Valuation of closing stock on basis of net realizable value



Valuing the closing stock at net realizable value method is duly recognized by AS-2 issued by the ICAI but, the onus is on the assessee to prove that the net realizable value whatever has been shown by him is the correct net realizable value and is less than the cost: the assessee has to satisfy the Assessing Officer by adducing the evidence that the net realizable value is less than the cost







D. Subhashchandra & Co.



ITA No. 2805/Ahd/2006

JANUARY 4, 2008




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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 audit report 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 the ICAI. Finished goods are valued at estimated net realizable value. Closing Stock is taken, valued & certified by Partner. Though it is merely technical matter, we had relied upon it.”

The learned AR before us vehemently argued that the stock has been valued in accordance with Item No.14 of AS-2 issued by the ICAI. We have 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 for specific projects should be assigned by specific identification of their individual costs."

This stipulates for a specific projects. Specific identification of cost means that specific costs are attributed to the identified items of inventories. When there are large numbers of inventories which was ordinarily interchangeable specific identification of cost is 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 learned AR are contrary to the facts on record, item No. 14 of AS-2 deals with the determination of the cost of inventory. The assessee has not valued the closing stock of polished diamonds at cost. Therefore, we do not agree with the submissions of the learned AR that there is no departure of AS-2 in the case of the assessee and the assessee's case is covered under Item No.14 of AS-2. Had the assessee assigned the cost to each piece of diamond, it could have been said that the assessee has valued the inventories in accordance with 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) of the income tax act. The Accounting standard no. 1 and accounting standard no.2. These Accounting standards are mandatory to be followed in view of Section 145(3). We noted that clause 4 on accounting 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. For this purpose, the major considerations governing the selection and application 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 presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form;

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

From the above, it is apparent that the accounting standard no.1 recognize "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 cannot be determined with certainty and represents only a best estimate in the light of the available information. In other way, it recognises that anticipate all the losses but not provide for the profit until and unless it is not realised. Valuing the closing stock at cost or market value whichever is lower is a well established method of accounting. This method is based on the principle of prudency. Hon'ble Supreme Court in the case of Chainrup sampatram vs CIT 24 ITR 481 accepted this principle. We noted from this decision that the Hon'ble Court explained the reasons for the said practice at page 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 their purchase, so that the cancelling out of the entries relating to the same stock from both sides of the account would leave only the transactions on which there have been actual sales in the course of the year showing the profit or loss actually realised on the year's trading. As pointed out in paragraph 8 of the Report of the Committee on Financial Risks attaching to the holding of Trading Stocks, 1919.

'As the entry for stock which appears in a trading account is merely intended to cancel the charge for the goods purchased, which have not been sold, it should necessarily represent the cost of the goods. If it is more or less than the cost, then the effect is to state the profit on the goods which actually have been sold at the incorrect figure.... From this rigid doctrine, one exception is very generally recognised on prudential grounds and is now fully sanctioned by custom, viz., the adoption of market value at the date of 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 goods in the following year, and may even have the effect, if prices rise again, of attributing to the following year's results a greater amount of profit than the difference between the actual sale price and the actual cost price of the goods in question (extracted in paragraph 281 of the Report of the Committee on the Taxation of Trading 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 in conformity with the ordinary principles of commercial accounting, unless of course, such principles have been superseded or modified by legislative enactments, unrealised profits in the shape of appreciated, value of goods remaining unsold at the end of an accounting year and carried over to the following year's account in a business that is continuing are not brought into the charge as a matter of practice, though, as already stated, loss due to a fall in price below cost is allowed even if such loss has not been actually realised. As truly observed by one of the learned judges in Whimster and 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 recognised where a trader purchased and still holds goods or stocks which have fallen in value. No loss has been realised- Loss may not occur. Nevertheless, at the close of the year he is permitted to treat these 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 where there is a fall in the value of the goods and the goods could not be sold even at cost, the assessee is permissible to value the goods at an estimated realizable value. But the estimated net realizable value must be based on the evidence and material on record. The onus is on the assessee to prove the estimated realizable value to be bonafide one. It cannot be just adhoc value just worked out on the basis of estimating gross profit at a predetermined rate and than working out the balancing value to be the closing stock and in case the assessing officer wants to verify the same, the details of estimating the net realizable value of each item be worked out so that the total may match with the value taken in the profit and loss account 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 so that 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 realisable value and is less than the cost. The assessee has to satisfy the AO by adducing the evidence that the net realizable value is less than the cost. In this case the assessee has not submitted any evidence to support the estimated net realizable value. Even the assessee has not shown the subsequent invoice to verify the value actually realized by the assessee. The AO has given sufficient opportunity to the assessee. The assessee for the first time has even filed the details of the valuation of polished diamonds before this Tribunal vide letter dated 26-07-2007, although the account of the assessee were duly audited u/s 44AB. The learned AR before us pointed out that the Gross Profit of the assessee during the year was 13.81% higher than the one which was earned in the earlier year. If the assessee has earned the gross profit at the rate of 13.81%, then the average net value realized in the case of the assessee should be more than the cost at least by 13.81% if the average cost method or the net realizable value is compared. The learned AR when asked for the evidence to support the net realizable value, expressed his inability and pointed out that the net realizable value has been worked out on the basis of valuation as examined by the partner. We cannot believe that the assessee was not keeping the accounts of each piece of diamond. Cut and Polished diamonds are sorted in different lots, sizes, qualities and these details are bound to be maintained according to the 4Cs(cut, carrat, clarity and colour) by a person who is dealing in diamond. Whenever rough diamonds are issued, expected yield is noted on the packets and these details are verified by the assessee or its representative when cut and polished diamonds are received from the labourers. In our opinion, the assessee could not run its business without getting the accounts of each and every piece of diamond. The AO in this case has valued the stock at average cost which in our opinion will be less than the realizable value as the assessee has shown the gross profit at the rate of 13.81% and valuing the stock at average cost, when it is less than realizable value is well recognized method of valuation of closing stock and duly recognized by AS 2 and prudency principles of accounting. Even Hon'ble Supreme court has also duly recognized this principal of valuation in the case of Chainrup Sampatram as quoted earlier. The assessee in this case since could not prove the net realizable value, therefore, the natural inference will be against the assessee. We therefore in view of the aforesaid discussion are of the view that the AO has rightly valued the closing stock of the polished diamonds at average cost by adopting per carate rate and accordingly confirm the order of the AO.

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