Section 145A: How To Calculate The Value Of Inventories For Taxation
The Government introduced Section 145A of the Income Tax Act on April 1, 1999. Herein, any assessee, being a business owner or a professional, can follow one of the following accounting systems — cash system or mercantile system as per Income Computation and Disclosure Standards(ICDS). This has to be done in compliance with Section 145 of the Income Tax Act.
Section 145A is about the valuation of goods/inventories while determining income from a business or a profession. Here is a detailed discussion focused on Section 145A, with the intent to give a complete idea to the readers about the same.
Valuation of the Inventories under the Income Tax Act
Every assessee must maintain books of accounts as required under the Income Tax Act. Section 145 of the Act prescribes the method of accounting for the income chargeable under the heading ” Profits and Gains from Business or Profession” and ” Income from Other Sources”.
There are two methods to record your income, assets, and liabilities:
- Cash method: Under this method, the record of transactions in books of accounts is as per the inflow or outflow of cash. Despite it being an easy and simple method of accounting, it is not recognised by the Companies Act due to a lack of accuracy.
- Mercantile method: The recording of transactions takes place as per accrual basis for all income or expenses whether or not you receive cash on the day of the transaction. The Companies Act recognises the method because it is highly accurate though more complex.
Here are a few other rules about the valuation of inventories as per this section:
- The cost of inventories should be computed using the First-in-First-Out method or the weighted average formula.
- Opening inventory will be the cost of inventory at the business commencement date. If it is a new business or any other case, then it will be the cost of inventory as of the last date of the immediately preceding year
- If dissolution occurs, irrespective of the continuation of the business, the cost of inventories shall be done on a net realisable value basis.
Note that if Income Computation and Disclosure Standards(ICDS) apply to any assessee, then the method of accounting should be as per it.
Section 145A (the Income Tax Act, 1961)
The Finance Act 2018, substituted the old Section 145A from April 1, 2017. It also replaced the earlier Sections 145A and Section 145B to give a more precise effect to the application of ICDS.
While determining an assessee’s taxable income under the heads,
“Profits and gains from business and profession”, or
“Income from other sources”, the purchase or sale of inventory and goods under income from business/profession, is to be valued in the following manner:
- The actual cost or Net Realisable Value(NRV), whichever is lower, is calculated according to the income computation and disclosure rules of Section 145(2).
- The valuation of the purchase and sale of goods/services and inventory would include any taxes, duty or cess, or fees by whatever name called and any fees paid or incurred to bring goods/services to their location as of the valuation day.
- The inventory is listed or unlisted securities but not quoted on a recognised stock exchange with regularity from time to time shall be valued at the actual cost initially recognised per the Income Computation, and Disclosure Standards(ICDS) notified under Section-145(2).
- The valuation of other securities shall be done at a lower of actual cost or Net Realisable Value in accordance with Income Computation and Disclosure Standards(ICDS)-Section 145(2).
- Scheduled commercial banks and public financial institutions must disclose their inventories per the guidelines by ICDS and RBI in this regard.
Net Realisation Value and Actual Cost of Inventories/Securities
Net Realisation Value (NRV): According to Section 145A of the Income Tax Act, the valuation of inventories and listed securities should be done at the price of NRV or the actual price, whichever is lower.
In the case of inventories, NRV is the estimated selling price of an asset when it is sold. The estimated completion costs and other expenses necessary for the sale reduce it. The cost of inventories includes expenses for purchases, services, conversion, and other costs to bring it to current conditions. The actual cost of inventories comprises the purchase price, including duties, taxes, freight charges, and other expenses directly related to its acquisition. Trade discounts and rebates are deducted from the cost to arrive at the purchase cost. However, the interest and borrowing costs are not part of the acquisition cost unless for recognition of interest.
When it comes to the actual cost of securities, it includes the following:
- Purchase price.
- Acquisition costs, including brokerage, tax, duty, cess, and other fees.
- Fair value price of a security acquired in exchange for another security.
- Exchanged for another asset, the fair value price of the security acquired.
Applicability of Income Computation and Disclosure Standards
ICDS was issued to bring uniformity between accounting policies governing the computation of income with tax-related provisions and reducing the irregularities between them; hence specific provisions of ICDS have been incorporated in the Income Tax Act itself.
Form 3CD (Tax Audit Report) is also revised for making mandatory disclosures in compliance with ICDS.
- Assesses are required to follow the Income Computation and Disclosure Standards for the valuation of inventories and securities as per Section 145A of the Income Tax Act.
- It applies to taxpayers with taxable income under the head business, profession, or other sources. The central government is empowered to notify the applicability of ICDS u/s 145(2) from time to time via the official gazette.
- The taxpayers following the mercantile accounting system and getting their accounts audited u/s 44AB are covered under the purview of this section. Even the non-corporate taxpayers who compute their income under the presumptive taxation scheme and the companies, irrespective of the applicability of accounting standards, need to follow it.
- Taxpayers must disclose the accounting policies and total inventories in their financial statements. The value thus shown must be lower than the actual cost or NRV.
- The central government notifies the applicability of ICDS from time to time in the official gazette.
The cost or NRV shall be calculated under ICDS. Comparison of cost or NRV shall be made category-wise.
ICDS is not applicable in the computation of MAT but for the computation of AMT. Again it is not applicable if the assessee is an individual or a HUF who is not required to get their books of accounts audited under Section 44AB of the Act. ICDS is not applicable for the maintenance of books of account. In case of conflict between the provisions of the Income-tax Act, 1961 (‘the Act’) and ICDS, the provisions of the Act will prevail.
However, if the Assessing Officer is not satisfied with the following, then he may assess in accordance with Section 144:
- Income has not been declared wholly and correctly, or
- The method of accounting is not the one regularly followed by the assessee, or
- Income has not been properly computed per ICDS.
Section 145A of the Income Tax Act prescribes the valuation of different types of inventories and securities to determine your taxable income. The actual cost or NRV, per the provisions of ICDS and subsections of Section 145, must be calculated. The lower of those two shall be considered for valuation. It will include purchase price, labour cost, taxes, duties, cess, conversion cost, etc. The various disclosures to be made in accordance with this section have also been prescribed.
Frequently Asked Questions
What are the primary features of ICDS(Income Computation and Disclosure Standards)?
The main features of ICDS are:
ICDS applies to all taxpayers.
It is applicable as far as the computation of income is concerned.
If there is a conflict between the provisions of the Income Tax Act and ICDS, the I-T Act will prevail.
It is not applicable for computing Minimum Alternate Tax (MAT).
It does not provide explanations/illustrations like Accounting Standards.
It is a list of principles to be applied while computing income.
What is the purpose behind India’s Income Computation and Disclosure Standards?
ICDS are guidelines issued by the Government to calculate their taxable income for the taxpayers. The main purpose is to bring uniformity in accounting standards in India. Applicability of these standards makes the computation of taxable income as per tax provisions. All those taxpayers having income under the head “Profit and Gains from Business or Profession” or “Income from other sources” as well as those choosing for presumptive taxation, must follow these standards.
What is meant by the Mercantile system of Accounting?
The mercantile accounting system means an accrual accounting basis wherein you record transactions when they arise. You record your earnings and expenses when you earn or spend. Once you adopt this system, it becomes applicable while calculating salaries, property income, and capital gains. The mercantile accounting system is a regular and standard method that the Companies Act also recognises.
Do the provisions of ICDS apply to Banks, Non-banking financial institutions, Insurance companies, the Power sector, etc.?
Unless specific provisions are given for a particular sector in the ICDS, the general provisions of ICDS apply to all taxpayers. There are specific provisions for banks and certain financial institutions per ICDS VIII. Similarly, Schedule 1 of the Act has specific provisions for Insurance Companies.
ICDS-I requires disclosure of significant accounting policies, and another ICDS requires specific disclosures. Where is the taxpayer required to make such disclosures specified in ICDS?
The disclosure is to be made in the Return of Income regarding the net effect on the income because of the application of ICDS. The disclosures under ICDS are made in the tax audit report form 3CD. But the taxpayers who are not liable for tax audits shall not make any separate disclosures.