What is ICDS II?

• Full Name: Income Computation and Disclosure Standards - II (Valuation of Inventories)
• Notification Date: 31st March 2015
• Applicable From: Assessment Year 2016-17 onwards
• Legal Basis: Section 145(2) of the Income Tax Act, 1961
• Purpose: To bring uniformity in computation of income and to avoid controversies in tax assessments

Why ICDS II was Introduced?

• Remove Subjectivity: Eliminate subjective treatment in inventory valuation
• Standardization: Create uniform standards across all taxpayers
• Prevent Revenue Leakage: Reduce tax avoidance through inventory manipulation
• Align with International Practices: Bring Indian tax system closer to global standards
• Reduce Litigation: Minimize disputes between taxpayers and tax authorities

2.1 Who Must Follow ICDS II?

• All Taxpayers: Computing income under the head "Profits and Gains of Business or Profession" or "Income from Other Sources"
• Companies: All companies irrespective of turnover
• Non-Corporate Entities: Following mercantile system of accounting
• Traders and Manufacturers: Dealing with goods and raw materials

2.2 Exemptions (Who Need NOT Follow)

• Individual/HUF: Computing income on cash basis
• Presumptive Taxation: Taxpayers under Section 44AD, 44ADA, 44AE, 44BB, 44BBB
• Special Income: Income from speculative business treated separately
• Small Taxpayers: Turnover below threshold opting for cash system

2.3 Types of Inventories Covered

3.1 Net Realizable Value (NRV)

• Definition: Estimated selling price in the ordinary course of business MINUS estimated costs of completion and estimated costs necessary to make the sale
• Formula: NRV = Estimated Selling Price - Completion Costs - Selling Costs
• Key Point: It represents the net amount that entity expects to realize from sale of inventory

3.2 Fair Value

• Definition: The amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction
• Market-Based: Based on market prices, not entity-specific factors
• Usage in ICDS: NOT used for inventory valuation (unlike AS/Ind AS)

3.3 Cost of Inventories

• Purchase Cost: Invoice price minus trade discounts, rebates and subsidies
• Conversion Costs: Direct labor, direct expenses, and production overheads
• Other Costs: Costs incurred to bring inventories to present location and condition
• Exclusions: Abnormal waste, storage costs, administrative overheads, selling costs

4.1 Basic Valuation Rule

4.2 Components of Cost

4.3 Special Considerations

A. By-Products and Scrap

• By-Products: Valued at NRV and deducted from cost of main product
• Scrap: Valued at NRV when measurable
• Treatment: Reduces cost of production of main product

B. Joint Products

• Allocation Method: Costs allocated on rational and consistent basis
• Basis Options: Relative sales value at split-off point or physical quantities
• Consistency: Same method to be followed year after year

C. Standard Costing

• Permitted: For convenience if results approximate actual cost
• Review Required: Standards must be regularly reviewed
• Revision: Update when conditions change significantly

5.1 Acceptable Methods under ICDS II

Method 1: First-In-First-Out (FIFO)

• Assumption: Items purchased first are sold first
• Valuation: Closing stock valued at most recent purchase prices
• Impact: In rising prices, higher closing stock value, lower COGS, higher profits
• Suitability: Suitable for perishable goods, fashion items

Method 2: Weighted Average Cost (WAC)

• Formula: WAC = Total Cost of Goods Available ÷ Total Units Available
• Application: Calculate average after each purchase (Moving WAC) or periodically
• Impact: Smoothens price fluctuations
• Suitability: Suitable for homogeneous goods, commodities

5.2 Specific Identification Method

• When Used: For items not ordinarily interchangeable
• Application: Goods segregated for specific projects or produced/purchased for specific customers
• Examples: Customized machinery, special orders, heavy equipment, ships, aircraft
• Requirement: Each item must be specifically identified and traceable

Key Differences - Detailed Analysis

1. Treatment of Interest Cost

• ICDS II: Interest cost specifically excluded - reduces inventory cost for tax purposes
• AS 2/Ind AS 2: Can be capitalized if qualifying asset and conditions met - increases financial reporting inventory
• Tax Impact: Creates timing difference between book profit and taxable profit

2. Mark-to-Market for Commodity Brokers

• ICDS II: Commodity brokers CANNOT use MTM - must value at cost or NRV
• AS 2: Allows MTM at NRV for commodity brokers-traders
• Practical Issue: Creates significant book-tax difference for commodity traders

3. Write-down and Reversal

• ICDS II: Once written down, NO reversal allowed even if circumstances change
• AS/Ind AS: Reversal permitted when conditions improve (not exceeding original cost)
• Conservative Approach: ICDS follows more conservative approach for tax purposes

8.1 Landmark Cases Related to Inventory Valuation

8.2 Summary of Judicial Principles

• Fundamental Rule: Value inventories at LOWER of Cost or Net Realizable Value
• Cost Formula: Use FIFO or Weighted Average (LIFO prohibited)
• Exclusions: Interest, storage costs, administrative overheads, abnormal waste - NOT included
• No Reversals: Write-downs cannot be reversed in future years
• Consistency: Same method must be followed year after year
• By-products: Valued at NRV and deducted from main product cost
• Book-Tax Differences: ICDS differs from AS/Ind AS requiring reconciliation
• Subsidies: Reduce purchase cost of inventory
• No MTM: Commodity traders cannot use mark-to-market under ICDS II
• Applicability: From Assessment Year 2016-17 for eligible taxpayers