Accounting For Inventories: In Light of AS 2 and Ind AS 2

1. Introduction

Inventory is a critical component of working capital and forms a substantial part of the current assets for many businesses. The valuation and accounting treatment of inventories significantly impact the financial statements, especially the cost of goods sold (COGS), gross profit, and net income. The ICAI has issued Accounting Standard 2 (AS 2) and Indian Accounting Standard 2 (Ind AS 2) to provide a structured approach for inventory accounting.

2. Scope of AS 2 and Ind AS 2

Both AS 2 and Ind AS 2 apply to the valuation and accounting of inventories except in the following cases:

– Construction contracts (dealt with by AS 7/Ind AS 115)

– Financial instruments

– Biological assets (related to agricultural activity, as per Ind AS 41)

– Work-in-progress under service contracts (AS 9 or Ind AS 115)

3. Definition and Classification of Inventories

Inventories are assets:

– Held for sale in the ordinary course of business

– In the process of production for such sale

– In the form of materials or supplies to be consumed in the production process or rendering of services

Classification may include:

– Raw materials

– Work-in-progress (WIP)

– Finished goods

– Stores and spares (in some industries)

4. Measurement of Inventories

Fundamental Principle: Inventories are to be measured at the lower of cost and net realizable value (NRV).

Cost of Inventories includes:

1. Cost of Purchase: Includes purchase price, import duties, freight, taxes (other than refundable taxes like GST input), less trade discounts.

2. Cost of Conversion: Includes direct labor and systematic allocation of fixed and variable production overheads.

3. Other Costs: Only to the extent they bring the inventory to its present location and condition.

Exclusions: Abnormal waste, Storage costs (unless necessary), Administrative overheads unrelated to production, Selling costs.

Example: A manufacturer purchases raw material at ₹1,000 per unit, incurs transport of ₹100, and gets a trade discount of 10%. Total cost per unit = ₹1,000 + ₹100 – ₹100 = ₹1,000.

NRV = Estimated selling price – Estimated cost of completion – Estimated selling and distribution cost.

5. Cost Formulas

AS 2 Permits: FIFO, Weighted Average

Ind AS 2 Permits: FIFO, Weighted Average

LIFO: Not permitted

Example:Opening Inventory: 100 units @ ₹1

Purchase 1: 100 units @ ₹12

Sale: 150 units

FIFO: COGS = (100 × ₹10) + (50 × ₹12) = ₹1,600

Weighted Avg: Avg Cost = ₹(100×10 + 100×12)/200 = ₹11

COGS = 150 × ₹11 = ₹1,650

6. Key Differences: AS 2 vs Ind AS 2

Scope on Service Providers: AS 2 excludes, Ind AS 2 includes.

NRV Reversal: Not permitted in AS 2, permitted in Ind AS 2.

Disclosures: More detailed under Ind AS 2.

Joint Products: Covered in Ind AS 2 with allocation based on NRV.

7. Advanced Issues in Inventory Accounting

Inventories in Foreign Currency: Not adjusted in inventory value.

Deferred Payment Terms: Excess payment treated as interest expense (Ind AS 2).

Allocation of Fixed Overheads: Based on normal capacity. Underutilization leads to expensed overheads.

Example: Fixed Overheads ₹5,00,000, Normal capacity 10,000 units, Actual 8,000. Only ₹4,00,000 is absorbed.

Joint and By-Products: Ind AS 2 uses NRV for allocation. By-products reduce total cost of main product.

8. Practical Illustration

ABC Ltd. inventory:

– Raw Material: ₹10,00,000 (NRV ₹9,00,000)

– WIP: ₹5,00,000 (NRV ₹5,50,000)

– Finished Goods: ₹7,00,000 (NRV ₹6,80,000

Valuation: Raw Material ₹9,00,000, WIP ₹5,00,000, Finished Goods ₹6,80,000

Total Inventory = ₹20,80,000

9. Disclosures under Ind AS 2

Entities must disclose:

– Accounting policies for measurement

– Cost formulas used

– Carrying amount by category

– Inventory write-downs and reversals

10. Conclusion

Inventory accounting reflects concepts like prudence, matching, consistency, and substance over form. AS 2 and Ind AS 2 ensure faithful representation. Ind AS 2 brings Indian GAAP closer to global standards. However, professional judgment and sound documentation are essential.

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In Light of AS 2 and Ind AS 2

By: Rahul Sharma

Qualification: FCA, MBA (Finance), LLB, CAIIB

ICAI Membership No.: 402506