INTRODUCTION

1. The Ministry of Finance vide Notification No. 87/2016 dated 29.09.2016 notified ten Income Computation and Disclosure Standards (ICDSs), operationalizing a new framework for computation of taxable income by all assessees (other than individual or a HUF who is not required to get his accounts of the previous year audited in accordance with the provisions of Section 44AB of the Income-tax Act, 1961) following the mercantile system of accounting for the purpose of computation of income under the heads “Profits and gains of business or profession” or “Income from other sources”. These standards became applicable w.e.f. April 1, 2016 and shall apply accordingly to the assessment year 2017-18 and subsequent assessment years. Taxable profits would now be computed after making appropriate adjustments to the financial statements (whether prepared under existing AS or Ind AS) to bring them in conformity with ICDSs.

ICDS-II applies to valuation of inventories and it requires that inventories should be valued at cost, or net realisable value, whichever is lower. For ascertaining cost, it prescribes certain cost formulas.

In this article, it is shown that for applying any of the prescribed cost formulas, an assessee must have quantitative details of his year-end inventories. In case of an assessee dealing in a large number of inter-changeable items, this is not possible and practicable.

The provisions of Section 44AA of the Income Tax Act, 1961 (“the Act”) which prescribes the books of accounts and other documents to be maintained by an assessee, does not explicitly require an assessee to maintain quantitative details of his inventory. He is required to maintain such books of account and other documents as may enable the Assessing Officer to compute his total income in accordance with the provisions of the Act. Hitherto, such small assessees have been estimating the value of their year-end inventories by adopting “Gross Profit Method” which is no longer recognised by ICDS-II.

In this way, ICDS-II compels an assessee to determine the quantitative details of his year-end inventory (or to invite adverse remarks from his auditor).  

Since, the above-stated paradigm shift is sought to be achieved through ICDS-II without amending the provisions of Section 44AA of the Act, the Author justifies the title of this article.

In view of hardship likely to be caused to small assessees, it is desirable that the provisions of ICDS-II should be amended to recognize the “Gross Profit Method”.

COST FORMULAS RECOGNISED BY ICDS-II

2. While prescribing the Cost Formulas, ICDS-II stipulates that the cost of inventories of items that are not ordinarily interchangeable; and goods or services produced and segregated for specific projects shall be assigned by specific identification of their individual cost. Where there are large numbers of items of inventory which are ordinarily interchangeable, specific identification of costs shall not be made but cost of such inventories shall be assigned by using the Firstin Firstout (FIFO), or weighted average cost formula. The techniques for the measurement of the cost of inventories, such as the standard cost method or the retail method, may be used for convenience if the results approximate the actual cost.

Thus, ICDS-II recognises only four kinds of cost formulas, viz., FIFO, Weighted Average cost, Standard cost method and Retail method.

WHETHER QUANTITATIVE DETAILS MANDATORY?

3. Let us examine how the above-mentioned four cost formulas work:  

The FIFO formula assumes that the items of inventory which were purchased or produced first are consumed or sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced. So, for application of this formula, it is necessary to determine the quantitative details of the items of inventory.

Under the weighted average cost formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. The average shall be calculated on a periodic basis, or as each additional shipment is received, depending upon the circumstances. So, for application of this formula also, it is necessary to determine the quantitative details of the items of inventory.

Standard cost formula takes into account normal levels of consumption of materials and supplies, labour, efficiency and capacity utilisation. They are regularly reviewed and, if necessary, revised in the light of current conditions. So, for application of this formula also, it is necessary to determine the quantitative details of the items of inventory.

The Retail method can be used in the retail trade for measuring inventories of large number of rapidly changing items that have similar margins and for which it is impractical to use other costing methods. The cost of the inventory is determined by reducing from the sales value of the inventory, the appropriate percentage gross margin. The percentage used takes into consideration inventory, which has been marked down to below its original selling price. Although under this method, value of inventory is estimated but the procedure involves determination of the retail value of the items of inventory, i.e. quantitative details. So, for application of this formula also, it is necessary to determine the quantitative details of the items of inventory.

From a study of all the above-mentioned four cost formulas, a conclusion is inevitable that an assessee must have quantitative details of his inventories and ICDS-II achieves this object without a specific provision, in this regard.  

GROSS PROFIT METHOD

4. Gross Profit Method is a technique used to estimate the value of inventory and cost of goods sold of a period on the basis of the historical or projected gross profit ratio of the business. This method is an alternative to the retail method of inventory estimation and it is usually used to estimate the value of inventory when the retail values of beginning inventory and purchases are not available.

Under both the Retail Method and the Gross Profit Method, value of inventory is estimated. But the difference lies in the fact that under the later method, the items of inventory are not at all ascertained i.e. quantified.  

DILEMMA OF SMALL ASSESSEES

5. A shop keeper dealing in a large number of items may compare well with a departmental store like “Big Bazar” so far as variety of goods dealt with by him are concerned but his volume of trade may be much lesser and so, he may not be in a position to afford the infrastructure and systems required to quantify the items of inventory.   

It would not be out of context to point out here that ICDS as notified on 31st March 2015 did not specifically permit standard cost method. Many large entities, particularly those using ERP packages record consumption of materials, etc. use standard cost.  Perhaps, when exposure drafts of ICDS were issued for public comment, they drew the attention of the Authorities to their problems and so, they have now been specifically permitted to apply Standard Cost Formula if the results approximate the actual cost.

But small traders who are unorganised, might not have made proper representations in this respect and so, now, they would have either to ascertain quantitative details of their inventory or invite adverse remarks from their Auditors that they have not complied with the provisions of ICDS-II.

CONCLUSION

6. ICDS-II imposes an impossible and impractical task upon a small trader to quantify the items of his inventory.  This burden is cast upon him indirectly through the provisions of ICDS-II without amending section 44AA of the Act. To be fair, the “Gross Profit Method” should have been recognised for estimating the value of his inventory.