Inventory Valuation: Precautions for Year ending 31st March 2026

Inventory Valuation is becoming a critical area in the wake of focused attention of the Tax Authorities, may it be Income Tax, GST or customs authorities. The authorities require the inventory valuation for their own purposes like customs may require the Valuation to consignments of products to ensure that proper customs duties are paid on exports primarily. The data submitted to customs authorities must be mapped with the inventory valuations of the same products in the organization. However, the Inventory Valuation as per income tax is being discussed here in this article.

Among the many structural reforms introduced by the Income-tax Act, 2025 (Act No. 30 of 2025), the legislative treatment of inventory valuation occupies a place of considerable fiscal and jurisprudential significance. Unlike capital asset valuation - which is governed by a detailed set of fair market value rules - inventory valuation sits at the intersection of tax accounting, commercial law, and regulatory oversight, drawing from multiple statutory sources simultaneously. Under Section 145A of the 1961 Act, inventory was to be valued in accordance with the method of accounting regularly employed by the assessee, but adjusted to include taxes and duties. Section 277 of the 2025 Act mandates valuation strictly at lower of cost or NRV as per ICDS - removing discretion and standardising the method across taxpayers.

This article offers a consolidated analytical examination of the principal provisions that govern the manner in which a taxpayer's inventory is valued, reported, and verified under the Income-tax Act, 2025. Specifically, the discussion traverses the following terrain:

• the power conferred on an Assessing Officer under Section 268(5)(ii) to direct independent inventory valuation;
• the statutory prescription for valuation methods under Section 277;
• the procedural framework established by Rule 171(2) of the Income-tax Rules, 2026 culminating in Form 101;
• and the way in which these streams converge with the disclosure obligations imposed on the statutory tax auditor through the relevant portions of Form 26.

The article is structured to serve the professional accountants who navigate these requirements on behalf of their clients, as well as the litigant and adjudicator who must appreciate the interplay of these provisions in a dispute context.

1. The Regulatory Architecture of Inventory Valuation

1.1 Why Inventory Valuation Matters in Income Tax

A business entity's taxable profits are inextricably tied to the way it values its inventory. At the simplest level, a higher closing stock value reduces the cost of goods sold and thereby inflates taxable income, while a lower valuation has the opposite effect. This arithmetical reality creates an incentive to manipulate inventory figures, whether upward to suppress losses or downward to erode taxable profits. The legislature has therefore been careful to enact provisions that (a) prescribe permissible valuation methods, (b) mandate disclosure of the method adopted, (c) require reconciliation where the method deviates from the prescribed norm, and (d) empower the tax authority to commission an independent valuation when it has reason to doubt the figures presented.

Historically, the Income Computation and Disclosure Standards (ICDS) - notified under the power now replicated in Section 276(2) of the 2025 Act brought a degree of standardisation to inventory accounting for tax purposes. ICDS II, which applies to the valuation of inventories, substantially mirrors the principles of Accounting Standard 2 (AS-2) issued by the Institute of Chartered Accountants of India (ICAI), anchoring measurement at cost or net realisable value (NRV), whichever is lower. However, as discussed below, the ICDS framework is not universal in its application - certain categories of inventory operate under different principles and the tax auditor must navigate these distinctions with care.

1.2 The Three-Tiered Regulatory Structure

The governance of inventory valuation under the Income-tax Act, 2025 may be understood as a three-tiered structure:

2. Section 268(5): The Power to Direct Independent Inventory Valuation

2.1 Situating Section 268 in the Broader Assessment Framework

Section 268 of the Income-tax Act, 2025 deals comprehensively with the power of the Assessing Officer to call for a special audit or, in appropriate cases, a special inventory valuation. The section grants an extraordinary power - one that goes beyond the routine scrutiny of accounts - and activates when the Assessing Officer arrives at the view that the nature and complexity of the taxpayer's accounts, or the public interest in ensuring fiscal accuracy, warrants an examination by a trained professional beyond the ordinary audit.

The power to direct inventory valuation is specifically housed in Section 268(5)(ii). To understand its scope, it is useful to first appreciate the structural logic of the section. Sub-section (1) of Section 268 empowers the Assessing Officer, with prior approval of the Principal Chief Commissioner, Chief Commissioner, Principal Commissioner, or Commissioner of Income-tax, to direct an assessee to get its accounts examined and audited. This is the "special audit" power. Sub-section (5) then bifurcates the mandate into two distinct streams: clause (i) addresses audit of accounts by a nominated accountant, while clause (ii) addresses inventory valuation by a nominated cost accountant.

2.2 What Section 268(5)(ii) Actually Requires

Under Section 268(5)(ii), once the Assessing Officer has directed an inventory valuation, the assessee is required to get its inventory valued by the cost accountant nominated by the Principal Chief Commissioner or Chief Commissioner or Principal Commissioner or Commissioner of Income-tax, as the case may be. The use of the word 'nominated' is significant: the taxpayer does not have the freedom to engage a cost accountant of its own choosing for this statutory exercise. The exercise of nomination resides in the senior tax authority, which is expected to draw upon the panel maintained under Rule 172. It needs mention that the Income Tax Department has already created panels at PCCIT office levels.

The valuation so conducted must be reported in Form 101 - the prescribed form under Rule 171(2) of the Income-tax Rules, 2026. The report is not a mere statement of figures but a comprehensive, documented exercise that covers the books of account, the method of valuation adopted for each category of inventory, a reconciliation with the figures disclosed in the tax audit report (Form 26), and a quantitative and monetary assessment of any variation.

2.3 Conditions Precedent: Prior Approval and Time Specificity

The power under Section 268(5)(ii) is not unfettered. The Assessing Officer cannot unilaterally direct inventory valuation. Prior approval from a senior authority is a mandatory pre-condition. This check serves as a safeguard against arbitrary exercise of a power that can be burdensome and disruptive to a business.

Furthermore, under Section 268(8), (9), and (10), the Assessing Officer specifies the period for which the valuation is to be conducted. This period-specificity is operationally important: the cost accountant's mandate is bounded by the period so specified, and the fee payable is computed with reference to the number of hours actually expended within that period. Under no circumstances, the period for submission of report shall exceed six months from the end of the month in which the assessee receives the information regarding conduct of Inventory Valuation

2.4 The Fee Structure Under Rule 172

Rule 172 of the Income-tax Rules, 2026 operationalises the remuneration framework for the cost accountant nominated under Section 268(5)(ii). The rule requires every Chief Commissioner of Income-tax to maintain a panel of cost accountants drawn from persons qualified under Section 268(13). When an inventory valuation is directed, the expenses - including the cost accountant's remuneration and those of any qualified or semi-qualified assistants engaged for the purpose - are regulated at not less than ₹3,750 and not more than ₹7,500 for every hour of the period specified by the Assessing Officer.

The cost accountant is required to maintain a time-sheet recording the hours actually expended and submit it along with the bill to the Chief Commissioner or Commissioner. The senior authority is charged with verifying that the hours claimed bear a reasonable relationship to the volume and complexity of the report produced. This oversight mechanism is intended to prevent inflated billing and to ensure that the public exchequer - which ultimately bears the cost of the exercise - is protected.

3. Section 277: The Statutory Prescription for Inventory Valuation Methods

3.1 The Role of Section 277 in the Valuation Ecosystem

If Section 268(5)(ii) addresses who values the inventory and under what authority, Section 277 addresses how the inventory is to be valued. The two provisions operate in tandem: Section 277 lays down the substantive standard, while Section 268(5)(ii) provides the enforcement mechanism when that standard is not self-evidently met from the taxpayer's own records.

Section 277 of the Income-tax Act, 2025 prescribes the method of valuing inventory for the purposes of computing income under the head "Profits and Gains of Business or Profession." Its sub-sections draw from the same underlying principles that inform ICDS II but give those principles statutory force. The four sub-clauses of Section 277(1) - referenced in the Schedule to Form 26 as 277(1)(i), 277(1)(ii), 277(1)(iii), and 277(1)(iv) - address different categories of inventory and different circumstances of valuation. The section 277 mandates that the valuation of inventory shall be made at lower of actual cost or net realisable value computed as per the income computation and disclosure standards notified under section 276(2);

3.2 The Core Principle: Cost or Net Realisable Value

The governing principle of Section 277, consistent with accepted accounting practice and ICDS II, is that inventory must be valued at cost or net realisable value, whichever is lower. This lower-of-cost-or-NRV rule serves a conservative function: it ensures that unrealised gains are not prematurely brought to tax, while write-downs to NRV are permitted to reflect economic reality.

Within this overarching principle, Section 277 makes allowance for different methods of cost determination. The cost of inventory may be determined using, among others, the actual cost method, the weighted average cost method, and - depending on the nature of the inventory - the first-in-first-out (FIFO) method. Each method produces a different cost figure for the same physical quantity of goods, and the choice of method has a direct bearing on taxable income.

3.3 Categories of Inventory and Their Special Treatment

Not all inventory is treated uniformly under the statute or under the ICDS framework. The Income-tax Rules, 2026, particularly through the structure of Form 101, recognise at least the following distinct categories of inventory, each of which may be subject to different valuation rules:

This article does not cover the inventory valuations of following categories of Inventories.

• Construction WIP (contracts)
• Securities held as stock-in-trade
• Livestock, agricultural / forest produce, mineral oils, ores and gases

3.4 The Significance of Disclosure under Section 277 in Form 26

Row 16 of Part D of Form 26 - the tax audit report - specifically requires the auditor to disclose the method of inventory valuation adopted during the year, separately for finished goods and raw materials. The auditor is further required to state whether, in the event of a deviation from the method prescribed under Section 277, any adjustment to profit or loss is required to comply with the section's mandate. Where such adjustment is warranted, the details must be furnished in the Schedule on Accounting Information.

This disclosure serves a dual purpose. First, it brings to the Assessing Officer's attention any departure from statutory norms, enabling informed scrutiny. Second, the Schedule on Accounting Information (Row 16(b) of Form 26) requires the auditor to quantify the net effect of any change in the method of inventory valuation, with sub-clause references to Sections 277(1)(i), 277(1)(ii), 277(1)(iii), and 277(1)(iv), thereby ensuring that the financial impact of the valuation choice is not left to inference.

4. Rule 171(2) and Form 101: The Mechanics of Independent Inventory Valuation

4.1 Rule 171: The Prescription of Forms

Rule 171 of the Income-tax Rules, 2026 performs the straightforward but essential function of prescribing the forms in which the two categories of report under Section 268(5) must be submitted. Rule 171(1) provides that an audit report under Section 268(5)(i) must be furnished in Form 100. Rule 171(2) - which is the subject of this article's deeper focus - prescribes that a report of inventory valuation under Section 268(5)(ii) must be in Form 101.

The terseness of Rule 171 belies the elaborate reporting architecture that Form 101 embodies. The form is not a simple statement of figures: it is a multi-part, multi-schedule document that demands the cost accountant's professional engagement across a wide range of valuation methodologies, physical verification exercises, and reconciliation exercises.

4.2 The Architecture of Form 101

Form 101 is divided into a principal certificate, Part A (particulars of the assessee), and an extensive Part B that constitutes the substantive inventory valuation report of the cost accountant. Each component serves a distinct function:

4.2.1 The Opening Certificate

The cost accountant opens Form 101 with a certification that draws together the core conclusions of the valuation exercise. The certificate addresses, in sequence: the identity of the assessee and the period under review; the fact that the valuation has been conducted in compliance with the provisions of the Act and the Income-tax Rules, 2026; the rupee values of opening and closing inventory as determined by the cost accountant; a confirmatory statement regarding access to books of account and branch data; and a declaration that any variations from the figures disclosed in Form 26 (or, where Form 26 is absent, from the audited accounts) have been adequately explained.

The last element of the certificate - the requirement to reconcile variations with Form 26 - is particularly significant. It creates a direct evidentiary link between the tax audit report and the inventory valuation report, ensuring that the two documents, prepared by different professionals under different statutory mandates, are cross-examined against each other. This poses an additional responsibility of Both Tax Auditors and Inventory Valuation Auditor to be extremely careful as different inventory valuations bring both of them under scrutiny at appropriate levels in case the assessee does not agree with the Inventory valuation by Cost Accountant appointed under Section 268(5)(ii)

4.2.2 Part A: Particulars of the Assessee

Part A of Form 101 captures the identifying data of the assessee: name (in full, without abbreviation), address of the head office and all branches, PAN, date of incorporation or formation, nature of business activity, details of principal products and services (with HSN codes and SAC codes wherever available), email address, contact number, and the relevant tax year. This information anchors the report to a specific legal entity and a specific fiscal period, and provides the jurisdictional context for the cost accountant's mandate.

4.2.3 Part B: The Substantive Valuation Report

Part B of Form 101 is where the cost accountant's professional work is documented. It is organised around nine principal line items/rows, each addressing a distinct dimension of the inventory valuation exercise. Rows 1 through 7 address the foundational matters - books of account, methods of accounting and valuation, financial summary, and physical verification - while Rows 8 and 9 contain the detailed valuation schedules.

4.3 The ICDS II Valuation Schedule (Row 8 of Form 101)

Row 8 of Form 101 contains the most detailed valuation exercise required of the cost accountant - the item-by-item valuation of all inventory categories to which ICDS II applies. For each category (finished goods, stock-in-trade, WIP, raw materials, by-products, and intermediate products), the cost accountant must provide a tabulation that captures, for both the opening and closing dates, the quantity held, the cost of production or purchase value, the net realisable value, the lower of the two, and the resultant monetary value.

The summary table at Row 8(g) brings together all categories into a single comparative statement, setting the cost accountant's values against those disclosed in Form 26 (or the audited accounts in the absence of Form 26) and computing the variation. The variation, if any, must be explained and quantified in terms of its impact on profit or loss and on income tax. This reconciliation table is the document's centrepiece from an assessment perspective: it is the figure that the Assessing Officer will examine most closely.

Row 8(h) requires the cost accountant to state the valuation method used for each inventory category's opening and closing stock, and - critically - to furnish detailed reasons and justification wherever the method applied by the cost accountant differs from the method employed by the assessee. This is not a mechanical exercise: it demands a substantive explanation of the methodological difference and a quantification of its financial effect.

4.4 Special Valuation Schedules: Non-ICDS II Categories (Row 9)

Row 9 of Form 101 addresses the three categories of inventory that are explicitly excluded from ICDS II's ambit, each of which demands a distinct valuation methodology:

• Construction Contracts (ICDS III): The percentage-of-completion method governs. The cost accountant must separately value completed units ready for sale, construction work-in-progress, construction materials, and supporting equipment and fittings. For WIP under long-term contracts, the stage of completion is the critical variable, and the cost accountant must specify the method used to determine it.
• Securities held as Stock-in-Trade (ICDS VIII): Listed shares, unlisted shares, debt securities, convertible securities, and other financial instruments each require separate valuation. The lower of actual cost and net realisable value governs, with NRV for listed shares determined by reference to exchange quotations.
• Livestock, Agricultural and Forest Produce, and Mineral Oils, Ores and Gases: These categories are measured exclusively at net realisable value, without the lower-of-cost-or-NRV test. The cost accountant must tabulate these separately and reconcile with Form 26.

Each of these sub-sections concludes with a comparison table that juxtaposes the cost accountant's values against the Form 26 disclosure, quantifies the variation, and computes the resultant income tax impact. The cumulative effect of all these schedules is a comprehensive inventory valuation dossier that leaves little room for unexplained discrepancy.

5. The Interplay between Form 101 and Form 26

5.1 Form 26 as the Primary Reference Point

Form 26 - the tax audit report prescribed under Section 63 of the Income-tax Act, 2025 - serves as the primary reference point against which the cost accountant's findings in Form 101 are benchmarked. The relationship is explicit and structural: Form 101 requires the cost accountant to compare every inventory value with the corresponding figure in Form 26 and to explain any variance.

This cross-referencing architecture is deliberate. The tax auditor and the cost accountant are independent professionals, each operating under a distinct statutory mandate. By requiring the cost accountant to reconcile with the tax auditor's figures, the legislature creates a built-in consistency check between two independent professional opinions on the same underlying subject matter - the assessee's inventory.

5.2 Inventory-Related Disclosures in Form 26

Within Form 26, the inventory-related disclosures are scattered across several parts of Part D, but they may be grouped into three thematic clusters:

Cluster 1: Method of Accounting and Valuation (Rows 15–17)

Row 15 of Part D requires the auditor to state the method of accounting employed (mercantile or cash) and to flag any change from the immediately preceding year. Row 16 requires the method of inventory valuation for finished goods and raw materials to be stated - with options being 'at cost', 'at net realisable value', or 'lower of cost and net realisable value'. Where the method deviates from Section 277, the auditor must answer in the affirmative and direct the reader to the Schedule on Accounting Information.

Row 17 addresses ICDS compliance more broadly: the auditor must state whether any adjustment to profit or loss is required to comply with the ICDS notified under Section 276(2), and whether any disclosure is required. The Schedule on Accounting Information then requires, at Row 16(b), a section-wise breakdown of the change in inventory valuation method's impact on profit/loss, with specific columns for Sections 277(1)(i) through 277(1)(iv).

Cluster 2: The ICDS Adjustments Table (Row 17 - Schedule on Accounting Information)

The Schedule on Accounting Information within Form 26 contains a ten-row ICDS adjustment table. Row ICDS II in this table specifically addresses the 'Valuation of Inventories' (other than the effect of change in valuation method already reported separately). The auditor must quantify the increase or decrease in profit/loss attributable to ICDS II adjustments and provide explanatory remarks. This table is the auditor's formal bridge between commercial accounting and income tax computation for all ICDS-covered items.

Cluster 3: Quantitative Details (Row 53 - Schedule on Quantitative Details)

Row 53 of Part D requires the auditor to disclose quantitative details of inventory movements - separately for trading units and manufacturing units. For a trading unit, the table captures opening stock, purchases, sales, closing stock, and any shortage or excess, for each principal item of goods. For a manufacturing unit, two separate tables are required: one for raw materials (covering consumption, production yield, closing stock) and one for finished products, by-products, and scrap.

This quantitative disclosure serves the function of physical flow verification at the audit level. A significant discrepancy between the physical quantities implied by this table and the quantities recorded by the cost accountant in Form 101 would be a red flag warranting further inquiry.

5.3 Where the Two Forms Diverge in Purpose

Notwithstanding their structural interdependence, Forms 26 and 101 serve fundamentally different purposes. Form 26 is a routine statutory disclosure - it is filed every year by an assessee whose accounts are required to be audited under Section 63, and it covers a wide canvas that includes not only inventory but also depreciation, international transactions, TDS compliance, and indirect tax details. The inventory-related portions of Form 26 are significant but not exhaustive.

Form 101, by contrast, is purpose-built for inventory valuation. It is filed only when the Assessing Officer has specifically directed a special inventory valuation under Section 268(5)(ii), and its sole concern is the accuracy and integrity of the assessee's inventory figures. Its depth - the item-level valuation tables, the physical verification confirmation, the three-year financial ratios, the ICDS compliance certification - is calibrated to the forensic demands of the assessment process rather than to the routine disclosure needs of the annual audit.

6. Practical Implications for Taxpayers and Practitioners

6.1 For the Assessee

A taxpayer who receives a direction under Section 268(5)(ii) must understand that the exercise is not merely administrative. The cost accountant's report has evidentiary value in assessment proceedings, and the Assessing Officer is entitled to use the findings in Form 101 as the basis for additions to income or disallowances. The assessee should therefore prepare proactively by ensuring that its books of account contain adequate quantitative records, that its physical stock records are contemporaneous and verifiable, and that the method of inventory valuation adopted in its accounts is consistent with Section 277 and ICDS II.

Where the assessee's valuation differs from the cost accountant's, the difference will be visible in the comparison tables of Form 101. The assessee has the opportunity to explain such differences - but that explanation must be documented and substantiated. Unexplained variances are likely to attract adverse inference.

6.2 For the Tax Auditor

The tax auditor's disclosures in Form 26 set the baseline against which the cost accountant's work in Form 101 is evaluated. The auditor must therefore exercise particular care in completing the inventory-related portions of Form 26, particularly the method of valuation, the ICDS adjustments, and the quantitative details. Errors or omissions in Form 26 that are exposed by the cost accountant's report in Form 101 can have consequences not only for the assessee but also for the auditor's professional standing.

The auditor should also be aware that any qualification or reservation expressed in the audit report regarding inventory - whether regarding the physical verification process, the method of valuation, or ICDS compliance - will be referenced by the cost accountant in Form 101, where the cost accountant is required to note any variations and explain them.

6.3 For the Cost Accountant

The cost accountant who is nominated under the panel maintained by the Chief Commissioner bears an independent professional responsibility. The mandate is not to validate the assessee's figures but to independently determine the correct inventory value. The cost accountant must conduct physical verification wherever feasible, examine the quantitative records, apply the appropriate valuation method for each category of inventory, and - where the result diverges from Form 26 - provide a reasoned, documented explanation.

The time-sheet requirement under Rule 172 is a reminder that the exercise is expected to be substantive and proportionate to the complexity of the assessee's inventory. The cost accountant's professional credibility rests on the quality of the report, not merely its form.

7. Conclusion

The framework for inventory valuation under the Income-tax Act, 2025 represents a carefully balanced regulatory architecture. Section 277 prescribes the substantive standard - cost or net realisable value, whichever is lower, with category-specific refinements. Section 268(5)(ii) provides the enforcement mechanism - the power to direct independent valuation by a nominated cost accountant when the Assessing Officer has reason to doubt the taxpayer's own figures. Rule 171(2) and Form 101 give that mechanism a structured, comprehensive reporting form. And the inventory-related disclosures in Form 26 - covering valuation method, ICDS adjustments, and quantitative details - create the reference baseline against which Form 101 is benchmarked.

Together, these instruments ensure that inventory valuation - a figure that directly determines taxable income - is subject to multiple layers of professional scrutiny and regulatory oversight. For the practitioner, mastering the interplay between these instruments is not merely a matter of compliance: it is a precondition for sound professional advice. For the revenue authority, the cross-referencing structure built into Forms 26 and 101 is the legislature's assurance that inventory figures are neither taken on faith nor verified in isolation.

In the broader context of the Income-tax Act, 2025's stated objective of consolidation and simplification, the inventory valuation framework stands as an example of principled regulatory design - where simplicity of expression in the statute is matched by thoroughness of elaboration in the rules and forms.

The author can also be reached at navneetic@yahoo.com

Statutory References

• Income-tax Act, 2025 (Act No. 30 of 2025) - Sections 268, 276, 277, 62, 63
• Income-tax Rules, 2026 - Rules 46, 47, 171, 172
• Form No. 101 - Inventory Valuation Report under Section 268(5)(ii) [Rule 171(2)]
• Form No. 26 - Tax Audit Report under Section 63 [Rule 47]
• Income Computation and Disclosure Standards - ICDS II (Valuation of Inventories), ICDS III (Construction Contracts), ICDS VIII (Securities)
• Gazette of India, Extraordinary, Part II - Sec. 3(i), dated 20 March 2026 (Notification of Income-tax Rules, 2026)