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Statements of Accounting Standards (AS 2) Revised
Valuation of Inventories
(In this Accounting Standard, the standard
portions have been set in bold italic type. These should
be read in the context of the background material which has been
set in normal type, and in the context of the 'Preface to the Statements
of Accounting Standards'.)
The following is the text of the revised
Accounting Standard (AS) 2, 'Valuation of Inventories', issued by
the Council of the Institute of Chartered Accountants of India.
This revised Standard supersedes Accounting Standard (AS) 2, 'Valuation
of Inventories', issued in June, 1981.
The revised standard comes into effect
in respect of accounting periods commencing on or after 1.4.1999
and is mandatory in nature.
Objective
A primary issue in accounting for inventories
is the determination of the value at which inventories are carried
in the financial statements until the related revenues are recognised.
This Statement deals with the determination of such value, including
the ascertainment of cost of inventories and any write-down thereof
to net realisable value.
Scope
1. This Statement should be applied
in accounting for inventories other than:
(a) Work in progress arising under construction contracts, including
directly related service contracts (see Accounting Standard (AS)
7, Accounting for 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 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.
2. The inventories referred to in paragraph
1 (d) are measured at net realisable value at certain stages of
production. This occurs, for example, when agricultural crops have
been harvested or mineral oils, ores and gases have been extracted
and sale is assured under a forward contract or a government guarantee,
or when a homogenous market exists and there is a negligible risk
of failure to sell. These inventories are excluded from the scope
of this Statement.
Definitions
3. The following terms are used
in this Statement with the meanings specified:
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.
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.
4. Inventories encompass 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. Inventories also encompass 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. 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 Accounting
Standard (AS) 10, Accounting for Fixed Assets.
Measurement of Inventories
5. Inventories should be valued at the lower
of cost and net realisable value.
Cost of Inventories
6. The cost of inventories should
comprise all costs of purchase, costs of conversion and other costs
incurred in bringing the inventories to their present location and
condition.
Costs of Purchase
7. The costs of purchase consist of
the purchase price including duties and taxes (other than those
subsequently recoverable by the enterprise from the taxing authorities),
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.
Costs of Conversion
8. The costs of conversion of inventories
include costs directly related to the units of production, such
as direct labour. They also include a systematic allocation of fixed
and variable production overheads that are incurred in converting
materials into finished goods. Fixed production overheads are those
indirect costs of production that remain relatively constant regardless
of the volume of production, such as depreciation and maintenance
of factory buildings and the cost of factory management and administration.
Variable production overheads are those indirect costs of production
that vary directly, or nearly directly, with the volume of production,
such as indirect materials and indirect labour.
9. The allocation of fixed production overheads for the purpose
of their inclusion in the costs of conversion is based on the normal
capacity of the production facilities. Normal capacity is the production
expected to be achieved on an average over a number of periods or
seasons under normal circumstances, taking into account the loss
of capacity resulting from planned maintenance. The actual level
of production may be used if it approximates normal capacity. The
amount of fixed production overheads allocated to each unit of production
is not increased as a consequence of low production or idle plant.
Unallocated overheads are recognised as an expense in the period
in which they are incurred. In periods of abnormally high production,
the amount of fixed production overheads allocated to each unit
of production is decreased so that inventories are not measured
above cost. Variable production overheads are assigned to each unit
of production on the basis of the actual use of the production facilities.
10. A production process may result in more than one product being
produced simultaneously. This is the case, for example, when joint
products are produced or when there is a main product and a by-product.
When the costs of conversion of each product are not separately
identifiable, they are allocated between the products on a rational
and consistent basis. The allocation may be based, 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 production. Most by-products as well as
scrap or waste materials, by their nature, are immaterial. When
this is the case, they are often measured at net realisable value
and this value is deducted from the cost of the main product. As
a result, the carrying amount of the main product is not materially
different from its cost.
Other Costs
11. Other costs are included in the
cost of inventories only to the extent that they are incurred in
bringing the inventories to their present location and condition.
For example, it may be appropriate to include overheads other than
production overheads or the costs of designing products for specific
customers in the cost of inventories.
12. Interest and other borrowing costs are usually considered as
not relating to bringing the inventories to their present location
and condition and are, therefore, usually not included in the cost
of inventories.
Exclusions from the Cost of Inventories
13. In determining the cost of inventories
in accordance with paragraph 6, 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 those costs are necessary in the production
process prior to a further production stage;
(c) Administrative overheads that do not contribute to bringing
the inventories to their present location and condition; and
(d) selling and distribution costs.
Cost Formulas
14. The cost of 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.
15. Specific identification of cost
means that specific costs are attributed to identified items of
inventory. 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 numbers of items of inventory
which are ordinarily interchangeable, specific identification of
costs is inappropriate since, in such circumstances, an enterprise
could obtain predetermined effects on the net profit or loss for
the period by selecting a particular method of ascertaining the
items that remain in inventories.
16. The cost of inventories, other
than those dealt with in paragraph 14, should be assigned by using
the first-in, first-out (FIFO), or 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.
17. A variety of cost formulas is used
to determine the cost of inventories other than those for which
specific identification of individual costs is appropriate. The
formula used in determining the cost of an item of inventory needs
to be selected with a view to providing the fairest possible approximation
to the cost incurred in bringing the item to its present location
and condition. The FIFO formula assumes that the items of inventory
which were purchased or produced first are consumed or sold first,
and consequently the items remaining in inventory at the end of
the period are those most recently purchased or produced. Under
the weighted average cost formula, the cost of each item is determined
from the weighted average of the cost of similar items at the beginning
of a period and the cost of similar items purchased or produced
during the period. The average may be calculated on a periodic basis,
or as each additional shipment is received, depending upon the circumstances
of the enterprise.
Techniques for the Measurement of Cost
18. Techniques for the measurement
of the cost of inventories, such as the standard cost method or
the retail method, may be used for convenience 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. They are regularly reviewed and, if necessary,
revised in the light of current conditions.
19. The retail method is often 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. The cost of the inventory is determined by reducing from
the sales value of the inventory the appropriate percentage gross
margin. The percentage used takes into consideration inventory which
has been marked down to below its original selling price. An average
percentage for each retail department is often used.
Net Realisable Value
20. The cost of inventories may not
be recoverable if those inventories are damaged, if they have become
wholly or partially obsolete, or if their selling prices have declined.
The cost of inventories may also not be recoverable if the estimated
costs of completion or the estimated costs necessary to make the
sale have increased. 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.
21. Inventories are usually written down to net realisable value
on an item-by-item basis. In some circumstances, however, it may
be appropriate to group similar or related items. This may be the
case with items of inventory relating to the same product line that
have similar purposes or end uses and are produced and marketed
in the same geographical area and cannot be practicably evaluated
separately from other items in that product line. It is not appropriate
to write down inventories based on a classification of inventory,
for example, finished goods, or all the inventories in a particular
business segment.
22. Estimates of net realisable value are based on the most reliable
evidence available at the time the estimates are made as to the
amount the inventories are expected to realise. These estimates
take into consideration fluctuations of price or cost 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.
23. Estimates of net realisable value also take into consideration
the purpose for which the inventory is held. For example, the net
realisable value of the quantity of inventory held to satisfy firm
sales or service contracts is based on the contract price. If the
sales contracts are for less than the inventory quantities held,
the net realisable 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 losses on firm purchase
contracts are dealt with in accordance with the principles enunciated
in Accounting Standard (AS) 4, Contingencies and Events Occurring
After the Balance Sheet Date.
24. Materials and other supplies held for use in the production
of inventories are not written down below cost if the finished products
in which they will be incorporated are expected to be sold at or
above cost. However, when there has been a decline in the price
of materials and it is estimated that the cost of the finished products
will exceed net realisable value, the materials are written down
to net realisable value. In such circumstances, the replacement
cost of the materials may be the best available measure of their
net realisable value.
25. An assessment is made of net realisable value as at each balance
sheet date.
Disclosure
26. 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 and its classification
appropriate to the enterprise.
27. 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 raw materials and
components, work in progress, finished goods, stores and spares,
and loose tools.
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