greateramount of profit than the difference between the actual sale priceand the actual cost price of the goods in question (extracted inparagraph 281 of the Report of the Committee on the Taxation ofTrading Profit presented to British Parliament in April, 1951).

While anticipated loss is thus taken into account, anticipated profit in the shape of appreciated value of the closing stock is not brought into the account, as no prudent trader would care to show increased profit before its actual realisation. This is the theory underlying the rule that the closing stock is to be valued at cost or market price whichever the lower is, and it is now generally accepted as an established rule of commercial practice and accountancy. As profit for income-tax purposes are to be computed inconformity with the ordinary principles of commercial accounting,unless of course, such principles have been superseded or modifiedby legislative enactments, unrealised profits in the shape ofappreciated, value of goods remaining unsold at the end of anaccounting year and carried over to the following year’s account ina business that is continuing are not brought into the charge as amatter of practice, though, as already stated, loss due to a fall inprice below cost is allowed even if such loss has not been actuallyrealised. As truly observed by one of the learned judges in Whimsterand Co. v. Commissioners of Inland Revenue [1926] 12 TC 813,827.

‘Under this law (Revenue law) the profits are the profits realised in the course of the year. What seems an exception is recognized where a trader purchased and still holds goods or stocks which havefallen in value. No loss has been realised- Loss may not occur.Nevertheless, at the close of the year he is permitted to treatthese goods or stocks as of their market value’.

No doubt, in view of the prudence and appropriate method of valuation is cost or market value whichever is less. No doubt wherethere is a fall in the value of the goods and the goods could not besold even at cost, the assessee is permissible to value the goods atan estimated realizable value. But the estimated net realizablevalue must be based on the evidence and material on record. The onusis on the assessee to prove the estimated realizable value to bebonafide one. It cannot be just adhoc value just worked out on thebasis of estimating gross profit at a predetermined rate and thanworking out the balancing value to be the closing stock and in casethe assessing officer wants to verify the same, the details ofestimating the net realizable value of each item be worked out sothat the total may match with the value taken in the profit and lossaccount as seems to have been happened in the case of the assessee otherwise the assessee would have filed all the details before the assessing officer during the course of the assessment proceeding sothat it onus would have been discharged.

The Institute of Chartered Accountant of India in their AS-2 has recognized under para 5 the cost or net realizable value whichever is less, to be a permissible method for valuing the closing stock. Valuing the closing stock at net realizable value method is therefore duly recognized by AS-2 issued by the but, the onus, in our opinion. is on the assessee to prove that the net realizable value whatever has been shown by him is the correct net realisablevalue and is less than the cost. The assessee has to satisfy the AOby adducing the evidence that the net realizable value is less thanthe cost. In this case the assessee has not submitted any evidenceto support the estimated net realizable value. Even the assessee hasnot shown the subsequent invoice to verify the value actuallyrealized by the assessee. The AO has given sufficient opportunity tothe assessee. The assessee for the first time has even filed thedetails of the valuation of polished diamonds before this Tribunalvide letter dated 26-07-2007, although the account of the assesseewere duly audited u/s 44AB. The learned AR before us pointed outthat the Gross Profit of the assessee during the year was 13.81%higher than the one which was earned in the earlier year. If theassessee has earned the gross profit at the rate of 13.81%, then theaverage net value realized in the case of the assessee should bemore than the cost at least by 13.81% if the average cost method orthe net realizable value is compared. The learned AR when asked forthe evidence to support the net realizable value, expressed hisinability and pointed out that the net realizable value has been worked out on the basis of valuation as examined by the partner. Wecannot believe that the assessee was not keeping the accounts ofeach piece of diamond. Cut and Polished diamonds are sorted indifferent lots, sizes, qualities and these details are bound to bemaintained according to the 4Cs(cut, carrat, clarity and colour) bya person who is dealing in diamond. Whenever rough diamonds areissued, expected yield is noted on the packets and these details areverified by the assessee or its representative when cut and polisheddiamonds are received from the labourers. In our opinion, theassessee could not run its business without getting the accounts ofeach and every piece of diamond. The AO in this case has valued thestock at average cost which in our opinion will be less than therealizable value as the assessee has shown the gross profit at therate of 13.81% and valuing the stock at average cost, when it isless than realizable value is well recognized method of valuation ofclosing stock and duly recognized by AS 2 and prudence principles of accounting. Even Hon’ble Supreme court has also duly recognized thisprincipal of valuation in the case of Chainrup Sampatram as quotedearlier. The assessee in this case since could not prove the netrealizable value, therefore, the natural inference will be againstthe assessee. We therefore in view of the aforesaid discussion areof the view that the AO has rightly valued the closing stock of thepolished diamonds at average cost by adopting per carate rate andaccordingly confirm the order of the AO.

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