The Supreme Court has laid down that the closing stock cannot be valued at a price below the well-established method of valuation adopted by a tax-payer.
The method of valuing closing stock has a critical bearing on taxable profits. A method which is chosen at the time of starting a business cannot be changed, except for compelling reasons. It is well-established, both in England and in India, that on general principles of commercial accounting, in the Profit and Loss Account of a merchants or manufacturers business, the value of the trading stock-in-hand at the beginning and at the end of the accounting year should be entered at cost or market value, whichever is lower.
The rule is obviously intended to be in favour of the trader and enables him to distribute his loss more evenly (Ramswarup Bengalimal vs. C.I.T. (25 I.T.R. 17, 24); and C.I.T. vs. Chengalvaraya Chetty (2 I.T.C. 14, 18)). Allowing the assessee to write down the stock when the market value is lower than cost is in effect the allowance of a reserve for future unrealised loss and, as such, is an exception to the general rule that a precautionary reserve for anticipated loss is not allowable and no unrealised loss can be set-off against the profits of the accounting period (Chainrup Sampatram vs. C.I.T. (24 I.T.R. 481, 485); Indo-Commercial Bank Ltd. vs. C.I.T. (44 I.T.R. 22, 32); C.I.T. vs. Chari & Ram (17 I.T.R. 1, 6); Whimster & Co. vs. I.R. (12 T.C. 813, 827)).
However, whereas the assessee can get an allowance in respect of future unrealised loss, the Department is not entitled, by putting on the stock the market value where it exceeds cost, to bring in and charge the unrealised notional profit (Chainrup Samapatram vs. C.I.T. (24 I.T.R. 481, 485); C.I.T. vs. Chari & Ram (17 I.T.R. 1, 7); Utting & Co. Ltd vs. Hughes (8 I.T.R. Supp. 57, 60)), unless the assessees regular basis of valuation is the market rate right from the inception of his business.
An important decision was recently given by the Supreme Court on the question whether the closing stock could be valued at below the cost price.
In C.I.T. vs. Hindustan Zinc Ltd (291 I.T.R. 391), the facts were that the assessee, which was at the relevant time a Government company, was engaged in the business of producing zinc concentrate that was utilised by the assessee captively.
During the assessment year 1996-97, zinc concentrate got accumulated and it was not possible to consume that quantity as the accumulated stock contained low metal content.
Since domestic consumption was not possible, it contemplated export and obtained permission of the Government of India and adopted the London Metallic Exchange Price of the closing stock as on March 31, 1996, which was lower than the weighted average cost by Rs 27.08 crore.
The Department held that the valuation of the closing stock was not in accordance with the accounting policy of the assessee and since there was no export during the accounting year ending March 31, 1996, made an addition to its profits.
The Appellate Tribunal deleted the addition made to the income of the assessee. On appeal, the High Court held that no substantial question of law arose for consideration.
On appeal, the Supreme Court held that it was generally accepted as an established rule of commercial practice and accountancy that the closing stock had to be valued at cost or market price whichever was lower. Ordinarily, the goods should not be written down below the cost except where there was an actual or anticipated loss.
On the other hand, if the fall in price was only such as it would reduce merely prospective profit, there would be no justification to discard the initial valuation at cost. Therefore, the assessee was not right in writing down the inventory (zinc concentrate) below the cost price by estimating its net realisable value at the London Metallic Exchange price and not at the domestic price.
Not source of profit
The Supreme Court observed that in the case of Chainrup Samapatram vs. C.I.T. (24 I.T.R. 481), it has been held that valuation of unsold stock at the close of the accounting period was a necessary part of the process of determining the trading results of that period.
It cannot be regarded as a source of profits. Profits can be correctly ascertained only after bringing into the trading account the closing stock wherever it may exist.
It was further held that 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 which should necessarily represent the cost of the goods.
While anticipated loss is 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 profits before its actual realisation.
To the same effect is the judgment of this Court in the case of C.I.T. vs. British Paints India Ltd (188 I.T.R. 44).
In this judgment, it has been held that it is a well-recognised principle of commercial accounting to enter in the profit and loss account the value of the stock-in-trade at the beginning and at the end of the accounting year at cost or market price, whichever is the lower.
Where the market value has fallen before the date of valuation and where the market value of the article on that date is less than its actual cost, the assessee is entitled to value the articles at market value and thus anticipate the loss which he may incur at the time of the sale of the goods.
It was further held that the correct principle of accounting is to enter the stock in the books of account at cost unless the value is required to be reduced by reason of the fall in the market value of the goods below the original cost.
Ordinarily, therefore, the goods should not be written down below the cost price except where there is an actual or anticipated loss.
On the other hand, if the fall in the price is only such as it would reduce merely the prospective profit, there would be no justification to discard the initial valuation at cost.
Adverting to the facts in the case of Hindustan Zinc Ltd, the Supreme Court held that the narrow controversy involved was whether the assessee was right in writing down the inventory (zinc concentrate) below the cost price by estimating its net realisable value at the LME price and not by estimating its net realisable value at the domestic price.
There was no dispute that as on March 31, 1996, the international prices of zinc concentrates were lower than the domestic prices thereof. Further, in the past the assessee has been valuing zinc concentrates at net realisable value at the domestic prices.
In view of the aforesaid decisions, the Supreme Court laid down the proposition that the closing stock cannot be valued at a price below the well-established method of valuation adopted by a tax-payer.
It is only in exceptional circumstances, where loss can be anticipated with some degree of certainty, that a departure from the established method of valuation would be justified.
H.P. Ranina (The author, a Mumbai-based advocate specialising in tax laws)