AS-2 Valuation of Inventory

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 Inventories are assets:
(a) held for sale in ordinary course of business;
(b) in the process of production fro such sale (WIP);
(c) in the form of materials or supplies to be consumed in the production process or
rendering of services.

However, this standard does not apply to the valuation of following inventories:
(a) WIP arising under construction contract (Refer AS – 7);
(b) WIP 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 realizable value in
accordance with well established practices in those industries.

Inventories should be valued at the lower of cost and net realizable value.
The cost of inventories should comprise -
(a) all costs of purchase
(b) costs of conversion
(c) other costs incurred in bringing the inventories to their present location and
The costs of purchase consist of -
(a) the purchase price
(b) duties and taxes ( other than those subsequently recoverable by the enterprise from the
taxing authorities like CENVAT credit)
(c) freight inwards and other expenditure directly attributable to the acquisition.

Trade discounts (but not cash discounts), rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase.

The costs of conversion include direct costs and systematic allocation of fixed and variable production overhead.

Allocation of fixed overheads 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.

Under Recovery: Unallocated overheads are recognized as an expense in the period in which they are incurred.
Example: Normal capacity = 20000 units
Production = 18000 units
Sales = 16000 units
Closing Stock = 2000 units
Fixed Overheads = Rs. 60000

Then, Recovery rate = Rs60000/20000 = Rs 3 per unit
Fixed Overheads will be bifurcated into three parts:
Cost of sales : 16000*3 = 48000
Closing stock : 2000 *3 = 6000
Under recovery : Rs 6000 ( to be charged to P/L)

(Apparently it seems that fixed cost element in closing stock should be 60000/18000*2000 =Rs 6666.67. but this is wrong as per AS-2)

Over Recovery: In period of high production, the amount of fixed production overheads is allocated to each unit of production is decreased so that inventories.
Example: Normal capacity = 20000 units
Production = 25000 units
Sales = 23000 units
Closing Stock = 2000 units
Fixed Overheads = Rs 60000

Recovery Rate = Rs 60000/20000 = Rs 3 per unit
But, Revised Recovery rate = Rs 60000/25000 = Rs. 2.40 per unit

Cost of sales : 23000*2.4 = Rs 55200
Closing Stock : 2000 *2.4 = Rs. 4800

Joint or by products:
In case of joint or by products, the costs incurred up to the stage of split off should be allocated on a rational and consistent basis. The basis of allocation may be sale value at split off point or sale value at the completion of production. In case of the by products of negligible value or wastes, valuation may be taken at net realizable value. The cost of main product is then joint cost minus net realizable value of by product or waste.

The other costs are also included in the cost of inventory to the extent they contribute in bringing the inventory to its present location and condition.

Interest and other borrowing costs are usually not included in cost of inventory. However, AS-16 recommends the areas where borrowing costs are taken as cost of inventory.

Certain costs are strictly not taken as cost of inventory.
(a) Abnormal amounts of wasted materials, labour, or other production costs;
(b) Storage costs, unless those costs are necessary in the production process prior
a further production stage;
(c) Administrative overheads that do not contribute to bringing the inventories to
their present location and condition;
(d) Selling and Distribution costs.

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
The cost of inventories is valued by the following methods;
• FIFO ( First In First Out) Method
• Weighted Average Cost

Cost of inventories in certain conditions:
The following methods may be used for convenience if the results approximate actual cost.
 Standard Cost: It takes into account normal level of consumption of material and supplies, labour, efficiency and capacity utilization. It must be regularly reviewed taking into consideration the current condition.
 Retail Method: Normally applicable for retail trade Cost of inventory is determined by reducing the gross margin from the sale value of inventory.

Net Realisable Value means the estimated selling price in ordinary course of business, at the time of valuation, less estimated cost of completion and estimated cost necessary to make the sale.

Comparison between net realizable value and cost of inventory

The comparison between cost and net realizable value should be made on item-by-item basis. (In some cases, group of items-by-group of item basis)

For Example:

Item A 100(cost) 90(nrv) 90(Inventory value as per AS-2)
Item B 100(cost) 115(nrv) 100(Inventory value as per AS-2)
Total 200(cost) 205(nrv) 200 190(Inventory value as per AS-2)

Raw material valuation
If the finished goods to which raw material is applied, is sold at profit, RAW MATERIAL is valued at cost irrespective of its NRV level being lower to its costs.
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