ASSISTANT COMMISSIONER OF INCOME TAX 25(3), MUMBAI vs. S. S. ENTERPRISES, MUMBAI

ORDER

PER N.K. PRADHAN, AM

1. On the facts and circumstances of the case and in law, the Ld. CIT(A) has erred in deleting the addition made by the AO of Rs.6,81,13,165/-.

2. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) has erred in deleting the addition by stating that that an enterprise may choose to apply this guide note from an earlier date provided it applies this guidance note to all transactions which commenced or were entered into on or after such earlier date. Whereas, no documentary evidence was bought before AO during scrutiny proceedings which suggested that the same principle was applied to transactions which commenced or were entered into on or after such earlier date? 3. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) has erred in ignoring that there is no provision of reversal of profit as per Income-tax Act, 1961.

The Assessment

In response to it, the assessee filed a reply stating that (i) till the assessment year 2012-13, it had offered profits from its project ‘S.S. House’, on percentage completion method basis, by declaring around 10-12% profits on its WIP on year to year basis and the same was done by debiting the WIP account and crediting the P&L account in the respective years; this way till AY 2012-13, it had offered a total of Rs.6,81,13,165/- as ‘profits on accrual basis’ ; (ii) however, after the introduction of Revised Guidance Note on ‘Real Estate Transactions’ prescribed by the Institute of Chartered Accountant of India (ICAI)[ in short ‘Guidance Note’] in AY 2013-14, it had again offered profits based on percentage completion method basis, this time by showing sales of Rs.65,12,000/- and claiming proportionate cost of Rs.45,07,663/-, thereby declaring net profit of Rs.20,04,337/-, (iii) however, when the assessee-firm was working out the revenue recognition for AY 2014-15, based on the costs incurred and agreements entered till date, future estimated costs and future sales expected, there was a total expected loss of Rs.3,95,51,736/- till AY 2014-15 ; as per the project report there was a further probable loss in AY 2015-16; (iv) the assessee was incurring a huge loss from the said project due to the fact that there were some irregularities in its construction activities due to which M/s S.S. Enterprises MCGM charges, (v) there was also a delay in the execution of the said project due to financial constraints on account of lack lusture response to the sales of the commercial unit in the said building, (vi) as per the aforesaid Guidance Note, any expected future losses should be recognized as an expense immediately and therefore in view of the losses, whatever profits declared earlier had to be reversed in AY 2014-15, so that the true status of the project could be reflected in the finalized accounts for AY 2014-15, (vii) therefore, the assessee-firm had no option than to reverse the profits shown in the earlier years, on account of expected estimated loss, by crediting the WIP in the current year (to bring WIP to its actual amount of cost incurred) as the same was inflated by debiting in the earlier years, (viii) further, to reverse the profits declared in AY 2013- 14, it had to add back the proportionate costs to the cost of WIP, by debiting the same to WIP account in the current year which was credited in the earlier years and also by adding back the amount of sales declared in AY 2013-14, to the amount of advances received in the current year, by crediting the same to the advances account, which was earlier reduced from the advances in AY 2013-14.

However, the AO was not convinced to the above submissions of the assessee for the reason that the assessee could not justify the criteria laid down in the Guidance Note on which it solely relied. The AO has quoted the following clause 1.5 of the Guidance Note which is as under :

M/s S.S. Enterprises 1.5 This Guidance Note should be applied to all projects in real estate which are commenced on or after April 1, 2012 and also to projects which have already commenced but where revenue is being recognized for the first time on or after April 1, 2012. An enterprise may choose to apply this Guidance Note from an earlier date provided it applies this Guidance Note to all transactions which commenced or were entered into on or after such earlier date. This Guidance Note supercedes the Guidance Note on Recognition of Revenue by Real Estate Developers, issued by the Institute of Chartered Accountants of India in 2006, when this Guidance Note is applied as above."

Further, the AO referred to the clause 5.9 of the Guidance Note which is produced below:

The changes to estimate referred in paragraph 5.8 above also include changes arising out of cancellation of contracts and cases where the property or part thereof is subsequently earmarked for own use or for rental purposes. In such cases any revenues attributable to such contracts previously recognized should be reversed and the costs in relation thereto shall be carried forward and accounted in accordance with AS 10, Accounting for Fixed Assets.

The AO observed that in assessee’s case neither the contracts were cancelled nor the property was earmarked for its own use or for rental purpose. This is evident from the fact that the assessee had not reflected any rental income in the P&L account. Further, as per the balance sheet, the assessee has not shown any flat/shop from ongoing project i.e. S.S. House in fixed asset schedule.

Thus observing that there is no provision to reverse the profits already offered on year to year basis and the fact that the assessee, who

M/s S.S. Enterprises is following percentage completion method can recognize some gain or loss related to a project in every accounting year in which the project continues to be active, the AO disallowed the claim of reversed profit of Rs.6,81,13,165/- in the P&L account.

Order of the CIT(A)

Observing as above, the Ld. CIT(A) held at para 5.7 of his order the following :

“5.7 After considering the totality of facts, rival submissions and on the basis of discussion mentioned above, I find force in the argument of the appellant. The Institute of Chartered Accountants of India has prescribed from time to time of various Accounting Standards and Guidance Notes in order to guide various enterprises while computing their profits from year to year. The percentage of completion method prescribed by the Institute of Chartered Accountants of India. The appellant has been consistently following the percentage completion method. As per guidance note of Institute of Chartered Accountants of India, when the total project costs will exceed total eligible project revenues, the expected loss should be recognized as an expense immediately. The appellant firm had declared profits Rs.6,81,13,165/- on percentage of completion method basis, year after year. When the appellant was finalizing the accounts and revenue working for A.Y. 2014-15, by following the percentage of completion method, there was a total loss emerging of more than Rs.3.95 cr. from the aforesaid project. Therefore, the appellant had declared such a loss by reversing the profits declared in the earlier years and arrive at a total correct picture of profitability of the project. The said guidance note can be applied even to those periods and or those

M/s S.S. Enterprises projects which have commenced earlier, from that earlier date, provided it is applied consistently to all the transactions thereafter. Further, appellant has stated that there was an actual loss of Rs.6,77,81,536/- in the A.Y.2015-16 and Rs.2,10,01,300/- in the A.Y. 2016-17. The appellant has filed loss return for the A.Y. 2015-16 and A.Y. 2016-17 and the said loss return was accepted by the department. In view of the above discussion, I came to the conclusion that the appellant has rightly followed the guidance note and recognized the loss correctly in the return of income. Therefore, A.O. is directed to delete the addition of Rs.6,81,13,165/-. This ground is allowed.”

Contentions of the Revenue

The Ld. DR further submits that in assessee’s case neither the contracts were cancelled nor the property was earmarked for its own use or for rental purposes. This is evident from the fact that the assessee has not reflected any rental income in the P&L account ; further, on perusal of the balance sheet, it is seen that the assessee has not shown any flat/shop from the ongoing project i.e. ‘S.S. House’ in fixed asset schedule. Thus the Ld. DR supports the order of the AO stating that the assessee has failed to substantiate its claim to reverse the profits.

M/s S.S. Enterprises The Ld. DR draws our attention to two sets of working of estimated profits as on 31st March 2014 signed and filed by the assessee.

Stating that the assessee is following percentage completion method and there is no such provision to reverse the profits already offered on year to year basis, the Ld. DR argues that the order passed by the AO be restored.

Contentions of the Assessee

Further, the Ld. counsels explain that the assessee had incurred a total loss from the aforesaid project due to the fact that the project got delayed beyond the expected date of completion which was further due

M/s S.S. Enterprises to certain modifications carried out in the internal layout of the commercial offices; further there were certain disputes between the partners inter se, due to which the project got delayed.

Also it is argued that the assessee has correctly reversed the profits declared till AY 2012-13, as the net result from the project was a loss and it had correctly followed the principles laid down in the Guidance Note. As per the said Guidance Note, if there were future expected losses, i.e. when the probable costs are likely to exceed the probable revenues, then in such a case, the estimated losses should be immediately recognized not waiting for the actual losses to occur. Such losses can also be recognized which are likely to be incurred, due to revision in the estimates, which principle the assessee has rightly followed, while ascertaining the profitability for the year under appeal. It is thus stated that the said Guidance Note clearly lays down the criteria that the estimates can be revised subsequently and the revenues previously recognized can be reversed due to such revision in estimates.

Referring to para 5.9 of the said Guidance Note i.e. ‘the changes to estimates referred to in paragraph 5.8 above also include changes arising out of cancellation of contracts …”, it is explained that the said words signify that cancellation of contracts and others are included and that by itself does not infer, only in such cases the estimates can be revised as the word mentioned is “include”. Thus the Ld. counsels argue that the revision of other accounts are also covered in the interpretation of the said Guidance Note.

M/s S.S. Enterprises Thus it is explained that the AO has failed to read that the said Guidance Note which mentions that “an enterprise may choose to apply this Guidance Note from an earlier date provided it applies this Guidance Note to all transactions which commenced or were entered into on or after such earlier date”.

Thus the Ld. counsels submit that as the Guidance Note issued by the ICAI is applicable to the instant case, the assessee has rightly followed the same and therefore, the order passed by the Ld. CIT(A) be affirmed.

Further, the Ld. counsels rely on the decision in CIT v. Virtual Soft Systems Ltd. (2018) 404 ITR 409 (SC), ACIT v. M/s ITD Cementation India Ltd. (ITA No. 3669/Mum/2011 for AY 2004-05 by ITAT, Mumbai), Dredging international N.V. v. ADIT (2011) 48 sot 430 (Mumbai), Aarts Module v. ITO (ITA No. 9302/BOM/92 for A.Y. 1984-85).

Reasons for the Decision

We discuss now the case-laws relied on by the Ld. counsels. In the case of Virtual Soft Systems Ltd. (supra) for the AY 1998-99, the assessee had entered the amount, inter alia, under the head ‘Lease equalization account’ at Rs.4,35,89,486/-. Under the P&L account for the said year, the assessee had reduced the aforesaid amount representing the lease equalization account from the lease rental of Rs.11,84,21,434/-. The AO

M/s S.S. Enterprises disallowed the said claim on the ground that the same was neither a liability nor an allowance nor an expenditure. The AO observed that the same was just a matching entry for the purpose of tallying the accounts with regard to the assets leased out. Aggrieved by the said order the assessee preferred an appeal before the CIT(A), who dismissed the appeal. In further appeal the Tribunal held that this is an appropriation on profit and thus cannot be allowed in the deduction. However, the High Court dismissed the Department’s appeal from the order of the Tribunal. On appeal by the Department, the Hon’ble Supreme Court held: that the assessee could be charged only on real income which could be calculated only after applying the prescribed method. The Act is silent on such deduction. For such calculation, the assessee had to have recourse to the Guidance Note prescribed by the Institute of Chartered Accountants of India. Only after applying such method which was prescribed in the Guidance Note, could the assessee show fair and real income liable to tax under the Act. Therefore, it could not be said that the assessee claimed deduction by virtue of the Guidance Note : it only applied the method of bifurcation as prescribed by the expert team of the Institute of Chartered Accountants of India. The assessee was entitled to bifurcate the lease rental in accordance with the accounting standards prescribed by the Institute. There was no express bar in the Act regarding the application of such accounting standards.

In M/s ITD Cementation India Ltd. (supra), the facts are that the AO issued show cause notice to the assessee requiring to explain as to why 100% loss was claimed even when the project was not completed 100%. The AO asked the assessee to explain why loss should not be allowed only upto the percent of work completed and why the excessive loss of M/s S.S. Enterprises Rs.1,58,77,508/- should not be disallowed and added back to the income of AY 2003-04. In response to it, the assessee explained to the AO that it was consistently following the Accounting Standard-7 (AS-7) issued by ICAI for valuation of WIP. It was explained that the valuation figures were based on the actual cost recorded in the books of account and an estimate of the profit/loss on a project on completion. However, the AO observed that the assessee has claimed entire foreseeable losses of future years in AY 2004-05. The Tribunal held that (i) section 145(2) of the Act provides that the Central Government may notify in the Official Gazette from time to time accounting standards to be followed by any class of assessees or in respect of any class of income; it is a fact that AS- 7 has not been notified by the Central Government ; however, this does not mean that the assessee is precluded from following AS-7, (ii) a perusal of the provisions of section 145 shows that the accounting standards which have been notified by the Central Government have to be mandatorily followed by the assessee ; but this does not mean that the assessee cannot follow the other accounting standards issued by ICAI, (iii) ICAI being the highest accounting body of the country, created by an Act of Parliament, accounting standards issued by it cannot be brushed aside lightly; on the contrary, if an assessee is following accounting standards issued by ICAI, it would give more credibility and authenticity to its accounts.

In Dredging international N.V.(supra), it is held that provisions for foreseeable losses made in accordance with guidelines of AS-7 and duly debited in audited accounts of company is an allowable expenditure.

M/s S.S. Enterprises In Aarts Module (supra), it is held that it is permissible for the assessee to work out the profit or loss in respect of a project on the basis of the WIP worked out at the net realizable value.

We follow the ratio laid down in the above case-laws relied on by the Ld. counsels. However, we find that the workings of total estimated loss on the project “S.S. House” as worked out by the assessee are not based on supporting computation and there are wide variations as discussed infra.

7.1 We may mention here that Accounting Standard (AS) is an authoritative statement issued by ICAI, a premier body of accounting in our country. It deals with the accounting issues related to a particular area which that standard wants to address.

Guidance Notes are primarily designed to provide guidance to members of ICAI on matters which may arise in the course of their professional work and on which they may desire assistance in resolving issues which may pose difficulty. Guidance Notes are recommendatory in nature.

7.2 The assessee has consistently followed the mercantile system of accounting as well as percentage completion method.

In CIT v. A. Gajapathy Naidu, (1964) 53 ITR 114 (SC), it is held by the Hon’ble Supreme Court that income is taxable when it accrues or is earned, if the assessee’s accounts are maintained on the mercantile basis. A profit can be said to have accrued or a liability or loss can be said to have been incurred only when the profit is either actually due or M/s S.S. Enterprises the liability becomes enforeceable. Further, it is held by the Hon’ble Bombay High Court in CIT v. Associated Commercial Corporation, (1963) 48 ITR 1 (Bom) that a mere claim to a profit or to a liability is not sufficient to make the profit to accrue or the liability to be incurred for the purposes of the Income Tax Act. It is also clarified by the Hon’ble Supreme Court in Morvi Industries Ltd. v. CIT, (1971) 82 ITR 835 (SC) that once accrued, it is liable to the charge even if, subsequently, it is forgone and not realized.

When a statute brings to charge certain income, its intention is to enforce the charge at the earliest point of time. The same is clarified in decision in T.N.K. Govindarajulu Chetty v. CIT (1973) 87 ITR 22 (Mad), affirmed in (1987) 165 ITR 231 (SC).

In exercise of the powers conferred by sub-section (2) of section 145 of the Income Tax Act, 1961 (43 of 1961), the Central Government notified AS-I and AS-II to be followed by all assessees following the mercantile system of accounting. As per it “accrual” refers to the assumption that revenues and costs are accrued, that is, recognized as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate.

7.3 The assessee is following consistently percentage of completion method. AS-7 (Revised) allows only percentage of completion method for construction contracts. The basic ingredients of the above method are (i) the recognition of revenue and expenses by reference to the stage of completion of a contract is called “the percentage of completion method”, (ii) the contract revenue is matched with the contract costs

M/s S.S. Enterprises (iii) this results in the reporting of revenue, expenses and profit that can be attributed to the proportion of work completed, (iv) this method provides useful information on the extent of contract activity and performance during a period, (v) contract revenue is recognized as revenue in the statement of profit and loss in the accounting periods in which the work is performed, (vi) contract costs are usually recognized as an expense in the statement of profit and loss in the accounting periods in which the work to which they relate is performed, (vii) however, any expected excess of total contract costs over total contract revenue is recognized as an expense immediately.

7.4 It is the contentions of the Ld. counsel that the assessee by following the Guidance Note reversed the profits shown in earlier years, on account of expected estimated loss, by crediting the WIP account in the current year (to bring the WIP to its actual amount of cost incurred) as the same was inflated by debiting in the earlier years.

The year-wise details of profit declared on the project “S.S. House” filed by the assessee are giving below :

Sr. No. A.Y. Profit declared (Rs.) 1. 2010-11 Rs.2,65,93,359/- 2. 2011-12 Rs.1,95,32,020/- 3. 2012-13 Rs.2,19,87,786/- Total Rs.6,81,13,165/- A perusal of the WIP account for the year ended 31.03.2014 shows that the WIP was shown at Rs.97,88,86,048/- and from the same the M/s S.S. Enterprises Rs.6,81,13,165/- was reduced on account of ‘reversal of profits declared in the earlier years on account of estimated loss expected’.

The Guidance Note primarily provides guidance on application of percentage of completion method prescribed in AS-7, ‘Construction Contracts’ where it is appropriate to apply this method as such transactions and activities of real estate have the same economic substance as construction contracts. In respect of transactions of Real Estate, which are in substance similar to the delivery of goods, the principles laid down in AS-9, Revenue Recognition are applied.

The relevant paragraphs of the Guidance Note are as under :

“5.7 When it is probable that total project costs will exceed total eligible project revenues, the expected loss should be recognized as an expense immediately. The amount of such a loss is determined irrespective of:

(a) commencement of project work; or (b) the stage of completion of project activity.

5.8 The percentage of completion method is applied on a cumulative basis in each reporting period to the current estimates of project revenues and project costs. Therefore, the effect of a change in the estimate of project costs, or the effect of a change in the estimate of the outcome of a project, is accounted for as a change in accounting estimate. The changed estimates are used in determination of the amount of revenue and expenses recognized in the statement of profit and loss in the period in which the change is made and in subsequent periods.

M/s S.S. Enterprises 5.9 The changes to estimates referred to in paragraph 5.8 above also include changes arising out of cancellation of contracts and cases where the property or part thereof is subsequently earmarked for own use or for rental purposes, in such cases any revenues attributable to such contracts previously recognized should be reversed and the costs in relation thereto shall be carried forward and accounted in accordance with AS 10, Accounting for Fixed Assets.”

7.4.1 In the instant case, the assessee has stated that it had incurred a total loss from the aforesaid project due to the fact that the project got delayed beyond the expected date of completion which was further due to certain modifications carried out in the internal layout of the commercial offices and further there were certain disputes between the partners inter se due to which the project got delayed. But no details on the above were filed before the AO..

7.4.2 We are reminded of the accounting principles that a reversing entry is the exact reverse of the adjusting entry to which it relates, the amounts and the accounts are the same ; the debits and credits are just reversed. We are also reminded that one can reverse adjusting entries only for accruals, such as salaries payable and unbilled revenue, with evidence.

The claim of the assessee is thus not tenable.

7.5 The Ld. counsel has filed an working of total estimated profits as on 31.03.2014 of the project “S.S. House” which is produced below :

“S.S. ENTERPRISES PROJECT. "S.S. HOUSE"

WORKING OF ESTIMATED PROFITS AS ON 31 ST MARCH 2014 Total agreements for sale entered till 31/03/2014 = 60,04,48,264.00 Further sale agreements epected in F.Y. 2014-15 = 30,00,00,000.00 Total estimated sales = 90,04,48,264.00 Total cost incurred till 31/03/2014 = 91,07,85,390.00 Further estimated costs = 3,00,00,000.00 94,07,85,390.00 Say = 94,00,00,000.00 Estimated Loss = 94,00,00,000.00 - 90,04,48,264.00 Total estimated loss = 3,95,51,736.00”

7.5.1 The Ld. DR also filed an working of total estimated profits as on 31.03.2014 of the project “S.S. House” given by the Ld. counsel, which is produced below :

“S.S. ENTERPRISES PROJECT. "S.S. HOUSE" WORKING OF ESTIMATED PROFITS AS ON 31 ST MARCH 2014 Total agreements for sale entered till 31/03/20 = 600,448,264.00 Further sale agreements epected in F.Y. 2014 = 300,000,000.00 Total estimated sales = 900,448,264.00 Total cost incurred till 31/03/2014 = 978,886,048.00 Further estimated costs = 3,00,00,000.00 1,008,886,048.00 Say = 1,008,880,000.00 Estimated Loss = 1,008,880,000.00 -900,448,264.00 Total estimated loss = 108,431,736.00 Out of loss of Rs.10.84 crores, Rs. 6.81 cr. has been recognized and balance Rs.3.53 cr. has not been recognized.”

7.6 But how to calculate the percentage of completion and current revenue from contract? The percentage of completion would be estimated by comparing total cost incurred to date with total cost expected for the entire contract : Cost to date Percentage of Completion = X 100% Cumulative cost incurred + estimated cost to complete Current Revenue Contract Price X Percentage of completion– Revenue previously recognized. from Contract 7.6.1 Let us illustrate it further by arithmetic:

Question:

On 1st December 2003, XYZ Construction Co. Ltd. undertook a contract to construct a building for Rs. 85 lakhs. On 31st March, 2003 the company found that it had already spent Rs.64,99,000 on the construction. Prudent estimate of additional cost for completion was Rs. 32,01,000. What amount should be charged to revenue in the final accounts for the year ended 31st March, 2003 as per provisions of Accounting Standard 7 (Revised)?

Answer :

Rs.

Cost incurred till 31st March, 2003 64,99,000

32,01,000 Prudent estimate of additional cost for completion Total cost of construction 97,00,000 Less : Contract price 85,00,000 Total foreseeable loss 12,00,000 According to AS 7 (Revised 2002), the amount of Rs.12,00,000 is required to be recognized as an expense.

Stage of completion = Rs.64,99,000 x 100 = 67% 97,00,000 Proportion of total contract value recognized as turnover as per AS 7 (Revised) on Construction Contracts = 67% of Rs.85,00,000 = Rs. 56,95,000/- Cost recognized =Rs.64,99,000 Lost till date =Rs.8,04,000 Provision for additional loss till date =Rs.3,96,000 Total estimated loss =Rs.12,00,000 7.7 An examination of the working of total estimated loss on the project “S.S. House” as worked out by the assessee clearly indicates that it suffers from basic deficiencies viz. (i) total cost incurred till 31/03/2014 Rs. 91,07,85,390/ or Rs. 978,886,048/- is not a reliable one, as the assessee is sticking to two figures, without supporting computation, and (ii) total estimated loss of Rs. 3,95,51,736/- or Rs.108,431,736/- is not a reliable one, as the assessee is sticking to two figures, without supporting computation, (iii) there is no prudent estimate of additional cost for completion of the project.

M/s S.S. Enterprises The matching principle requires recording expenses in the same accounting period in which the revenues were earned as a result of the expenses. Expense recognition, similar to revenue recognition, has a balance sheet effect. In this view, expense recognition is simultaneous with a decrease in an asset or an increase in a liability.

In such a scenario, reversal of profits declared in the earlier years on account of estimated loss expected of Rs. 6,81,13, 166/- in WIP for the impugned assessment year by the assessee upsets the applecart of mercantile system of accounting, the matching principles. Further, it dislocates the equilibrium of the following equation, which is central to AS-7 (Revised). Cost to date Percentage of Completion = X 100% Cumulative cost incurred + estimated cost to complete Current Revenue Contract Price X Percentage of completion– Revenue previously recognized. from Contract Therefore, no reliance can be placed on the above workings of total estimated loss as on 31.03.2014 of project “S.S. House” arrived at by the assessee, which are nothing but bald statements.

As the order passed by the Ld. CIT(A) is not based on proper appreciation of facts and law, we set it aside. Resultantly, the order passed by the AO is restored.

M/s S.S. Enterprises Order pronounced in the open Court on 28.10.2019.