Valuation of Inventories

VALUATION OF INVENTORIES – AS -2

INVENTORIES: It is defined as "A company’s merchandise, raw materials, finished & unfinished products which have not yet been sold." These are considered liquid assets, since they can be converted into cash quite easily. It includes finished goods, work- in-progress, raw material, consumables, loose tools, etc., which are held for resale or consumption.

Inventories should be valued at the lower of COST and NET REALIZABLE VALUE.

·        COST: cost of purchase + cost of conversion + other cost incurred to bring the inventory to its present location and condition.

·       Cost of Purchase: It includes taxes, duties (except which are later on recoverable by the enterprise from taxing authorities), freight inward etc. Trade discount, rebate, duty drawback etc. will be deducted. Cenvatable excise duty paid on inputs is excluded.

·        Cost of Conversion: It includes labour cost, fixed and variable production overheads.

Ø Fixed production overhead: It should be allocated on the basis of normal capacity. Actual production can be used if it approximates the normal capacity.

In case of low production the unabsorbed fixed overhead will not be allocated to inventory cost. But in case of abnormally high production the inventory cost will be appropriately reduced so as to include actual fixed overhead over total production.

·         In case of joint products, joint cost should be allocated on some reasonable and consistent bases. E.g. their respective sales valued at separation stage or after further processing.

·        In case of by products, scraps etc.: If not very significant are valued at net realizable value and this value is deducted from the cost of main product.

·        Following should not be included in cost of inventory

Ø Storage cost

Ø Administrative overhead

Ø Selling and distribution cost

Ø Abnormal losses / wastages

Ø Interest and other borrowing cost

·        Specific pricing is applied for items that are not interchangeable and goods and services which are produced and segregated for a specific purpose / project.

·        Cost should be calculated by FIFO or weighted average method. Weighted average can be calculated after every lot is received or on periodic basis. i.e. periodic weighted average method.

·        Standard cost or retail method can be used for convenience if results approximate the actual cost.

·        Comparison of cost and net realizable value should be done on item basis or similar and interchangeable items can be grouped (i.e. group basis but not on aggregate basis i.e. global basis) But it should not be based on a classification like all finished goods, all raw materials, etc.

·        Net realizable value estimation will also consider the purpose for which inventory is held. In case of firm contracts for sales, the contract price and for the excess inventory general selling price will be considered. Contingent loss on firm contract in excess of inventory held will be provided as AS-4

·        Material and other supplies held for use in the production of inventories will generally be not valued below the cost if the net realizable value of finished goods for which such material is going to be used will be equal to or above the cost. Otherwise if material prices decline, the same will be valued at lower than cost (which can be replacement cost.) Normal stock will have to be written down to NRV if finished goods will sell at a loss. This is because if the loss making finished goods is discontinued, stocks of raw materials have to be sold off.

·        Disclosure in the financial statement in respect of AS -2 :

Ø Accounting policy adopted in measuring inventories

Ø Cost formula used

Ø Classification of inventories: like finished goods, WIP, raw material, spare parts and its carrying amount.

·        Summary :

Ø In case of high production, the overhead should be allocated on the basis of actual production.

Ø Royalty based on production is part of cost of inventory but royalty based on sale is not.

Ø Excise duty, paid or payable, in respect of inventory of finished goods is a part of cost.

Ø Inventories be valued at cost net of ‘CENVAT’ credit.

Ø For buyer, the goods in transit are included in inventory, only if the risk and rewards of ownership have passed to him. If not, it is the inventory of the seller.

Ø Material given on loan is not an inventory. Rather, it should be shown as Loans and Advances.

Ø Net realizable value should be estimated at each balance sheet date.

Tree Diagram – Valuation of Stock of Raw Material

Valuation of Stock of Raw Material 

Books referred: Students’ guide to Accounting Standards