The Hindu Business Line : A date with the stock

VALUATION of inventory is an issue by itself in income-tax assessments. Right from the time the Supreme Court held that closing inventory has to be valued to arrive at true profits, there have been enough controversies on the methods and the process of valuation of inventory for income-tax purposes. The Income-tax Act, 1961 does not prescribe any method of valuing of closing inventory except that in determining the method of accounting under Section 145 of the Act, stock valuation is an essential ingredient in various accounting pronouncements. AS-2 (Valuation of Inventories), in particular, prescribes the method for stock valuation.

The Madras High Court had to consider an interesting question on valuation of inventory for a sugar company in the context of value determined after the balance-sheet date. This was in the CIT vs Tamil Nadu Sugar Corporation Ltd (2003 265 ITR 466) case.

Facts, issues

The assessee is a wholly-owned undertaking of the Tamil Nadu Government and the issue relates to assessment year 1984-85 and the year ending was September 30, 1983. The assessing officer (AO), while completing the assessment, was of the opinion that there was an undervaluation of the closing stock of the free sugar held by it.

The assessee valued the closing stock of the free sugar at Rs 330 per quintal when its accounts were finalised on October 25, 1983, whereas the assessee closed its accounts for the assessment year in question on September 30, 1983, and according to the AO, the assessee ought to have taken the selling rate of sugar prevailing on September 30, 1983, which was Rs 352 per quintal.

The AO was of the opinion that there was an undervaluation of the closing stock of the free sugar at the rate of Rs 22 per quintal and found that the assessee had 99,636 quintals of free sugar as the closing stock as on September 30, 1983, and made an addition of Rs 21,91,992 towards undervaluation of the closing stock of the sugar.

The first appellate authority upheld the addition. The assessee carried the matter in appeal before the Appellate Tribunal, which followed the decision of the Delhi High Court in the CIT vs Mahalakshmi Sugar Mills Co. Ltd (1993 200 ITR 275) case and held that the assessee had adopted the closing stock with reference to the selling price subsequent to the last date of the accounting year since it was nearer to reality.

The Tribunal also held that the assessee was following a recognised system of valuation of closing stock regularly and the system adopted by the assessee was a recognised one. The Tribunal, therefore, held that there was no reason to disturb the valuation and deleted the addition and allowed the appeal preferred by the assessee.

The matter reached the High Court. The question for consideration here was whether the company was justified in adopting the lower value of inventory taking into account the fluctuation in values post-balance-sheet date?

Accountancy principles

The International Accounting Standard 2 on the subject of valuation of inventories states thus:

"Inventories should be measured at the lower of cost and net realisable value. Estimate of net realisable value are based on the most reliable evidence available at the time the estimates are made as to the amount the inventories are expected to realise. These estimates take into consideration fluctuations of price or cost directly relating to events occurring after the end of the period to the extent that such events confirm conditions existing at the end of the period."

The Indian Accounting Standard 2 (revised) on the subject states thus:

"Inventories should be valued at the lower of cost and net realisable value.

Estimates of net realisable value are based on the most reliable evidence available at the time the estimates are made as to the amount the inventories are expected to realise. These estimates take into consideration fluctuations of price or cost directly relating to events occurring after the balance-sheet date to the extent that such events confirm the conditions existing at the balance-sheet date."

The sum total of the issue is that closing stock has to be valued on the balance-sheet date at cost or market, whichever is lower. The method to arrive at the cost has been spelt out by the Accounting Standard, which stipulates methods such as first-in first-out (FIFO) and weighted average cost. Also AS 4 (Contingencies and Events Occurring after the Balance Sheet Date) requires entities to take into account events after the balance-sheet date, which will throw better light on the asset existing on the balance-sheet date.

High Court decision

The Madras High Court confirmed the addition made by the AO and held that the company is precluded from adopting the value prevailing after the balance-sheet date for inventory valuation. The court reasoned that "... it is open to take note of the events occurring after the balance-sheet date to the extent that such events conform to the conditions existing at the balance-sheet date.

However, in the present case, the situation is that there is a wide fluctuation in the value of sugar prevalent at the end of the accounting year from the value prevalent when its accounts were finalised... "

The Madras High Court accordingly disregarded the effect of events occurring after the balance-sheet date for the purpose of inventory valuation.

In sugar and similar industries, seasonal variations in prices cause lots of problems in inventory valuation. But then the year-end date is sacrosanct for various aspects of accounting, including inventory valuation. There are limitations on extending the scope and ambit of the accounting standard on contingencies and events occurring after the balance-sheet date to issues as the one discussed above.

While the Madras High Court decision (supra) would have settled the issue on this in the context of inventory valuation, the principles laid down is relevant for other similar cases too.