Tax authority cannot change accounting method or estimate profits without rejecting audited books; additions deleted, assessee wins appeals

ITAT Mumbai (AT) held that the AO was not justified in changing the method of accounting and estimating profits without first rejecting the audited books. It noted that CIT(A), while applying the percentage completion method using audited data up to AY 2019-20, failed to consider certain crucial factual aspects subsequently clarified by the assessee. After factoring in the actual financial data up to AY 2022-23, the correct position showed a loss for both assessment years under appeal. Consequently, the additions made by the AO and partially sustained by CIT(A) were deleted, and the assessee's appeals were allowed.

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ISSUES PRESENTED AND CONSIDERED

1. Whether the Assessing Officer could estimate and recognise profit from a real estate project by treating the project as complete and substituting the assessee's percentage completion method without first rejecting the books of account.

2. Whether, when applying the percentage completion method, the proper measure of project revenue and project cost for computing profit/loss for relevant years must include (a) total project direct costs up to completion (including costs incurred after the assessment years where audited figures are available), (b) estimated future direct costs, and (c) indirect costs from project inception to the relevant date.

3. Whether the re-computation of project profit by the first appellate authority, which used partial subsequent-year data, was erroneous for omitting certain factual components, and whether a re-computation that incorporates audited financial data up to a later year changes the outcome.

ISSUE-WISE DETAILED ANALYSIS

Issue 1: Legitimacy of estimating profit without rejecting books of account and changing accounting method

Legal framework: The percentage completion method is an accounting method recognised for construction and real estate contracts; tax authorities may estimate income but the change of accounting treatment or estimation of profits without first rejecting books of account is legally problematic.

Precedent Treatment: The Tribunal treats the principle that AO should not alter or substitute the assessee's recognized method of accounting (percentage completion) to compute profit unless there is justification to reject books-a principle followed by the Court in this judgment.

Interpretation and reasoning: The Tribunal notes the AO applied a completed-project approach based on survey findings and actual occupation, thereby computing profit on actual sales without rejecting the books. The Tribunal found no valid basis to reject the assessee's books or to change the method, especially where the assessee consistently applied percentage completion and produced audited financials showing project costs beyond the assessment years. The Tribunal emphasises that accepted accounting treatment (percentage completion) cannot be supplanted by AO's estimate absent rejection of books or clear evidence of manipulation.

Ratio vs. Obiter: Ratio - The Tribunal holds it impermissible for the AO to apply a completed-project estimation and change the accounting method without rejecting books of account; such a change warrants deletion of the additions made on that basis.

Conclusion: The additions made by the AO (and partially sustained by the CIT(A)) based on treating the project as complete are deleted because the AO did not reject the books before substituting the revenue recognition method.

Issue 2: Proper components of project revenue and project cost under percentage completion method

Legal framework: Under the percentage completion method, revenue recognised is proportionate to the stage of completion measured against total project revenue and total project costs. Total project cost must include all direct costs to completion and appropriate indirect costs attributable to the project.

Precedent Treatment: The Tribunal follows the Guidance Note of the Institute of Chartered Accountants of India (ICAI) as the accounting benchmark for revenue recognition and cost allocation in construction/re-development projects; this is applied in tax computation unless displaced by cogent reasons.

Interpretation and reasoning: The Tribunal accepted the assessee's submission that (a) total direct cost must include actual costs incurred up to project completion and reasonable estimates of remaining direct costs, (b) indirect costs attributable to the project from inception to the relevant date must be included, and (c) figures available in audited financial statements for years subsequent to the assessment years are relevant to correctly compute total project cost and percentage completion. The Tribunal found the CIT(A) had not incorporated all such costs (notably indirect costs prior to the two years and direct costs up to completion) and that correcting these factual omissions converts the computed profit into a loss for both assessment years.

Ratio vs. Obiter: Ratio - For tax computation using percentage completion method, total project cost must include direct costs up to completion (including audited subsequent-year costs where available and credible estimates for remaining costs) and attributable indirect costs from project inception; omission of these components can materially distort profit/loss and lead to incorrect additions.

Conclusion: The Tribunal accepted the assessee's recomputation (which included audited costs up to later years and estimated remaining costs plus indirect costs) and concluded the project showed losses for both assessment years, warranting deletion of additions.

Issue 3: Validity of appellate re-computation and use of subsequent audited data

Legal framework: Appellate authorities may re-compute assessed income if they base computations on correct and admissible factual material; audited financial statements are admissible and relevant for determining project costs and stage of completion where available by the date of appellate order.

Precedent Treatment: The Tribunal accepts that appellate authorities can and should consider subsequent audited figures available on record, but must do so comprehensively (i.e., include all relevant costs) to ensure correct computation.

Interpretation and reasoning: The Tribunal observed that the CIT(A) did re-compute profit for one year but used incomplete data (direct costs only up to a certain year and ignored indirect costs from inception). The assessee produced audited financials extending up to Assessment Year 2022-23 which were available before the CIT(A)'s order date; those figures, if incorporated correctly, alter the percentage completion and convert the profit into loss. The Tribunal found the assessee's detailed re-working credible and consistent with the Guidance Note and available audited data, and therefore accepted it.

Ratio vs. Obiter: Ratio - Where audited financial data for years subsequent to the assessment year are available and are relevant to compute total project cost/stage of completion, appellate authorities must consider such data fully; partial consideration leading to omission of material cost items renders re-computation erroneous.

Conclusion: The Tribunal re-computed on the basis of audited figures up to the later year and complete cost components, concluding losses for both years and directing deletion of additions upheld by revenue authorities.

Interrelationship and cross-references

The Tribunal's conclusions on Issues 1-3 are interdependent: the impermissibility of AO's change in accounting method without rejecting books (Issue 1) is reinforced by the finding that a correct percentage completion computation (Issue 2), employing audited subsequent-year data (Issue 3), yields losses rather than profits. See Issue 2 for details on cost components and Issue 3 for admissibility of subsequent audited data.

Overall Conclusion

The Tribunal allowed the appeals, deleted the additions made by the Assessing Officer and sustained by the first appellate authority, and directed that computation of profit/loss be governed by the percentage completion method properly applied with inclusion of total direct costs to completion and attributable indirect costs, using audited financial data available to the appellate authority.

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