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CONTENTS

 

AS 2: VALUATION OF INVENTORIES* [Revised in 1999]. 2

APPLICABILITY.. 2

SCOPE OF AS - 2. 2

MEASUREMENT OF INVENTORIES. 3

STEPS IN VALUATION OF INVENTORIES. 3

COST OF INVENTORIES. 3

COSTS OF PURCHASE. 3

COSTS OF CONVERSION.. 3

OTHER COSTS. 4

EXCLUSIONS FROM THE COST OF INVENTORIES. 5

COST FORMULAE. 5

TECHNIQUES FOR THE MEASUREMENT OF COST.. 7

NET REALIZABLE VALUE. 7

DISCLOSURE. 8

INCOME TAX & ACCOUNTING STANDARDS:. 8

CASELAWS:. 8

SECTION 145A of INCOME TAX ACT & ACCOUNTING STANDARD 2:. 8

 


 

AS 2: VALUATION OF INVENTORIES* [Revised in 1999]

APPLICABILITY

 

This Accounting Standard applies to Level I, Level II and Level III Entities.

 

This Standard should be applied in accounting for inventories other than: [Para 1]

 

a)    Work in progress arising under construction contracts, including directly related service contracts (see Accounting Standard (AS) 7, Construction Contracts);

b)    Work in progress arising in the ordinary course of business of service providers;

c)     Shares, debentures and other financial instruments held as stock-in-trade; and

d)    Producers - inventories oflivestock, agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, mineral oils, ores and gases to the extent that they are measured at net realizable value in accordance with well-established practices in those industries. When such inventories are measured at net realizable value, changes in that value are recognised in profit or loss in the periodof the change.

 

MEASUREMENT & RECOGNITION:

 

Meaning of Inventories: [Para 3.1]

 

Inventories are assets:

a)    held for sale in the ordinary course of business;

b)    in the process of production for such sale; or

c)     in the form of materials or supplies to be consumed in the production process or in the rendering of services.

 

Inventories encompass: [Para 4]

1.    Goods purchased and held for resale, for example, merchandise purchased by a retailer and held for resale, computer software held for resale, or land and other property held for resale

2.    Finished goods produced, or

3.    Work in progress being produced, by the enterprise

4.    Materials, maintenance supplies, consumables and loose tools awaiting use in the production process.

 

A primary issue in accounting for inventories is the determination of the value at which inventories arecarried in the financial statements.

 

This Accounting Standard deals with:

 

1.    The accounting treatment for inventories- is prescribed in AS 2 "Valuation of Inventories", whichprovides guidance for determining the value at which inventories, are carried in the financialstatements until related revenues are recognised.

2.    Guidance on the costformulas- that are used to assign costs to inventories and any write-down thereof to net realizable value.

 

Inventories Include:

 

Inventories encompass goods purchased and held for resale, for example, merchandisepurchased by a retailer and held for resale, computer software held for resale, or land and otherproperty held for resale. [Para 4]

 

Inventories also encompass finished goods produced, or work in progressbeing produced, by the enterprise and include materials, maintenance supplies, consumables andloose tools awaiting use in the production process. [Para 4]

 

Inventories Exclude:

 

The inventories referred to in paragraph 1 (d) above, are measured at net realizable value at certainstages of production. [Para 2]

 

This occurs, for example, when agricultural crops have been

 

Example of Disclosures under AS - 2:

Anant Raj Industries Limited:

Development rights: At cost of acquisition, including cost of acquiring rights of any interested party. Development rights are considered to have been acquired on execution of a Development Agreement upon visiting of irrecoverable rights in the company to construct, market, and sell the development over land and realize and retain the economic and other benefits.

harvested or mineraloils, ores and gases have been extracted and sale is assured under a forward contract or a governmentguarantee, or when a homogenous market exists and there is a negligible risk of failure to sell. Theseinventories are excluded from the scope of this Standard.[Para 2]

 

Inventories do not include machinery spares whichcan 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 Accounting Standard (AS) 10, Accountingfor Fixed Assets. [Para 4]

MEASUREMENT OF INVENTORIES

[Para 5]

 

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

 

Meaning of Cost: [As explained in Para 6 to 13]

Cost has not been specifically defined in this Standard.

 

Meaning of Net Realizable Value: [As explained in Para 20 to 25]

Net Realizable Value is defined in Para 3.2 to mean 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.

STEPS IN VALUATION OF INVENTORIES

1.       Determination of Cost of Inventories

2.       Determination of Net Realizable value of inventories

3.       Comparison between the cost and net realizable value

 

COST OF INVENTORIES

 

The cost of inventories should comprise of: [Para 6]

       i.        Costs of purchase,

      ii.        Costs of conversion and

    iii.        Other costs incurred in bringing the inventories to their present location and condition.

COSTS OF PURCHASE

[Para 7]

 

The costs of purchase consist of:

       i.        Purchase price including duties and taxes (other than thosesubsequently recoverable by the enterprise from the taxing authorities),

      ii.        Freight inwards and otherexpenditure directly attributable to the acquisition.

     iii.        Trade discounts, rebates, duty drawbacks and othersimilar items are deducted in determining the costs of purchase.

 

Deductions from cost of purchase include:

      i.        Duties & Taxes recoverable from taxing authorities

     ii.        Trade Discounts

    iii.        Rebates

    iv.        Duty Drawbacks

     v.        Other similar items

COSTS OF CONVERSION

[Para 8, 9, 10]

 

The costs of conversion of inventories include:

 

       i.        Direct Costs

      ii.        Fixed Production Overheads

     iii.        Variable Production Overheads

 

DIRECT COSTS:

 

Costs directly related to the units of production, such as direct labour.

FIXED PRODUCTION OVERHEADS:

 

Costs of Conversion also include a systematic allocation of fixed productionoverheads that are incurred in converting materials into finished goods.

 

Fixed production overheads arethose indirect costs of production that remain relatively constant regardless of the volume ofproduction, such as depreciation and maintenance of factory buildings and the cost of factorymanagement and administration.

 

The allocation of fixed production overheads for the purpose of their inclusion in the costs ofconversion is based on the normal capacity of the production facilities.

Normal capacity is theproduction expected to be achieved on an average over a number of periods or seasons under normalcircumstances, taking into account the loss of capacity resulting from planned maintenance. The actuallevel of production may be used if it approximates normal capacity.

The amount of fixed productionoverheads allocated to each unit of production is not increased as a consequence of low production oridle plant.

Unallocated overheads are recognised as an expense in the period in which they areincurred.

In periods of abnormally high production, the amount of fixed production overheads allocatedto each unit of production is decreased so that inventories are not measured above cost.

 

VARIABLE PRODUCTION OVERHEADS:

 

Costs of Conversion also include a systematic allocation of fixed productionoverheads that are incurred in converting materials into finished goods.

 

Variable production overheads are those indirect costs of productionthat vary directly, or nearly directly, with the volume of production, such as indirect materials andindirect labour.

 

Variableproduction overheads are assigned to each unit of production on the basis of the actual use of theproduction facilities.

COSTS OF CONVERSION IN CASE OF JOINT PRODUCTS OR BY-PRODUCTS:

 

What are Joint Products / By Products?

A production process may result in more than one product being produced simultaneously. This isthe case, for example, when joint products are produced or when there is a main product and a byproduct.

 

How is the cost of conversion allocated between Joint Products?

When the cost of conversion of each product is not separately identifiable, total cost of conversion is allocated on the basis of relative sale value of the product.

 

How is the cost of conversion allocated between By Products?

         If by-products, scrap or waste materials are not of material value, they are measured at NRV.

         Then NRV is deducted from cost of conversion, we get Net cost of conversion.

         This Net cost of conversion is distributed among the main products.

 

OTHER COSTS

[Para 11, 12]

 

Other costs are included in the cost of inventories only to the extent that they are incurred inbringing the inventories to their present location and condition. For example, it may be appropriate toinclude overheads other than production overheads or the costs of designing products for specificcustomers in the cost of inventories.

 

Interest and other borrowing costs are usually considered as not relating to bringing theinventories to their present location and condition and are, therefore, usually not included in the cost ofinventories.

 

The draft format of Cost Sheet is attached herewith for ready reference. This will help identify the costs ideally included in the valuation of Raw Materials, Work-in-Progress and Finished Goods to some extent.

EXCLUSIONS FROM THE COST OF INVENTORIES

[Para 13]

 

In determining the cost of inventories in accordance with paragraph 6, it is appropriate to excludecertain costs and recognise them as expenses in the period in which they are incurred. Examples ofsuch costs are:

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

b)    storage costs, unless those cost are necessary in the production process prior to a furtherproduction stage;

c)     administrative overheads that do not contribute to bringing the inventories to their presentlocation and condition; and

d)    selling and distribution costs

 

COST FORMULAE

[Para 14, 15, 16, 17]

 

Valuation of Inventories for Specific Projects:

 

Application of this Formula of Costing of Inventories:

Inventory - Goods or services produced and segregated for specific projects

Formula Used - Specific identification of cost method

Costs Included - Costs attributable to the Project

 

 

Explanation:

The cost of inventories of items that are not ordinarily interchangeable and goods orservices produced and segregated for specific projects should be assigned by specificidentification of their individual costs.

 

Specific identification of cost means that specific costs are attributed to the identified items ofinventory. This is an appropriate treatment for items that are segregated for a specific project,regardless of whether they have been purchased or produced.

 

However, when there are large numbersof items of inventory which are ordinarily interchangeable, specific identification of costs isinappropriate since, in such circumstances, an enterprise could obtain predetermined effects on the netprofit or loss for the period by selecting a particular method of ascertaining the items that remain ininventories.

 

Examples of Inventories valued on Specific Identification Cost method:

[As seen from the Financial Statements of some companies]

 

1.    Tea whether unblended, blended and packed [Balmer Lawrie and Company Limited]

2.    Aluminum conductors used in power transmission business [Sterlite Technologies Limited]

3.    Items of Jewellery in case of Jewellery Business

 

 

Valuation of Inventories other than the above:

 

A variety of cost formulas is used to determine the cost of inventories other than those for whichspecific identification of individual costs is appropriate. The formula used in determining the cost of anitem of inventory needs to be selected with a view to providing the fairest possible approximation to thecost incurred in bringing the item to its present location and condition. The two major and most popular Formulae

 

Example of Disclosures under AS - 2:

Bajaj Hindusthan Limited:

Inventories:

 

By-products - Molasses and Bangasse have been valued at estimated realizable value.

Trial run inventories are valued at cost or estimated realizable value whichever is lower.

used for valuation of Inventories other than Inventories for Specific Projects are:

 

       I.        Valuation on First In First Out (FIFO) Basis:

 

Application of this Formula of Costing of Inventories:

Inventory - Goods or services produced other than above

Formula Used-FIFO / Weighted Average Method

Costs Included - Cost of Purchase + Cost of Conversion + Other Costs incurred in bringing the inventories to theirpresent location and condition

 

Explanation:

 

The cost of inventories, other than those dealt with in paragraph 14, should be assigned byusing the first-in, first-out (FIFO) cost formula. The formula used shouldreflect the fairest possible approximation to the cost incurred in bringing the items of inventoryto their present location and condition.

 

The FIFO formula assumes thatthe items of inventory which were purchased or produced first are consumed or sold first, andconsequently the items remaining in inventory at the end of the period are those most recentlypurchased or produced.

 

Examples of Inventories valued on FIFO method:

[As seen from the Financial Statements of some companies]

4.    Finished Goods [Majority of the companies e.g.: Apollo Tyres Limited, Abbot India Limited, Alstom Projects Limited]

5.    Work-in-progress [ Bajaj Electricals Limited]

6.    Raw Materials in form of Tapes [Zee Entertainment Enterprises Limited]

 

 

Valuation of Inventories on Weighted Average (WAM) Basis:

Application of this Formula of Costing of Inventories:

Inventory - Goods or services produced other than above

Formula Used - Weighted Average Method

Costs Included - Cost of Purchase + Cost of Conversion + Other Costs incurred in bringing the inventories to their present location and condition

 

Explanation:

The cost of inventories, other than those dealt with in paragraph 14, should be assigned by using the weighted average cost formula. The formula used should reflect the fairest possible approximation to the cost incurred in bringing the items of inventory to their present location and condition.

 

Under the weighted average cost formula, the cost of each item is determinedfrom the weighted average of the cost of similar items at the beginning of a period and the cost ofsimilar items purchased or produced during the period. The average may be calculated on a periodicbasis, or as each additional shipment is received, depending upon the circumstances of the enterprise.

 

Examples of Inventories valued on Weighted Average Method:

[As seen from the Financial Statements of some companies]

 

1.    Crude Oil, Petroleum products etc. [Chennai Petroleum Corporation Limited]

2.    Work in Progress [Alstom Projects India Limited]

3.    Stores and Spares [Adani Enterprises Limited]

4.    Own Manufactured moulds used for manufacture of glass [Hindustan National Glass & Industries Limited]

5.    Fuel & stores, spares and tools [Kalpataru Power Transmission Limited]

6.    Arbitrage / Trading Position of the company in shares [Motilal Oswal Financial Services Limited]

7.    The stock of Central Government securities, Treasury Bills (including cash management bills), State Development Loans and PSU/Corporate Bonds & Debentures, Equity Shares [PNB Gilts Limited]

 

 

TECHNIQUES FOR THE MEASUREMENT OF COST

 

Example of Disclosures under AS - 2:

Brigade Enterprises Limited:

Valuation of inventories, representing food and beverages, held at Sheraton Bangalore at Brigade Gateway has been done after providing for obsolescence, if any, at lower of Cost or Net Realizable Value. The cost is generally calculated on weighted average basis.

 

[Para 18, 19]

       I.        STANDARD COST:

This method takes into account the normal levels of consumption of materials and supplies, labour etc. And it needs to be reviewed and revised on the basis of current conditions.

 

     II.        RETAIL METHOD:

The applicability of this method requires following conditions:

         Rapidly changing Items

         Have similar margins

         Impracticable to use other costing method

The cost of the inventory is determined by reducing from the sales value of the inventory theappropriate percentage gross margin. The percentage used takes into consideration inventory whichhas been marked down to below its original selling price. An average percentage for each retaildepartment is often used.

NET REALIZABLE VALUE

[Para 20, 21, 22, 23, 24, 25]

 

Why are Inventories valued on Net Realizable Value?

 

Ans.: The practice of writing down inventories below cost to net realizable value isconsistent with the view that assets should not be carried in excess of amounts expected to be realized from their sale or use.

 

When are Inventories valued on Net Realizable Value?

 

Ans.:Inventories are valued on NRV if those inventories are damaged, if they havebecome wholly or partially obsolete, or if their selling prices have declined. The cost of inventories mayalso not be recoverable if the estimated costs of completion or the estimated costs necessary to makethe sale have increased.

 

Manner of Valuing the Net Realizable Value:

 

Ans.:Inventories are usually written down to net realizable value on an item- by-item basis. In somecircumstances, however, it may be appropriate to group similar or related items. This may be the casewith items of inventory relating to the same product line that have similar purposes or end uses and areproduced and marketed in the same geographical area and cannot be practicably evaluated separatelyfrom other items in that product line. It is not appropriate to write down inventories based on aclassification of inventory, for example, finished goods, or all the inventories in a particular businesssegment.

 

How is the Net Realizable Value estimated?

 

Ans.:Estimates of net realizable value are based on the most reliable evidence available at the timethe estimates are made as to the amount the inventories are expected to realize. These estimates takeinto consideration fluctuations of price or cost directly relating to events occurring after the balancesheet date to the extent that such events confirm the conditions existing at the balance sheet date.

 

Estimates of net realizable value also take into consideration the purpose for which the inventoryis held. For example, the net realizable value of the quantity of inventory held to satisfy firm sales orservice contracts is based on the contract price. If the sales contracts are for less than the inventoryquantities held, the net realizable value of the excess inventory is based on general selling prices.Contingent losses on firm sales contracts in excess of inventory quantities held and contingent losseson firm purchase contracts are dealt with in accordance with the principles enunciated in AccountingStandard (AS) 4, Contingencies and Events Occurring after the Balance Sheet Date2.

 

Materials and other supplies held for use in the production of inventories are not written downbelow cost if the finished products in which they will be incorporated are expected to be sold at orabove cost. However, when there has been a decline in the price of materials and it is estimated thatthe cost of the finished products will exceed net realizable value, the materials are written down to net realizable value. In such circumstances, the replacement cost of the materials may be the bestavailable measure of their net realizable value.

 

An assessment is made of net realizable value as at each balance sheet date.

 

DISCLOSURE

[Para 26, 27]

The financial statements should disclose:

a)    The accounting policies adopted in measuring inventories, including the cost formulaused; and

b)    The total carrying amount of inventories and its classification appropriate to theenterprise.

 

Information about the carrying amounts held in different classifications of inventories and theextent of the changes in these assets is useful to financial statement users. Common classifications ofinventories are raw materials and components, work in progress, finished goods, stores and spares,and loose tools.

 

INCOME TAX & ACCOUNTING STANDARDS:

CASELAWS:

 

      i.        As per this Standard, inventory has to be valued at lower of cost and net realizable value. This method is also recognized for income-tax purposes in case of a going concern. Only in a case where the fundamental accounting assumption of going concern no longer holds good, the closing stock has to be valued at market price. The Supreme Court, in ALA Firm v. CIT (1991) 189 ITR 285, held that when a firm is dissolved and the business is discontinued, closing stock taken over by the partner has to be valued at market value and not at cost. The principle involved in this case is that the fundamental accounting assumption of going concern cannot be applied for valuing stock-in-trade at the time of dissolution.

 

     ii.        In CIT v. British Paints India Ltd. (1991) 188 ITR 044, the Supreme Court held that while valuing the closing stock of paints, total exclusion of all overheads was not permissible. A reasonable portion of the overheads has to be included. This decision is in accordance with the principles enunciated in AS-2.

 

    iii.        In Hela Holdings Pvt. Ltd. v. CIT. (2003) 263 ITR 0129, the Calcutta High Court has held that where the change in the method of valuation of stock effected by the assessee is in accordance with the Accounting Standard and the new method has been followed consistently in the subsequent years, such a change in method would be valid and proper.

 

SECTION 145A of INCOME TAX ACT & ACCOUNTING STANDARD 2:

 

AS-2 recognises Exclusive method of inventory valuation whereas section 145A of the Income-tax Act, 1961 prescribes Inclusive method of inventory valuation.

a)    As per section 145A of the Income-tax Act, 1961, the valuation of purchase and sale of goods and inventory for the purposes of determining the income chargeable under the head ?Profitsand gains of business or profession? has to be: in accordance with the method of accounting regularly employed by the assessee; and

b)    further adjusted to include the amount of any tax, duty, cess or fee, by whatever namecalled, actually paid or incurred by the assessee to bring the goods to the place of itslocation and condition as on the date of valuation.

 

The intention of section 145A is to ensure that the sale of goods and purchase of goods aregrossed up by including the excise duty, tax, cess, etc., Inventory should also be grossed upin the same manner. However, the CENVAT credit, if any available towards such duty paidshould not be taken into account.

 

There are two methods for accounting of tax, duty etc. while preparing accounts. They are theInclusive method and the Exclusive method. Under the Inclusive method, the amounts aregrossed up whereas under the Exclusive method, the figures are shown net of CENVAT credit.

 

Section 145A requires assessees to follow only the Inclusive method, whereas AS-2 on?Valuation of Inventories? requires adoption of Exclusive method.