AS 2 - Valuation of Inventories

The Council of the Institute has recently released the revised AS 2, which has come into effect in respect of accounting periods commencing on or after 1st April, 1999 and is mandatory in nature.

Purpose: This standard lays down the principles to be considered in computing the value of inventories and also ensures adequate disclosure of the policy adopted by each enterprise.

Scope: This Statement should be applied in accounting for inventories other than:

1. Work in progress arising under construction contracts, including directly related service contracts (see AS 7).
2. Work in progress arising in the ordinary course of business of service providers.
3. Shares, debentures and other financial instruments held as stock-in-trade; and
4. Producer's inventories of livestock, agricultural and forest products, and mineral oils, ores and gases to that extent that they are measured at net realisable value in accordance with well established practices in those industries.

Definitions

• Inventories are assets:
  1. held for sale in the ordinary course of business.
  2. in the process of production for such sale.
  3. in the form of materials or supplies to be consumed in the production process or in the rendering of services.
  Note: Inventories include goods, computer software, land or other property purchased and held for resale. Inventories also include finished goods produced, or work in progress being produced, materials, maintenance supplies, consumables and loose tools awaiting use in the production process. However, inventories do not include machinery spares which can be used only in connection with an item of fixed asset and whose use is expected to be irregular; such machinery spares are accounted for in accordance with AS 10 - Accounting for Fixed Assets.

• Net Realisable Value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated cost necessary to make the sale.

Measurement of Inventories

Inventories should be valued at the Lower of Cost and Net Realisable Value.

The practice of writing down inventories below cost to Net Realisable Value is consistent with the view that assets should not be carried in excess of amounts expected to be realised from their sale or use.

Cost of Inventories should comprise:

1. Cost of Purchase: includes duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities like MODVAT), freight inwards and other expenditure directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase.
2. Cost of Conversion: includes costs directly related to the units of production, such as direct labour and a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods.
3. Other Costs: included only to the extent they are incurred in bringing the inventories to their present location and condition.

Further in the case of Joint Products and By-products if the costs of conversion is not separately identifiable, it is allocated between the products on a rational and consistent basis, for example on the relative sales value of each product either at the stage in the production process when the products become separately identifiable, or at the completion of the production. If By-products are immaterial, they are measured at Net Realisable Value and this value is deducted from the cost of the main product.

Also, it is appropriate to exclude the following costs from inventories:

1. Abnormal wastages of materials, labour or other production costs
2. Storage costs, unless they are necessary in the production process
3. Administrative overheads which do not contribute to bringing the inventories to their present location and condition
4. Selling and distribution overheads

Cost Formula: Cost of Inventory should be arrived by using first-in, first-out or weighted average cost formula.However, for inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by specific identification of their individual costs.

Techniques for the Measurement of Cost

Standard Cost method or the Retail method can also be used for the measuring of the cost of Inventories, if the results approximate the actual cost. Standard costs take into account normal levels of consumption of materials and supplies, labour, efficiency and capacity utilisation. These are regularly revised in the light of current conditions. The retail method is used in the retail trade for measuring inventories of large numbers of rapidly changing items that have similar margins and for which it is impracticable to use other costing methods.

Net Realisable Value

Inventories are written down to Net Realisable value on an item-by-item basis except where it is appropriate to group similar or related items.

If the materials are held for use in the production of inventories, they are not written down below cost if the finished goods are expected to be sold at or above cost.

An assessment of net realisable value is made as at each balance sheet date. Net realisable value is based on the most reliable evidence available at the time of valuing inventories as to the amount the inventories are expected to realise. The valuation takes into consideration cost and selling price fluctuations directly relating to events occurring after the balance sheet date to the extent that such events confirm the conditions existing at the balance sheet date.

Disclosures

1. The accounting policies adopted in measuring inventories, including the cost formula used.
2. The total carrying amount of inventories and its classification appropriate to the enterprise, viz raw materials and components, work in progress, finished goods, stores and spares, and loose tools.