Holding

The assessing officer may, under section 145, reject a method of accounting that does not adhere to the established practice of valuing closing stock at cost or market whichever is lower, when such a method prevents proper deduction of income.

Summary

Mis. Sanjeev Woolen Mills, a manufacturer and exporter of woolen blankets, valued its closing stock of finished goods at market price (converted from US dollars) rather than at cost or the lower of cost/market. Due to a sharp rupee devaluation in AY 1992‑93, this method produced an inflated gross profit, enabling the firm to claim a deduction under section 80HHC. In the subsequent year, the firm reported a loss with nil closing stock. The Revenue invoked section 145 of the Income‑Tax Act, adding Rs 2.67 crore to income, arguing that the accounting method prevented proper deduction of income. The C.I.T. (Appeals) dismissed the Revenue’s claim, the ITAT allowed it, and the High Court upheld the Revenue. The Supreme Court held that the assessing officer is empowered under section 145 to reject a method that does not follow the established practice of valuing closing stock at cost or market whichever is lower, as it yields notional profit and impedes proper income computation. Consequently, the Revenue’s action was justified and the appeal was dismissed.

Issues considered

The assessing officer’s power under section 145 to reject an assessee’s method of valuing closing stock at market price higher than cost.
Whether a method of accounting consistently applied by the assessee can be overridden when it results in notional profit and hampers proper income deduction.
Whether the valuation of closing stock must follow the ‘cost or market whichever is lower’ rule for income‑tax purposes.

Legislation cited

Income Tax Act, 1961s. 144, s. 145, s. 459, s. 80HHC

Subjects

Income TaxSection 145Closing stock valuationCost or market lower ruleAssessing officer powerNotional profitRupee devaluationMethod of accountingSection 80HHC deduction

Judgment

MIS. SANJEEV WOOLEN MILLS A
v.
COMMISSIONER OF INCOME TAX, MUMBAI

NOVEMBER 24, 2005

[DR. AR. LAKSHMANAN AND P.P. NAOLEKAR, JJ.J B

Income tax Act, 1961-Section 145-Assessee adopted the method of
valuation of closing stock of finished goods at market price-Indian Rupee
was devalued against U.S. Dollar in a particular assessment year-Assessee C
disclosed huge gross profit in that year and claimed a benefit of deduction
under the Act-Assessee disclosed loss in subsequent assessment year-
Revenue rejected the method of accounting adopted by the assessee on the
ground that income could not be properly deduced-Commissioner (Appeals)
dismissed the appeal but the order was set aside by Appellate Tribunal-
High Court allowed the appeal of the Revenue-Correctness of-Held, D
Revenue has power under the Act to adopt a suitable method of accounting
if it is of the opinion that income cannot be properly deducted from the
method adopted by the assessee-On facts, assessee has not adopted the
correct and established method of valuation of closing stock of finished
goods at cost or market price, whichever is lower-Hence, the action of the E
Revenue is justified.

Appellant-assessee is engaged in import of synthetic waste and
manufacture and export of woolen blankets. The appellant was maintaining
books of account on mercantile basis. The closing stock of raw-materials/
semi-finished goods was being valued at cost price and finished gods at market F
price. The market price of the finished goods in U.S. Dollars was being
converted to Indian Rupees by applying prevailing exchange rate on the
closing accounting date.

During assessment year 1992-93, Indian Rupee was devalued against
US Dollar. The price of one US Dollar as on 1.4.1991 and 31.3.1992 were Rs. G
18 and Rs. 31 respectively. Accordingly, the opening and closing stock of
finished goods were valued at market price at Rs. 90 and Rs. 130 per kg
respectively by applying the prevailing exchange rate. The appellant disclosed
huge gross profit thereby and claimed benefit of deduction under section

459 H
460 SUPREME COURT REPORTS (2005) SUPP. 5 S.C.R.

A 80HHC of the Income Tax Act, 1961. For the assessment year 1993-94, the
appellant showed a loss by disclosing nil closing stock. The Revenue invoked
Section 145 of the Act on the ground that income could not properly be deduced
from the method of accounting adopted by the appellant and hence added an
amount of Rs. 2,67,38,280 to the total income of the assessee for the
assessment year 1993-94. The appeals by the appellant preferred before
B Commissioner of Income Tax (Appeals) were dismissed but were allowed by
Income tax Appellate Tribunal. The appeals preferred by tlie Revenue before
High Court were allowed.

In appeals to this court, the appellant contended that the Revenue has
C no jurisdiction to invoke section 145 of the Act on the ground that the finished
goods were valued at market price consistently from the year 1985-86 and
accepted by the Revenue; and that the method of accounting cannot be
questioned for the assessment year 1992-93 merely on the ground of claiming
benefit under section 80HHC of the Act in that year.

D Revenue contended that section 145 of the Act has been rightly invoked
on the ground that the appellant did not adopt the well established method of
accounting in valuing closing stock at cost or market price whichever is
lower; that the appellant adopted the method of accounting in valuing closing
stock at market price merely to claim maximum benefit under Section 80HHC
of the Act in assessment year 1992-93 and for suppression of profit in the
E next assessment year; and that since each accounting year being a separate
unit in itself, the acceptance of the method of accounting by the Revenue in
the past would be no ground to prohibit invoking Section 145 of the Act.

Dismissing the appeals, the Court

F HELD: 1. Under Section 145 of the Income Tax Act, 1961, the chargeable
income has to be deduced from the accounts regularly employed by the
appellant The assessing officer can apply a different method of accounting to
deduce the income chargeable if he is of the opinion that from the method
employed by the appellant, the chargeable income cannot properly be deduced.
G The recognized and settled accounting practice of accounting with the closing
stock in the accounts has to be valued at cost or market price whiChever is
lower. In the present case, the appellant has not adopted the established and
settled practice. The market value of the stock has been taken into
consideration while arriving at chargeable income although the market value
of the stock is more than the cost value of the stock. The profit earned is only
H
SANJEEVWOOLEN MILLS v. COMMISSIONER OF INCOME TAX [NAOLEKAR, J.] 461

notional. There is no transfer of the goods and the closing stock remains the A
opening stock of the next accounting year. The income which has not been
derived at by the appellant cannot be said to be the income chargeable for
income and, therefore, the rejection of the accounts maintained by the
appellant for the valuation of the closing stock by the assessing officer and
confirmed by the High Court is in accordance with law. [473-B-EI
B
· C.I. T. v. A. Krishnaswami Mudaliar, (1964) 53 ITR 122; Kikabhai
Premchandv. C.J.T., (1953) 24 ITR 506; Chainrup Sampatram v. C./.T., (1953)
24 ITR 481; A.L.A. Firm v. C./.T., (1991) 189 ITR 285; Shakti Trading Co. v.
C.l. T., [2001] 6 SCC 455; S.N. Namasivayqm Chettiar v. C./. T., (1960) 38 ITR
579; C.l.T. v. Sarangpur Cotton Mfg. Ltd., (1938) 6 ITR 36; C.l.T. v. Hind C
Construction Ltd, (1972) 83 ITR 211; C./. T. v. Bir/a Gwalior (P) Ltd., (1973)
89 ITR 266 and C./. T., Bombay City Iv. Messrs. Shoorji Val/abhdas & Co.,
(1962) 46 ITR 144, referred to.

Commissioner ofthe Inland Revenue v. Cock, Russel and Co. Ltd, (1949)
29 Tax Cases 387 = [19491 All E.R. 889 and Whimster and Co. v. C.l.R., (1925) D
12 Tax Cases 813, referred to.

CIVIL APPELLATE JURlSDfCTION : Civil Appeal Nos. 6735-6736 of
2003.

From the Judgment and Order dated 11.12.2002 of the Bombay High E
Court in LT.A. Nos. 9 and 10 of 2001.

B.V. Desai and Ms. Sheenam Parwanda for the Appellant.

Rajiv Dutta, Arijit Prasad and B.V. Balaram Das for the Respondent.
F
The Judgment of the Court was delivered by

P.P. NAOLEKAR, J. The appellant, (hereinafter to be referred to as an
'assessee') is a firm engaged in the imports of synthetic waste and manufacture
and export of woolen blankets. Since the assessee had been in export, the
economy of the business of the assessee worked out on the basis of U.S. $ G
price and for the purpose of stock valuation, the same was recorded in
Rupees for which the prevailing exchange rate was applied. The assessee was
maintaining books of accounts on a consistent method on mercantile basis
right from the insertion of its business and Department has accepted the same
for the purpose of income-tax except in the years in question. Since the
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462 SUPREME COURT REPORTS [2005) SUPJt1j°s S.C.R.

A Account Year, 1986-87, the assessee followed the method of accouJlng, and
for which the stock of raw-material/semi-finished goods were valu~d at cost
price and finished goods at the market price. k
~i
For the Assessment Year 1992-93 (hereinafter to be referred~to as the
'First year'), the assessee valued the closing stock at the rate of Rs1J301- per
B kg. whereas the opening stock were shown at Rs.90/- per kg. In the s bsequent
year 1993-94, the assessee valued the opening stock at Rs.130 per · · . for the
finished goods and there was no closing stock. The assessee retu ed a loss
of Rs.54,420/- for the second year. For the First year, the assesse: claimed
benefit under Section 80 HHC of the Income-tax Act 1961 (herein fter to be
C referred to as an 'Act'). It is the case of the assessee that during th Financial
year 199I-92, the Rupee had undergone de-valuation against U.S.$. The price
of the U.S. $ as on l.4.l 991 was Rs.l 8/- per Dollar and at the time of the
closing as on 31.3.1992, it was Rs.31/- per U.S. Dollar. As per the evidence,
the assessee's case is that at the relevant time the market price of the blanket
in the international market was U.S.$ 4.59 per kg. and the rate of U.S. Dollar
D in Rupees 18.20 per Dollar. As such, the market price was Rs.90/- per kg. as
on 31.3.1991/1.4.1991 (closing stock of the previous year/opening stock
valuation for the year 1992-93 ). At the end of the year 1992-93, on 31.3 .1992,
the market price of the blanket in the international market was U.S. $5.35 per
kg. and the rate of U.S.$ in Rupee was Rs.31/- per Dollar and the market price
E worked out to be Rs.165 .85 per kg. and on 31.3 .1992 after deducting the
transport charges, freight, commission and other incidental charges to the
tune of Rs.35.85, price of the blanket at market value was fixed at Rs.130 per
kg. which was shown as closing stock value of the Assessment Year 1992-
93. The assessee has taken the value of the closing stock as on 31st of March
as the opening stock on I st of April to be the same in every year for the
F finished product at market value and the raw material at cost price. The
assessee also valued the market price of the finished product at the rate of
Rs.98/- as on 1.4.1991 as the actual market price of Rs.130/-per kg. as on
31.3 .1992 and also on 1.4.1992 the price of the finished product as opening
stock value for the Second Year.

G The Assessing Officer has found that on adoption of the aforesaid
method, there is a stark contrast in the gross profit ratio for the accounting
year 1990-91, 1991-92 and 1992-93. He concluded that the method of valuing
the closing stock.at market value resulted in a distorted picture and assessee
had artificially inflated the profits in order to get benefit under Section 80 HHC
H of the Act, which amounted to tax planning with intent to defraud the Revenue.
SANJEEVWOOLEN MILLS v. COMMISSIONER OF INCOME TAX (NAOLEKAR,J.] 463

The Assessing Officer ruled that by following the aforementioned method, A
the assessee effectively showed to earn income out of itself, which was
totally against the basic principles of accountancy and law. He further observed
that by proper application of the provisions of the Act and principles of
accountancy, the assessee had to value its closing stock at cost or market
price whichever was lower but that was not done. He further found that in
the Second Year, the assessee had valued opening stock at Rs.130 per kg. in B
place of Rs.90 per kg. which had suppressed the factum of profits. He applied
the standard prescribed for "Valuation of Inventory" at the cost price and
added an amount of Rs.2,67,38.280.00 to the total income of the assessee for
the second year.

The assessee preferred an appeal for the First Year and also for the
c
Second Year before the C.l.T. (Appeals). Both the appeals were dismissed by
C.l.T. (Appeals) by observing that by merely following a particular system of
accounting regularly in the past would not entitle the assessee to follow the
same system of accounting which was not in accordance with the standard
principles of accountancy and placed reliance on the judgment of this Court D
in British Paints v. C./. T. (1991) 188 l.T.R. 44. It was held that the Assessing
Officer had rightly interfered, as duty bound under provisions of Section 145
of the Act to conclude the correct taxable income of each year and for that
purpose, there was need to change the system of accounting regularly followed
by the assessee, that must be done. As per the appellate authority, no person E
could earn profit from his own pocket. The valuation of the closing stock
required valuing of closing stock either at cost or at market price, whichever
was lower.

The assessee, aggrieved by the orders passed by C.I.T. (Appeals),
further filed appeals before the l.T.A.T. The Income-tax Appellate Tribunal F
allowed the appeals of the assessee taking the view that the application on
the principle of lower cost or market value was pre-dominantly wrong because
there had been several accepted method of accounting such as pure cost
method, LIFO, FIFO etc. and observation of the Assessing Officer and the
first appellate authority regarding a particular method is the only correct
method, was held to be totally absurd. It was observed that lower of the cost G
or market value method might certainly be considered to be a prudent method
of accounting and might be followed by the vast majority of business
enterprises but what might not be considered prudent did not necessarily
incorrect or against the principles of accounting and hence if any firm has
been employing the market value method for a long time consistently, it could H
SUPREME COURT REPORTS [2005) SUPP. 5 S.C.R.

A~ nofhe considered as against the principles of accountancy nor the method
·· ". ;;i ~ . ·a<l~pted for defrauding the Revenue. The Tribunal has directed that valuation
-<~ of the finished goods as made by the assessee be accepted. Regarding
opening stock of the Second Year, the Tribunal has allowed the assessee to
value it as the closing stock of the First year. The Revenue challenged this
B order of the Tribunal in the High Court of Bombay by filing an Income-tax
Appeal.

The Division Bench of the Higt: Court by its judgment dated 11.12.2002
allowed both the appeals and held that the method of valuation of closing
stock adopted by the assessee was not correct and that the entire device was
C to inflate deduction under Section 80 HHC and to suppress the profits in the
Second Year because the correct taxable income could never be computed on
the basis of the system of relief provided under Section 80 HHC and that
under the different assessment year constituting separate unit and the principle
of 'lower of the cost or market value' had been fully satisfying the mandatory
touchstone of "no escapement of tax" rule. Against this order of the High
D Court, the assessee has came before this Court.

Shri B.V. Desai, learned counsel for the appellant has urged that in the
facts and circumstances of the case where in the First Year, the v~luation of
the stock increased pre-dominantly because of the market factor and also the
sudden spurt and increase in the exchange rate of U.S. $, it could not have
E been said that the appellant has adopted a method of accounting to defraud
the Revenue particularly so when the accounting method chosen by the
assessee is not for a particular year and is being adopted consistently from
the year 1985-86. It is further urged that it is a well-settled principle of income-
tax Jaw that the assessee is free to adopt any system of accounting and the
p valuation chosen at the market rate has been a well settled principle of
accounting and therefore simply because the assessee has claimed benefit
under Section 80 HHC, in a particular year the method of accounting could
not have been found fault with. It was further urged that the provisions of
Section 145 (I) of the Act are not attracted as the assessee had adopted the
valuation of the finished goods on market price and consistently followed the
G same. The contention of the counsel proceeded on the exercise of jurisdiction
and he urged that the power under Section 145 of the Ad could only be
exercised if there is material to prove that the method _ip question is such that
in the opinion of the Assessing Officer, the income cannot be properly
deducted. The sine qua non for enforcing the provisions of Section 145 of -
H the Act is that the Assessing Officer should be of the opinion that from the
SANJEEVWOOLEN MILLS 11. COMMISSIONER OF INCOME TAX [NAOLEKAR, J.) 465

method of accounting the income cannot be properly deducted and this A
opinion should be based on sound and reasonable footing. On the other
hand, Shri Rajiv Dutt, Sr. Advocate for the respondent has urged that the
established and consistent practice of accounting which is accepted by Courts
is valuation of the closing stock either at the cost or at market price, whichever
was lower. If the established practice of accounting is not adopted, the
Assessing Officer was justified in invoking Section 145 of the Act. The B
method of accounting chosen by the assessee was merely to claim maximum
deduction under Section 80 HHC in the First Year and suppression of the
profit in the Second year. It is further urged that each accounting year being
a separate unit in itself, merely because in the past Department accepted a
method, would be no ground to prohibit the assessing officer from exercising C
his discretion and powers under Section 145 of the Act.

To appreciate and to deal with the rival contentions put forward by the
learned counsel in the facts of the present case, it would be appropriate to
re-produce the relevant provisions of Section 145 (I) of the Income-tax Act
as was applicable at the relevant time. Section 145 (1) of Income-tax Act reads D
as under:

145. (I) Income-chargeable under the head "Profits and gains of
business or profession" or "Income from other sources" shall be
computed in accordance with the method of accounting regularly
employed by the assessee: E
Provided that in any case where the accounts are correct and complete
to the satisfaction of the Assessing Officer but the method employed

- is such that, in the opinion of the Assessing Officer, the income
cannot be properly deduced therefrom, then the computation shall be
made upon such basis and in such manner as the Assessing Officer
may determine:
F

Provided further that where no method of accounting is regularly
employed by the assessee, any income by way of interest on securities
shall be chargeable to tax as the income of the previous year in which G
such interest is due to the assessee:

Provided also that nothing contained in this sub-section shall preclude
an ;ssessee from being charged to income-tax in respect of any
interest on securities received by him in a previous year if such
interest had not been charged to income-tax for any earlier previous H
466 SUPREME COURT REPORTS [2005] SUPP. 5 S.C.R.
\-
A year.

Where the Assessing Officer is not satisfied about the correctness or
the completeness of the accounts of the assessee, the Assessing
Officer may make an assessment in the manner provided in Section
144.
B
Section 145 provides that in case assessing officer is of the view that
the assessee's accounts are incomplete or incorrect or method of accounting
has not been regularly followed by the assessee, the Assessing Officer may
resort to make best judgment assessment in the manner provided under
Section 144 of the Act instead of making assessment under Section 145 of
C the Act. To attract Section 145 of the Act, it is necessary that:

(a) the assessee has computed the income in accordance with the
method of accounting regularly employed by the assessee; and
(b) provided where the accounts are correct and complete to the
D satisfaction of the assessing officer; but
(c) the method employed is such that in the opinion of the assessing
officer, the income cannot be deduced therefrom then the
assessing officer may adopt a different method of computation
of the income as he may determine.

E The assessee may employ whichever basis of valuation of stock in
hand, but it must adhere to that consistently year after year. Casual departure
of valuation of trading stock in hand at cost or market value is not permissible.
The method adopted of maintaining the accounts should be definite method
of valuation which is carried by the assessee from year to year. To attract the
F provision of Section 145 of the Act the consistent method of maintaining
accounts books is a first condition thereafter the assessing officer should be
of the view that the accounts are correct and complefe but the method
employed is such that in the opinion of the assessing officer the income
cannot properly be deduced therefrom. The choice of method of accounting
regularly employed by the assessee lies with the assessee but the assessee
G would be required to show that he has followed the chosen method regularly.
The Department is bound by the assessee's choice of method regularly
employed unless by this method the true income, profit of accounts cannot
be arrived at. The assessee's regular method would not be rejected as improper
merely because it gives him the benefit in certain years or that as per the
H assessing officer the other method would have been more preferable. The
SANJEEV WOOLEN MILLS v. COMMISSIONER OF INCOME TAX [NAOLEKAR, J.] 467

method of accounting cannot be substituted by the assessing officer merely A
because it is unsatisfactory. What is material for the purpose of Section 145
is, the method to be such that the real income, profit and gain can be properly
deduced therefrom. If the method adopted does not afford true picture of
profit, it would be rejected, but then such rejection should be based on
cogent evidence and would be done with caution. The power can be exercised B
by the assessing authority to choose the basis and manner in computation
of income but he must exercise his discretion and judgement judicially and
reasonably.

In the present case the assessee throughout has computed the income
and maintained accounts on the basis of valuation of opening stock of raw C
material and semi finished goods at stock price and finished goods at the
market price. The assessee has adopted method of accounting whereby closing
stock of the year is the opening stock of the next year, and the valuation
placed by the assessee upon his closing stock of the year as the valuation
of the opening stock of the next year. As per the assessing officer by virtue
of this method in the assessment year 1992-93 the gross profit ratio was D
Rs.2054.60% for.the first year which stood in stark contrast to 119.18% for
the accounting year 1991-92 and 64.85% for accounting year 1991 and,
therefore, the method adopted shows artificially inflated profit in order to get
the deduction benefit under Section 80HH (C) of the Income Tax Act. While
framing the question of law the High Court has also framed a question E
whether in the facts and circumstances of the case and in law, the ITAT was
justified in holding that the higher market rate of valuation of closing stock
adopted by the assessee was correct, without appreciating that acceptance
of said method had resulted in doctored abnormal gross profit ratio of2054.60%,
which by no yardstick of basic principle of accountancy could be held as
proper reflection of income. The High Court has arrived at the conclusion that F
this gross inflation in the profit was made merely to get the benefit of Section
80HH(C) for the first year and suppress the profit in the second year. Thus
it is apparent that the assessing officer as well as the High Court were
impressed by the factor that the method adopted by the assessee in computing
. the income results in showing of abnormally gross profit ratio and that was G
done for the purposes of taking benefit under Section 80HH(C) for the first
year and for reducing the profit in the second year by showing the value of
the finished products at the market rate at the end of the first year and in the
beginning of the second year. Although it is correct to say that regular
method of accounting adopted cannot be rejected by the assessing officer
merely on the basis of profit earned or loss suffered by the assessee in H
468 SUPREME COURT REPORTS [2005) SUPP. 5 S.C.R.

A particular year but that can be certainly a reason for an assessing officer to
make deeper probe of the account to find and whether the accounts reflects
real income, profit and gains of the assessee.

It is settled law that the true trading result of business for an accounting
period cannot be ascertained without taking into account the stock in trade
B .at the end of the accounting period. While considering the method of
accounting in C.l.T. v. A. Krishnaswami Muda!i11r, (1964) 53 l.T.R. 122, this
Court pointed out that in the event where the assessee is following the cash
system of accounting, the valuation of the closing stock cannot be dispensed
with. The Court quoted with approval the following observations in
C Commissioner of the Inland Revenue v. Cock, Russell and Co. Ltd, ( 1949) 29
Tax Cases 387 = [1949] All E.R. 889:

"There is no word in the statutes or rules which deals with this
question of valuing stock-in-trade. There is nothing in the relevant
legislation which indicates that in computing the profits and gains of
D a commercial concern the stock-in-trade at the start of the accounting
period should be taken in and that the amount of the stock-in-trade
at the end of the period should also be taken .in. It would be fantastic
not to do it : it would be utterly impossible accurately to assess
profits and gains merely on a statement or receipts and payments or
on the basis of turnover. It has long been recognized that the right
E method of assessing profits and gains is to take into account the
value of the stock-in-trade at the beginning and the value of the
stock-in~trade at the end as two of the items in the computation. I
need not cite for the general proposition, which is admitted at the Bar,
that for _the purposes of ascertaining profits and gains the ordinary
F principles of commercial accounting should be applied, so long as
they do not conflict with any express provision of the relevant statutes"

The Court further observed:

"We have already said that in England there is no provision which
compels the tax officer to adopt in the compumtion of income the
G system of accounting regularly employed by the assessee. But
whatever may be the system, whether it is case or mercantile, as
observed by Croom-Johnson J. in a trading venture it would be
impossible accurately to assess the true profits without taking into
account the value of the stock-in-trade at the beginning and at the
H end of the year.... " •/
SANJEEVWOOLEN MILLS v. COMMISSIONER OF INCOME TAX [NAOLEKAR, J.] 469

From the above it is clear that it is settled law that true profit of business for A
an accounting period cannot be ascertained without taking into account the
value of the stock in trade remaining at the end of the period and that such
valuation is a necessary element in the process of determining the trade result
of the period. The principles on which the method of valuation of closing
stock is done is also well settled. They have been set out in Whimsier and B
Co. v. C.l.R., (1925) 12 Tax Cases 813 in the following words:-

"In computing the balance of profits and gains for the purposes
of income ...tax two general and fundamental commonplaces have
always to be kept in mind. In the first place, the profits of any
particular year or accounting period must be taken to consist of the C
difference between the receipts from the trade or business during
· such year or accounting period and the expenditure laid out to earn
those receipts. In the second place, the account of profit and loss to
be made up for the purpose of ascertaining the difference must be
framed consistently with the ordinary principles of commercial
accounting, so far as applicable, and in conformity with the rules of D
the Income-tax Act, or of that Act as modified by the provisions and
schedules of the Acts regulating excess profits duty, as the case may
be. For example, the ordinary principles of commercial accounting
require that in the profit and loss account of a merchant's or
manufacturer's business the values of the stock-in-trade at the
beginning and at the end of the period covered by the account should E
be entered at cost or market price, whichever is lower; although there
is nothing about this in the taxing statutes."

In the words of Bose, J. in Kikabhai Premchandv. CIT, (1953) 24 I.T.R.
506 (SC) at page 510 :- F
"The appellants's method of book-keeping reflects the true position.
As he makes his purchases he enters his,.,stock at the cost price on
one side of the accounts. At the close of the year he enters the value
of any unsold sfock at cost on the other side of the accounts thus
canceling out entries relating to the same unsold stock earlier in the G
accounts; and then that is carried. forward as the opening balance in
the next year's account. This canceling out of the unsold stock from
both sides of the accounts leaves only the transactions on which
there have been actual sales and gives a true and actual profit or loss
on his year's dealings."
H
470 SUPREME COURT REPORTS [2005] SUPP. 5 S.C.R.

A The rationale behind valuation of the stock at "cost" or "market",
whichever is lower is explained by Patanjali Sastri, CJ in Chainrup Sampatram
v. C./. T., (1953) 24 l.T.R. 481 (S.C.) at Page 485:-

"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
B 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
canceling out of the entries relating to the same stock from both sides
of the account would leave only the transactions on which there have

c been actual sales in the course of the year showing the profit or loss
actually realized 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 the trading account is merely intended to cancel the charge for the
goods purchased which have not been sold, it should necessarily
D 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 recognized 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 Jess, than cost. It is of course
E 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
F Report of the Committee on the Taxation of Trading Profits presented
to British Parliament in April 1951 ). While anticipated loss is thus
taken into account, anticipated profits in the shape of appreciated
value of the closing stock is not brought into account, as no prudent
trader would care to show increased profit before its actual realization.
This is the theory underlying the rule that the closing stock is to be
G valued at cost or market price whichever is the lower, and it is now
generally accepted as an established rule of commercial practice and
accountancy."

In A.L.A. Firm v. C.l.T., (1991) Vol.189 I.T.R. (S.C.) page 285, the Court
H said that as against the valuation of the stock at cost or market whichever
SANJEEVWOOLEN MILLS v. COMMISSIONER OF INCOME TAX [NAOLEKAR, J.] 471
is lower, valuation of the closing stock at the market value will invariably A
create problem. For, if the market value is higher than the cost then the
~-

accounts will reflect notional profits not actually realized. On the other hand,
if the market value is less, the assessee will get the benefit of the notional
loss which he has not incurred. Nevertheless, as mentioned earlier, the ordinary
principle of commercial accounting permit valuation at cost or market whichever B
is lower. The proper practice is to value the closing stock at cost. That will
eliminate entries relating to the same stock from both sides of the account.
To this Rule, custom recognized only one exception and that is to value the
stock at market value that is lower. But on no principle can one justify the
valuation of the closing stock at a market value higher than the cost as that
will result in taxation of the notional profits the assessee has not realized. In C
Shakti Trading Co. v. C./. T., Coimbatore, [2001] 6 S.C:C. 455, this Court had
held that the proper practice is to value the closing stock at cost. To this Rule,
the custom recognized only one exception and that is to value the stock at
market value if it is lower. But on no principle can one justify the valuation
of the closing stock at market value higher than the cost as that will result
in taxation of notional profits which the assessee has not realized. The D
aforesaid catena of decision recognized in the accounting practice, of valuation
of closing stock and permissible limit thereof of showing the stock at cost or
at market value whichever is lower. Permissibility of value of the stock at a
market value would be only if the valuation of the market value of the stock
is lower than the cost of the stock. E
In C.J. T. v. A. Krishnaswami Muda/iar, (1964) 53 I.T.R. 122, at page 128:-

"Again as observed by this Court in C.J. T. v. McMillan and Co.,
(1958) 33 l.T.R. 182, the expression 'in the opinion of the Income-tax
Officer' in the proviso to Section 13 of the Indian Income-tax Act, F
1922 does not confer a mere discretionary power; in the context it
imposes a statutory duty on the Income-tax Officer to examine in
every case the method of accounting employed by the assessee .and
to see whether or not it has been regularly employed and to determine
whether the income, profits and gains of the assessee could properly
be deduced therefrom." G
It is said in S.N. Namasivayam Chettiar v. C.l.T., (1960) 38 l.T.R. 579
(S.C.), it is for the officer to consider the material placed before him and, if,
upon such consideration, he is of the opinion that correct profits and gains
could not be deduced from the accounts, he would then be obliged to have
recourse to the proviso to section 13 of 1922 Act which corresponds to H
472 SUPREME COURT REPORTS [2005] SUPP. 5 S.C.R.

A Section 145 of the Act.
In C./. T. v. Sarangpur Cotton Mfg. ltd, ( 1938) 6 ITR 36, Lord Thankerton
stated that section 13 of the Indian Income-tax Act, 1922, related to a method
of accounting regularly employed by the assessee. The section postulated
that such a method of accounting was the necessary basis of computation,
B unless in the opinion of the Income-tax Officer, the income, profits and gains
could not properly be deduced from such method. But it could very well be
that, "though the profit brought out in the accounts is not the true figure for
income-tax purposes the true figure can be accurately deduced therefrom ...
But it was not a correct view that the Income-tax Officer was ''prima facie
C entitled" to accept the profits mentioned in the accounts where there was a
method of accounting regularly employed by the assessee. "It is the duty of
the Income-tax Officer, where there is such a method of accounting to consider
whether income, profits and gains can properly be deduced therefrom, and the
proceed according to his judgment on this question. From the aforesaid
decision one can easily deduce the principle that it is the duty of the assessing
D officer to examine in every case the method of accounting adopted by the
assessee and to see whether the income, profit and gains of the assessee
could properly be assessed therefrom. If the assessing officer is of the view
that the profit could not be properly deduced from the accounts maintained
he can apply the provisions of Section 145 of the Act. In the present case,
E the method adopted by the assessee is to value the closing stock at the
market value irrespective of the fact whether the market value of the stock at
the relevant time is more than the cost value of the stock, which necessarily
results in an imaginary or notional profits to the assessee which he has not

F
actually received. In fact such a notional imaginary profit cannot be taxed. It
is well settled principle as held in Kikabhai Premchand v. C./. T., ( 1953) 24
I.T.R. 506 (S.C.) Constitution Bench judgment that the firm cannot make profit
out of itself. The transaction which is not business transaction and does not
-
derive immediate pecuniary gain is not subjected to tax In the present case
by. showing the market value of the closing stock the ·assessee has earned
potential profit out of itself in as much as the stock in trade remained with
G the assessee at the closing of the accounting year. Secondly, putting the
stock at the market value does not and cannot bring in any real profit which
is necessary for taxing the income under the Act as is held in Chainrup
v.
Sampatram C.l.T., (1953) 24 I.T.R. 481 (S.C.) and C/Tv. Hind Construction
ltd, (1972) 83 ITR 21 I. Thirdly, it is settled principle oflncome-tax Law that
it is the real income, which is taxable under the Act. This proposition was
H enunciated in C.l T. v. Bir/a Gwalior (P.) ltd, (1973) 891.T.R.266 (S.C.), which
SANJEEVWOOLEN MILLS v. COMMISSIONER OF INCOMETAX [NAOLEKAR, J.] 473

was pronounced in C.l.T., Bombay City Iv. Messrs. Shoorji Vallabhdas and A
Co., (1962) 461.T.R. 144 (S.C.).

Under Section 145 of the Act chargeable income has to be deduced from
the accounts regularly employed by the assessee, if in the opinion of the
assessing officer the accounts are correct and complete. The assessing officer
can apply a different method of accounts to deduce the income chargeable B
if in his opinion the method employed by the assessee the chargeable income
cannot properly be deduced. The recognized and settled accounting practice
of accounting with the closing stock in the accounts has to be valued on the
cost basis or at the market value basis if the market value of the stock is less
than the cost value. In the present case the assessee has not adopted the C
established and settled practice. The market value of the stock has been taken
into consideration while arriving at chargeable income although the market
value of the stock is more than the cost value of the stock. The profit earned
is only notional. There is no transfer of the goods and the closing stock
remains the opening stock of the next accounting year. The income which has
not been derived at by the assessee cannot be said to be the income chargeable D
for income and, therefore, the rejection of the accounts maintained by the
assessee for the valuation of the closing stock by the assessing officer and
confirmed by the High Court is in accordance with law. The power exercised
by the assessing officer under Section 145 is as per the principles enunciated
by various authorities and the courts. We do not find any good or sufficient E
reason to interfere with the order passed by the High Court. The appeals is
dismissed with no order as to costs.

B.S. Appeals dismissed.