Introduction: Closing stock valuation is a crucial aspect of accounting, influenced by the Matching Principle and accounting standards like AS-2. This article delves into the principles governing closing stock valuation, the application of AS-2, and the considerations of the matching principle.
Matching Principle
Matching principle is an accounting principle for recording both revenues and expenses. Revenues and Expenses should relate to the same period / same time frame – for example time frame can be from 01.04.2022 to 31.03.2023. According to this principle all revenues are accounted for and ideally all the expenses incurred to earn the said revenues are also accounted for.
Prepaid Expenditure
Prepaid expenses are those expenses the benefit of which will accrue to the business in future but the expenses are paid today / now. The best example is Insurance. Let us say the insurance premium on stocks is paid for the period from 01.08.2022 to 31.07.2023. Eight months insurance premium will be treated as expenditure since the benefit is received in the financial year 2022 – 2023 or the year in which it is paid and will be debited / charged to profit and loss account as an expenditure. Four months of insurance premium the benefit of which will arise / accrue to the business in the financial year 2023 – 2024 is treated as pre-paid expenditure and is treated as an asset.
Closing Stock
Purchases made in a financial year are charged off to profit and loss account and the left over stock at the year end or the stock remaining unsold at the year end represents closing stock and is valued and is credited to the profit and loss account and is depicted in the balance sheet as current assets.
Basically closing stock in business includes raw materials, work in progress and finished goods. In this article an attempt is being made to discuss the valuation of closing stock of raw material and finished goods.
Valuation of Inventory in respect of financial instruments ( like shares, bonds, debentures and etcetera ) and Valuation of biological assets ( like animals, plants etcetera ) and Valuation of commodities like crude oil, minerals, etcetera and commodities held by commodity traders and Work In Progress in respect of construction contracts are not touched upon.
Raw materials which are purchased to be consumed in the manufacturing process and left over or unconsumed at the year end & finished goods bought by the traders for reselling remaining unsold at the year end, the valuation of these two items is discussed here in this article.
Accounting Standard ( AS ) – 2
According to this standard inventories are assets (1) held for sale in the ordinary course of the business (2) In the process of production for such sales (3) in the form of materials or supplies to be consumed in the production process or in rendering of services.
Accounting Standard ( AS ) -2 issued by the Institute Of Chartered Accountants of India is applicable to all types of business being run by individuals, partnership firms, companies, HUFs and others.
The meaning of the inventory as per Indian Accounting Standard ( Ind AS ) – 2 notified under section 133 of The Companies Act 2013 is more or less similar to the meaning as discussed in Accounting Standard (AS) 2 issued by ICAI.
Measurement Of Inventories
As per the said standards inventories should be valued at the lower of cost and net realizable value.
Now what is “cost” and what is “ net realizable value”
Cost And Cost Of Purchase
According to AS – 2, cost means all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.
According to the same standard cost of purchase consists of price including duties and taxes ( other than those subsequently recoverable by the enterprise from the taxing authorities ), freight inward, and other expenditure directly attributable to the acquisition. Trade discounts, rebates, duty backs, and other similar items are deducted in determining the costs of purchase.
Taxes are of two types (1) Direct Taxes, which is levied on the income of the individuals, firms, companies and others. Example :: Income Tax. (2) Indirect Taxes, which are imposed or charged on production or consumption of goods and services. Example :: Goods And Services Tax. Duties are also of two types (1) Customs duty – which is imposed on the goods imported into India and (2) Excise Duty – which is charged on the goods manufactured in India. Customs duty and excise duty have been replaced with Goods And Services Tax.
Net Realizable Value
Net Realizable Value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
Valuation Of Closing Stock
So, the value of closing stock should include cost of purchase, duties and taxes ( other than those subsequently recoverable by the enterprise from the taxing authorities ), Freight and other expenditure directly attributable to the acquisition.
That means value of closing stock would include the basic price plus net of indirect taxes i.e. after adjusting input tax from out put tax i.e. net output tax and freight and other expenditure. And this value of closing stock is credited to the profit and loss account and is treated as current asset.
Purchases and sales are recorded net of GST in the trading and profit and loss account. The output tax is treated as a liability and not as an expenditure. The input tax is treated as an asset and not as an income. Ultimately the liability of output tax is discharged after taking credit for input tax.
Conclusion
As I have discussed earlier that the expenditure that is debited to trading , profit and loss account and which is not consumed / absorbed in the year in which it is incurred is reversed and is treated as current asset. Such expenses are net of indirect taxes since the indirect taxes are not debited to profit and loss account but are treated as asset and liability.
Similarly while valuing closing stock would it be correct to include indirect taxes as part of closing stock value when indirect taxes are not treated as expenditure or income.
In my opinion indirect taxes should not be included in the closing stock value along with the basic price, freight and other expenditure since indirect taxes are not treated as income or expenditure. By including indirect taxes the value of the closing stock gets increased. Net Realizable Value is the estimated selling price in the ordinary course of business which also includes indirect taxes.
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