Accounting Standard 2: ‘Valuation of Inventory’

INTRODUCTION

AS 2 typically refers to “Accounting Standard 2,” which deals with the valuation of inventories. It provides guidelines for determining the cost of inventories and the methods to be used for their valuation, such as FIFO (first-in, first-out), LIFO (last-in, first-out), or weighted average cost. It’s a fundamental accounting standard for businesses to ensure accurate financial reporting.

WHAT IS INVENTORY?

AS 2 (Revised) defines inventories as assets held

• for sale in the ordinary course of business, or
• in the process of production for such sale, or
• for consumption in the production of goods or services for sale, including maintenance supplies and consumables other than machinery spares, servicing equipment and standby equipment meeting the definition of Property, plant

and equipment. Inventories encompass goods purchased and held for resale, for example merchandise (goods) purchased by a retailer and held for resale, or land and other property held for resale. Inventories also include finished goods produced, or work in progress being produced, by the enterprise and include materials, maintenance supplies, consumables and loose tools awaiting use in the production process.

Following are excluded from the scope of AS 2 (Revised).

(a) Work in progress arising under construction contracts, i.e. cost of part construction, including directly related service contracts, being covered under AS 7, Accounting for Construction Contracts; Inventory held for use in construction, e.g. cement lying at the site should however be covered by AS 2(Revised).

(b) Shares, debentures and other financial instruments held as stock-in-trade. It should be noted that these are excluded from the scope of AS 13 (Revised) as well. The current Indian practice is however to value them at lower of cost and fair value.

(c) Producers’ inventories of livestock, agricultural and forest products, and mineral oils, ores and gases to the extent that they are measured at net realisable value in accordance with well established practices in those industries, e.g. where sale is assured under a forward contract or a government guarantee or where a homogenous market exists and there is negligible risk of failure to sell.

(d) Work in progress arising in the ordinary course of business of serviproviders i.e. cost of providing a part of service. For example, for a shipping company, fuel and stores not consumed at the end of accounting period is inventory but not costs for voyage-in-progress.

MEASUREMENT OF INVENTORIES

Inventories should be valued at lower of cost and net realisable value. Net realisable 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. The valuation of inventory at lower of cost and net realisable value is based on the view that no asset should be carried at a value which is in excess of the value realisable by its sale or use.

EXAMPLE 1-

On 31st March 20X1, a business firm finds that cost of a partly finished unit on that date is ` 530. The unit can be finished in 20X1-X2 by an additional expenditure of ` 310. The finished unit can be sold for ` 750 subject to payment of 4% brokerage on selling price. The firm seeks your advice regarding the amount at which the unfinished unit should be valued as at 31st March, 20X1 for preparation of final accounts. Assume that the partly finished unit cannot be sold in semi-finished form and its NRV is zero without processing it further.

Solution-

COSTS OF INVENTORY

Costs of inventories comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

• Cost of PURCHASE

The cost of purchase refers to the total amount of money spent on acquiring a product or service. It includes the purchase price plus any additional expenses such as taxes, shipping fees, and other related costs.

• Cost of CONVERSION

In the context of inventory valuation, the cost of conversion could refer to the direct costs incurred in converting raw materials into finished goods. These costs include direct labor, direct expenses, and overhead costs directly attributable to the conversion process.

EXAMPLE 2

ABC Ltd. has a plant with the capacity to produce 1 lac unit of a product per annum and the expected fixed overhead is Rs. 18 lacs. Fixed overhead on the basis of normal capacity is Rs. 18 (18 lacs/1 lac).

Case 1: Actual production is 1 lac units. Fixed overhead on the basis of normal capacity and actual overhead will lead to same figure of Rs. 18 lacs. Therefore, it is advisable to include this on normal capacity.

Case 2: Actual production is 90,000 units. Fixed overhead is not going to change with the change in output and will remain constant at Rs. 18 lacs, therefore, overheads on actual basis is Rs. 20 per unit (18 lacs/ 90 thousands). Hence by valuing inventory at Rs. 20 each for fixed overhead purpose, it will be overvalued and the losses of Rs. 1.8 lacs will also be included in closing inventory leading to a higher gross profit then actually earned. Therefore, it is advisable to include fixed overhead per unit on normal capacity to actual production (90,000 x 18) Rs. 16.2 lacs and rest Rs. 1.8 lacs should be transferred to Profit & Loss Account.

Case 3: Actual production is 1.2 lacs units. Fixed overhead is not going to change with the change in output and will remain constant at Rs. 18 lacs, therefore, overheads on actual basis is Rs. 15 (18 lacs/ 1.2 lacs). Hence by valuing inventory at Rs. 18 each for fixed overhead purpose, we will be adding the element of cost to inventory which actually has not been incurred. At Rs. 18 per unit, total fixed overhead comes to Rs. 21.6 lacs whereas, actual fixed overhead expense is only Rs. 18 lacs. Therefore, it is advisable to include fixed overhead on actual basis (1.2 lacs x 15) Rs. 18 lacs.

JOINT OR BY PRODUCTS

AS 2 refers to Accounting Standard 2, which deals with the valuation and accounting treatment of inventories. According to AS 2, joint products are two or more products produced simultaneously from the same process up to a certain point of separation where each product becomes identifiable. By-products, on the other hand, are minor products that have minimal sales value compared to the main product and are often produced incidentally during the production process. Both joint products and by-products have specific accounting treatments outlined in AS 2 to ensure proper valuation and reporting in financial statements.

EXCLUSIONS FROM THE COST OF INVENTORIES

In determining the cost of inventories, it is appropriate to exclude certain costs and recognise them as expenses in the period in which they are incurred.

Examples of such costs are:

(a) Abnormal amounts of wasted materials, labour, or other production costs;

(b) Storage costs, unless the production process requires such storage;

(c) Administrative overheads that do not contribute to bringing the inventories to their present location and condition;

(d) Selling and distribution costs.

COST FORMULAS

AS 2, or Accounting Standard 2, provides guidelines for the valuation and accounting treatment of inventories. It doesn’t specify specific formulas for calculating costs, but it outlines principles for determining the cost of inventories, including:

1. Purchase Cost: The cost of purchase includes the purchase price, import duties, taxes, and other directly attributable costs such as transportation, handling, and insurance.

2. Production Cost: For items produced internally, the cost includes direct materials, direct labor, and a portion of manufacturing overheads.

3. Net Realizable Value (NRV): Inventories should be valued at the lower of cost and net realizable value. NRV is the estimated selling price less the estimated costs of completion and selling expenses.

4. Cost Formulas: AS 2 allows for different cost formulas to be used for valuing inventories, such as First-In-First-Out (FIFO), Weighted Average Cost, and Specific Identification. The choice of formula depends on the nature of the inventory and industry practices.

5. Consistency: Whichever cost formula is used, it should be consistently applied from period to period to ensure comparability of financial statements.

While AS 2 provides principles and guidelines for inventory valuation, specific calculations may vary depending on the nature of the business and the inventory management practices followed.

DISCLOSURES

The financial statements should disclose:

(a) The accounting policies adopted in measuring inventories, including the cost formula used; and

(b) The total carrying amount of inventories together with a classification appropriate to the enterprise. Information about the carrying amounts held in different classifications of inventories and the extent of the changes in these assets is useful to financial statement users. Common classifications of inventories are:

(1) raw materials and components,

(2) work in progress,

(3) finished goods,

(4) Stock-in-trade (in respect of goods acquired for trading),

(5) stores and spares,

(6) loose tools, and

(7) Others (specify nature).

COMPARISON OF COST AND NET

REALISABLE VALUE

The comparison between cost and net realisable value should be made on item-by-item basis. In some cases nevertheless, it may be appropriate to group similar or related items.

COMPARISON BETWEEN COST AND NET REALIZABLE VALUE OF INVENTORY

Cost and Net Realizable Value (NRV) are two important factors in calculating inventory value, especially when following the principles outlined in Accounting Standard 2 (AS 2).

1. Cost:

– Cost refers to the actual cost incurred to acquire or produce inventory. It includes direct costs such as purchase price, direct labor, and direct materials, as well as indirect costs such as overheads allocated to production.

– Cost provides a measure of the investment made in inventory.

2. Net Realizable Value (NRV):

– NRV is the estimated selling price of inventory less estimated costs to complete and sell the inventory.

– It represents the amount of revenue expected to be generated from the sale of inventory after deducting any additional costs required to make the sale.

Comparison:

– AS 2 requires inventory to be valued at the lower of cost and net realizable value. This means that inventory should be valued at whichever is lower between its cost and its NRV.

– If the cost of inventory is higher than its NRV, it indicates that the inventory may not be sold for enough to cover its costs. In this case, the inventory should be written down to its NRV to reflect its lower value on the balance sheet.

– Comparing cost and NRV ensures that inventory is not overstated on the balance sheet, as it reflects the lower of the two values, thus providing a more conservative approach to inventory valuation.

– This comparison helps in ensuring that inventory is reported at a value that reflects its economic benefit to the entity, considering the potential revenue from its sale.

In summary, while cost represents the historical investment in inventory, NRV reflects its expected revenue generation potential. Comparing these two values ensures that inventory is appropriately valued on the balance sheet, reflecting its true economic value to the entity.

EXAMPLE:

• X Co. Limited purchased goods at the cost of Rs. 40 lakhs in October, 20X1. Till March, 20X2, 75% of the stocks were sold. The company wants to disclose closing stock at Rs. 10 lakhs. The expected sale value is Rs. 11 lakhs and a commission at 10% on sale is payable to the agent. Advise, what is the correct closing stock to be disclosed as at 31.3.20X2.

Solution

As per AS 2 (Revised) “Valuation of Inventories”, the inventories are to be valued at lower of cost or net realisable value. In this case, the cost of inventory is Rs. 10 lakhs. The net realisable value is 11,00,000 × 90% = Rs. 9,90,000. So, the stock should be valued at Rs. 9,90,000.

Conclusion: AS 2 plays a vital role in ensuring accurate and transparent inventory valuation practices for businesses. By adhering to its guidelines, companies can effectively measure the cost of inventories, assess their net realizable value, and disclose relevant information to stakeholders. Understanding AS 2 empowers businesses to make informed decisions regarding inventory management and financial reporting, contributing to overall organizational success and accountability.

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The above article is referred and compiled from various resources.

The above article is written and compiled by:

SNEHAL SUBUDHI (CA INTER STUDENT)