AS-2: Valuation of Inventories

Inventories helps in determining the carrying amount of inventories in financial statements. This includes determination of cost of inventory and any amount to be written off to bring it to Net Realisable Value (NRV). Inventory valuation impacts both P&L as well as Balance sheet, if there are any miscalculations in inventory valuations. So this standard is important. 

This standard is not applicable to for: 

• Work-in-progress (WIP) arising under construction contracts (as it is discussed in AS-7). 

• WIP of service providers. 

• If the entity holds shares, debentures and other financial instruments as stock-in-trade (as it was discussed in the footnote of AS-13). 

• Inventories of livestock, agricultural and forest products,  mineral oils, ores and gases to the extent that they are  measured at NRV in accordance with well established practices in those industries ( No AS exists) 

Definition of Inventory includes the following: 

Inventories are assets which are held for sale in the ordinary course of business (Finished Goods) or used in the process of production for such sale (Raw material, WIP) or to be consumed in the process production or in the rendering of the services (consumables and loose tools). 

Valuation of Inventory: 

Inventory is valued at Cost or Net Realizable Value (NRV) whichever is lower.  

Cost of inventory includes cost of purchase, cost of conversion and other costs incurred to bring the inventory to present location and condition. 

Cost of Purchase includes all costs incurred to purchase the material. The items that are directly related to the purchase of material are  

• Purchase Price (Basic price of material), 

• Non refundable taxes and duties, carrying cost (inward freight cost), Inward Insurance cost, All other costs incurred directly related to acquisition and bringing it to ware house are to be added to Purchase Price. 

• Trade discounts, Quantity discounts, Duty drawbacks and other similar items are to be deducted from the Purchase Price. 

Cost of Conversion includes the costs incurred to convert the raw materials into finished goods i.e. costs like Labor, Factory rent, Fuel Costs, Power expenses (factory overheads) and other items. The overheads should be absorbed as Factory overheads which are divided into two types based on its nature as Variable expenses which change along with the volume of production and Fixed expenses which do not change with volume of production. 

Absorption of overheads should be done as follows: 

1. Variable Overheads should be absorbed on actual capacity utilization 

1. When Actual capacity is more than Normal capacity then Fixed Overheads should be absorbed on Actual capacity. When Actual capacity is less than Normal capacity then Fixed Overheads should be absorbed on Normal capacity. 

Actual capacity is the actual production of goods. Normal capacity is the number of units of production on an average over a period after considering normal loss of capacity under normal circumstances. 

Some factory costs like consumable stores and spares, depreciation of plant and machinery, factory building, lease rent of productions assets, etc. should be absorbed in the calculation of per unit cost. 

All Other costs incurred to bring the inventory to present location and condition like quality control cost, R&D cost incurred for development and improvement of process or product, etc. 

The costs that should be excluded from COST are: 

• Abnormal waste of Raw Material, labor or other production costs. 

• Storage Costs 

• General administration Overheads 

• Selling and Distribution costs 

• Interest and financial charges (if it does not satisfy the  AS 16) 

This unallocated expenditure should be transformed to P&L a/c in the period which it is incurred. 

Allocation of Costs in Special situations: 

Joint Product 

Two or more outputs generated simultaneously, by a single manufacturing process using common input, and being substantially equal in value (Butter, Cheese and cream from milk, etc). 

In this case the joint (common) costs are allocated between the products on a rational and consistent basis. Basis of allocation may be on the sales value of each product when the products become separately identifiable or on the sale value after completion of production. 

By Product 

It is a secondary or incidental product in a process of manufacture and generally it has insignificant value (In Sugar Manufacturing, Sugar is the main product and molasses is by product). 

As per AS – 2, there is no need to find out the cost of by product but it is required to find out the cost of the main product. The cost of the main product can be found by finding joint costs of both and computing NRV of by product at the time of separation and deducting that NRV from the joint cost. 

Cost of inventory can be ascertained in the following manner: 

• If inventory items are not interchangeable, a Specific Identification cost method is used. In this method allocation of specific costs to specific/identified inventory. 

• If items are interchangeable, the entity can adopt any method of inventory valuation which gives fairest possible approximation to cost incurred to bring items to present location and condition. AS 2 is not particular about any method but it should give the fairest possible approximation to cost. Mostly methods like FIFO, Weighted Average can be used as it satisfies the above objective. 

• Standard Cost or retail method may be used for convenience if a result approximates to cost and regularly review the standard cost and revise it if necessary. 

• Standard cost method is the cost that entity fixes the approximate rate of products based on costs, experience etc. irrespective of actual cost or any method like FIFO or LIFO. 

• Retail method is used for entities that are into retail business. It is not possible to use FIFO or any other cost formula in this business hence they can follow retail cost method.  

NRV is the estimated selling price in the ordinary course of business less cost of completion and cost to make the sale. 

NRV of WIP 

NRV of WIP is not possible to determine as nobody purchases it. It is to be converted into Finished Goods and to sell as Finished Goods. Hence we compute NRV of WIP with expected selling price of Finished Goods and deduct the costs to be incurred to complete it as Finished Goods and Costs incurred to sell. 

NRV of Raw Materials 

Actually Raw material valuation is not based on Cost or NRV whichever is less. Its valuation is fully based on Finished Goods valuation because Finished goods are produced to sell but Raw materials are purchased for not to sell. If the entity is able to sell the Finished Goods at the cost or above cost, Raw material should be valued at Cost only. If Finished Goods are sold below cost, then Raw Material should be valued at Replacement Cost. 

Replacement Cost is the amount that an entity would have to pay to replace an asset at the present time, according to its current worth. 

Inventories are usually written down to NRV on an item by item basis. 

DISCLOSURES: 

• Accounting policies adopted in measuring inventories, including the cost formula used and 

• The total carrying amount of inventories and its classification appropriate to the enterprise. 

Comparison of AS 2 –Valuation of Inventories, Ind AS 2 – Inventories and IAS 2 – Inventories: 

• AS 2 deals with determination of cost and its subsequent recognition as an expense but along with cost determination, cost formulas to assign costs to inventories are dealt in Ind AS 2. 

• Ind AS 2 excludes commodity broker-traders who measure their inventories at fair value costs to sell. AS 2 does not contain any such aspect. 

• Ind AS 2 gives an explanation with regards to inventories of service providers whereas AS 2 does not discuss that. 

• AS 2 excludes the producers inventories of livestock, agricultural and forest products, mineral oils, ores and gases. But Ind AS 2 gives guidance on such inventory and excludes only the measurement of such inventories. 

• AS 2 requires assessment NRV at to be each balance sheet date and does not deal with such reversal but Ind AS 2 provides detailed guidance in case of subsequent assessment of NRV. It also deals with the reversal of the write-down of inventories to NRV to the extent of the amount of original write-down, and the recognition and disclosure thereof in the financial statements. As per IAS 2 Reversals arising from an increase in NRV are recognized as a reduction of the inventories expense in the period in which they occur. 

• AS 2 specifically says that formula used to determine the cost of Inventories should give the fairest possible approximation to the cost. However Ind AS 2 does not specifically state so and requires the use of consistent cost formulas for all inventories having a similar nature and use to the entity. 

• As per AS 2 Inventories in form of finished goods and WIP are required to be stated at the lower of cost and NRV. But as per IAS 2 All inventories are required to be stated at the lower of cost and NRV. 

• Interest and other borrowing costs are not included in cost of inventories in AS 2 but in IAS 2 Purchase of inventories on deferred settlement terms, excess payment over normal price is to be accounted as interest over the life of financing. Foreign exchange fluctuation gain or loss cannot be considered as inventories cost.   
  

Ind AS 2 and IAS 7 requires more disclosure as compared to AS 2 as follows: 

• The carrying amount of inventories carried at fair value less costs to sell

• The amount of inventories recognized as an expense during the period

• The amount of any write-down of inventories recognized as an expense in the period  

• The amount of any reversal of any write-down that is recognized as a reduction in the amount of inventories recognized as expense in the period. 

• Reversal of write down and circumstances that lead to write down. 

• Inventories pledged as security for liabilities. 

References from Board Materials:

• Accounting Standard 2 –Valuation of Inventories

• Ind AS 2 – Inventories

• IAS 2 – Inventories