VALUATION OF INVENTORIES (AS-2)

Objective

The objective of this standard is to formulate the method of computation of cost of inventories/stock, determine the value of closing stock/inventory at which the inventory to be shown in balance sheet till it is not sold and recognized as revenue.

Definition

Inventories are assets.

• Held for sale in the ordinary course of business (finished goods).
• In the process of production of such sale (raw material and work-in-progress).
• In the form of materials or supplies to be consumed in production process or in the rendering of services (stores, spares, raw material, consumables).

Applicability

Accounting Standard-2 is not applicable in following case:

• Work-in-progress arising under construction contract including directly related to service contract.
• Work-in-progress arising in ordinary course of business for service providers (Incomplete consultancies services, Incomplete merchant bank activities, Medical services in progress)
• Financial Instrument held as stock-in-trade (Shares, Debentures, Bonds etc.)
• Producers inventories like livestock, agricultural and forest products, minerals oils, ores and gases. Such inventories are valued at net realizable value.

Measurement of Inventories

Inventories should be valued at lower of cost and net realizable value.

Major points for valuation of Inventories are:

• Determination of cost of inventories.
• Determination of net realizable value of inventories.
• Comparison between the cost and net realizable value.

What is Cost of Inventories

Cost of Inventory includes -

• Cost of purchase
• Cost of conversion
• Other cost (Incurred in bringing the inventories to their present location and condition)

Cost of Purchase – Cost of purchase includes -

• Purchase price
• Duties & Taxes
• Freight inward
• Other expenditure directly attributable to the acquisition.

Less:

• Duties & taxes recoverable by enterprises from taxing authorities
• Trade discount
• Rebate
• Duty drawback
• Other similar item.

Cost of conversion: It consist of the Cost directly related to the units (i.e. Direct Labour, Direct Material, Direct Expenses)

Systematic Allocation of fixed and variable production overheads incurred in converting material into finished goods.

• Fixed production overhead: Indirect cost of production that remains relatively constant regardless of volume of production (i.e. Depreciation and Maintenance of factory building cost of factory management).
• Variable Production Overhead: Indirect cost of production varies directly or nearly directly with the volume of production (i.e. indirect material, indirect Labour).
• Allocation of fixed production overhead: On normal capacity.
• Allocation of variable production overhead: On actual production.
• In case of joint products: When the cost of conversion of each product is not separately identifiable, total cost of conversion is allocated between the products on the rational and consistent basis. (i.e. allocation on the basis of relative sale value of product).
• In case of by-product: If by-products, scrap or waste materials are not of material value, they are measured at net realizable value. Then net realizable value is deducted from cost of conversion. Net cost of conversion (i.e. cost of conversion – net realizable value) is distributed among the main products.

Other cost: Cost incurred in bringing the inventories to their present location and condition.

Exclusions from cost of Inventories

Following costs are excluded from the cost of Inventories:

• Abnormal amounts of wasted material, labour, other production cost
• Storage cost
• Administrative overhead
• Selling and distribution cost

Cost Formula

Specific identification method for determining cost of inventories – Specific identification method means directly linking the cost with specific item of inventories. This method has application in following conditions –

• In case of purchase of item specifically segregated for specific project and is not ordinarily interchangeable.
• In case of goods of services produced and segregated for specific project.

Where specific identification method is not applicable – Where specific identification method is not applicable, the cost of inventories is valued by the following methods:

• FIFO (First In First Out)
• Weighted Average Cost.

Cost of inventories in certain condition

When it is impractical to calculate the cost, the following methods may be followed to ascertain cost.

• Standard Cost
• Retail Method

These methods may be used for convenience if the results

Standard Cost – It takes into account normal level of consumption of material and supplies, labour, efficiency and capacity utilization. It must be regularly reviewed and revised taking into consideration the current condition.

Retail Method – It is generally used in retail business when it is difficult to ascertain cost of individual item. It is applicable when items of inventories are rapidly changing items and have similar margins and for which it is impracticable to use other costing method.

Under this method the cost of inventory is determined by reducing from the sale value of inventories the approximate percentage gross margin. The percentage used takes into consideration the inventory that has been marked down to below its original selling price.

What is Net Realizable Value?

 Net realizable value means the estimated selling price in ordinary course of business, less estimated cost of completion and estimated cost necessary to make the sale. Net realizable value is estimated on the basis of most reliable evidence at the time of valuation. Estimation of net realizable value also takes into account the purpose for which the inventory is held.

Estimation of net realizable value

The net realizable value of the material and other supplies held for use in production of finished goods is estimated as under:

• If finished product in which raw material and supplies is used is sold at cost or above cost, then the estimated realizable value of raw material and supplies is considered more than its cost.
• If finished product in which raw material and supplies is used is sold below cost. Then the estimated realizable value of raw material or supplies is equal to replacement price of raw material or supplies.

Comparison between cost and net realizable value

The comparison between cost and net realizable value should be made item by item or by group of items.

Disclosure in the financial statement

The financial statement should disclose the following:

• Accounting policy adopted in measuring inventories.
• Cost formula used.
• Classification of inventories like finished goods, WIP, Raw Material, spare parts and its carrying amount.