2024 (2) TMI 1594 - AT - Income Tax

Consistent prior-period accounting bars disallowance; selective audit 'cherry-picking' rejected, matter remitted for fresh assessing officer review

Maharastra State Electricity Distribution Co. Ltd. Versus Dy. Commissioner of Income-tax-14 (2) (1), Mumbai and (Vice-Versa)

ITAT MUMBAI - AT held that the assessee's consistent practice of accounting prior-period expenditure when crystallized - and symmetrically reporting ... Disallowance of prior period expenditure - assessee has been consistently following the same method of accounting in respect of prior period expenditure - HELD THAT:- Assessee has been consistently following the method accounting of debiting the expenditure as and when the same is crystallized. We find that the assessee is not only claiming the expenditure in this manner but is also offering prior period income by adopting the same approach. There cannot be two different scales in accepting prior period income but not allowing prior period expenditure. The issue is perennial. The Tribunal in the past while adjudicating this issue has placed reliance on Mahanagar Gas Ltd.[2013 (7) TMI 118 - BOMBAY HIGH COURT] We see no reason to take a different view in the impugned assessment year. AO is directed to delete the addition on account of prior period expenditure. Hence, the assessee succeeds on ground No.1 of appeal. Addition based on selective comments made by the Comptroller and Auditor General (CAG) on accounts of assessee /appellant - There were adverse comments by the CAG on two issues and on the other two issues there were positive comments. The short prayer of the assessee is that if, Assessing Officer has considered negative comments to make addition, the Assessing Officer should have considered positive comments of the CAG to grant relief. We find merit in the submissions of the assessee. Cherry picking of items from CAG report to make addition is unjustified and arbitrary. We deem it appropriate to restore this issue back to the file of Assessing Officer for denovo examination. The Assessing Officer shall consider the comments of the CAG in whole and thereafter decide the issue by passing a speaking order. ISSUES PRESENTED AND CONSIDERED 1. Whether prior period expenditure debited in the Profit & Loss account can be disallowed for the assessment year where such items are crystallized on receipt of bills, when the assessee follows a consistent mercantile method of accounting and similarly records prior period income. 2. Whether additions to income can be made by the Assessing Officer selectively on the basis of adverse comments in a Comptroller and Auditor General (CAG) audit report while ignoring favourable CAG comments and the assessee's replies (i.e., whether 'cherry-picking' of CAG observations to support additions is permissible), and what is the appropriate procedure when such selective treatment is alleged. 3. (Revenue point closely related to issue 2) Whether the principle of taxing income in the year of accrual/matching principle precludes acceptance of the assessee's accounting treatment for items identified via CAG comments, when Revenue contends such treatment amounts to deferral of tax. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Allowability of Prior Period Expenditure Legal framework: Under the mercantile system of accounting, items are recorded when they are crystallized/ascertained; prior period items may be debited/credited in the P&L account when liabilities/receivables are crystallized in the year of receipt of bills or reconciliation. Taxability/deductibility follows accounting treatment unless the method is arbitrary or inconsistent with accepted principles. The matching principle and accrual concepts inform but do not automatically invalidate consistent accounting conventions. Precedent Treatment: The Tribunal relied on earlier decisions in the assessee's own appeals where identical heads of prior period expenditure were allowed when crystallized on receipt of bills in the current assessment year, and on a binding decision of the jurisdictional High Court (Mahanagar Gas Ltd.) accepting prior period adjustments where accounting method is consistent. Interpretation and reasoning: The Tribunal examined the components of the disputed prior period expenditure (including short provision for power purchase, operating expenses, employee cost, depreciation under-provided, interest and other charges, administration and material expenses, and adjustments to past billing). It found that (a) identical components were treated as prior period items in earlier years; (b) the assessee consistently recorded such items as and when crystallized; and (c) prior period income was likewise recorded and accepted. The Assessing Officer's objection that some items (e.g., interest and other charges, or billing adjustments) were not 'strictly' prior period expenses was rejected on the ground that consistency of accounting and the established approach in earlier years meant that disallowing expenditure in this year, while having accepted prior period income, would be arbitrary and inconsistent. The Tribunal emphasized that the AO relied on the fact that earlier AOs had made similar additions, but subsequent Tribunal and High Court rulings in identical factual matrices supported deletion of such additions. Ratio vs. Obiter: Ratio - where an assessee consistently follows a mercantile method of accounting and records prior period items only when crystallized (and similarly records prior period income), the AO cannot disallow such expenditure merely because some components might technically pertain to earlier periods. The decision to delete the addition is a binding ratio in the facts of this case. Obiter - ancillary observations about the remote offices transmitting consolidated expenses to head office are explanatory. Conclusion: The addition of Rs.104,465.06 lacs on account of prior period expenditure is to be deleted. The Tribunal directed the Assessing Officer to allow the prior period expenditure, following consistent accounting practice and precedent. Issue 2 - Additions based on selective CAG comments (cherry-picking) and procedural treatment Legal framework: Statutory audit observations (here, by CAG) are material for assessment but must be considered in entirety; assessing authorities are required to form independent satisfaction based on materials on record, give the assessee opportunity to rebut, and pass a speaking order. Administrative or audit observations cannot be used selectively in a manner that results in arbitrary additions without holistic consideration and appropriate adjudication. Precedent Treatment: The Tribunal applied general principles of administrative fairness and precedents forbidding arbitrary or selective reliance on audit reports to make additions. It noted that replies and explanation submitted by the assessee and the audit committee's acceptance/rejection on different points must be considered together. Interpretation and reasoning: The Tribunal reviewed the CAG report which contained four comments - two where the audit committee accepted the assessee's replies and two where adverse comments remained. The Assessing Officer had taken cognizance only of the adverse comments and made additions aggregating Rs.7,87,99,095/-. The Tribunal found this selective adoption of CAG observations to be arbitrary ('cherry-picking') and unjustified. Given that some CAG observations were favourable and others unfavourable, a fair and lawful exercise required the AO to consider the CAG report as a whole, examine the assessee's responses, verify records, afford the assessee an opportunity of hearing, and pass a reasoned order. Consequently, the Tribunal declined to decide the factual correctness of the additions itself and instead remitted the matter to the Assessing Officer for de novo examination with directions to consider the entire CAG report and the assessee's submissions and to pass a speaking order after affording reasonable opportunity. Ratio vs. Obiter: Ratio - an assessing authority cannot make additions based on selected adverse comments in an audit report without considering favourable comments and the assessee's explanations; such selective reliance is arbitrary and requires fresh adjudication. Obiter - the precise merits of each CAG comment were not decided by the Tribunal and remain open for AO's fresh consideration. Conclusion: The Tribunal allowed the assessee's ground seeking reconsideration of the additions for statistical purposes and remitted the matter to the Assessing Officer for de novo examination of all CAG comments, verification of records, and passing of a speaking order after providing the assessee an opportunity to be heard. Issue 3 - Revenue's contention on matching principle and deferral of taxation (linked to CAG additions) Legal framework: The Revenue's challenge was premised on the settled accounting/tax principle that income should be taxed in the year in which it accrues (matching/realization principles). However, that principle must be balanced against the assessee's chosen, consistent accounting treatment and the requirement that AO base any addition on admissible material and a clear finding that the accounting is incorrect or contrived to defer tax. Precedent Treatment: The Tribunal observed that the Revenue's ground arises from the same contested CAG observations and the approach of the Assessing Officer in making additions. The Tribunal found that where the AO's action was procedurally and substantively selective, the Revenue's reliance on matching principle could not sustain the addition without a fresh, holistic fact-finding exercise. Interpretation and reasoning: Because the Tribunal remitted the CAG-linked additions to the AO for fresh adjudication, and because the CIT(A)'s order similarly directed verification, the Tribunal held there was no infirmity in the appellate order. The revenue appeal on this ground suffers from the same defect of premature acceptance of selective audit comments without comprehensive examination; the Tribunal therefore dismissed the Revenue's appeal in respect of this ground. Ratio vs. Obiter: Ratio - a high-level contention that the assessee's methodology amounts to tax deferral cannot succeed where the assessing authority has not made an explicit, verified, and reasoned finding after considering all material; remand for fresh consideration is appropriate. Obiter - the Tribunal did not decide whether the matching principle was violated on merits; that remains open for AO's determination on remand. Conclusion: Revenue's appeal challenging the CIT(A)'s direction for verification and deletion of the CAG-linked additions is dismissed. The AO is to reconsider the matter in accordance with directions given under Issue 2.