ICAI Notes- Unit 1: Assets Based Accounting Standards | Advanced Accounting for CA Intermediate PDF Download

 Page 1


 
 
 
 
LEARNING OUTCOMES 
 
 
ASSETS BASED 
ACCOUNTING 
STANDARDS 
 
UNIT 1: ACCOUNTING STANDARD  2  
VALUATION OF INVENTORY 
 
After studying this unit, you will be able to comprehend  the 
? Definition of Inventory; 
? Measurement of Inventories;  
? What is included in Cost of Inventories;  
? Exclusions from the Cost of Inventories;  
? Cost Formulas;  
? Techniques for the Measurement of Cost. 
 
 
 
 
    
 
CHAPTER 
 
 
5 
© The Institute of Chartered Accountants of India
Page 2


 
 
 
 
LEARNING OUTCOMES 
 
 
ASSETS BASED 
ACCOUNTING 
STANDARDS 
 
UNIT 1: ACCOUNTING STANDARD  2  
VALUATION OF INVENTORY 
 
After studying this unit, you will be able to comprehend  the 
? Definition of Inventory; 
? Measurement of Inventories;  
? What is included in Cost of Inventories;  
? Exclusions from the Cost of Inventories;  
? Cost Formulas;  
? Techniques for the Measurement of Cost. 
 
 
 
 
    
 
CHAPTER 
 
 
5 
© The Institute of Chartered Accountants of India
ADVANCED ACCOUNTING 
 
 
 
 5.2 
1.1 INTRODUCTION 
The accounting treatment for inventories is prescribed in AS 2 (Revised) 
‘Valuation of Inventories’, which provides guidance for determining the value at 
which inventories, are carried in the financial statements until related revenues 
are recognised. It also provides guidance on the cost formulas that are used to 
assign costs to inventories and any write-down thereof to net realisable value.  
1.2 INVENTORIES 
AS 2 (Revised) defines inventories as assets held  
• for sale in the ordinary course of business, or 
• in the process of production for such sale, or  
• for consumption in the production of goods or services for sale, including 
maintenance supplies and consumables other than machinery spares, servicing 
equipment and standby equipment meeting the definition of Property, plant 
and equipment.  
Inventories encompass goods purchased and held for resale, for example 
merchandise (goods) purchased by a retailer and held for resale, or land and other 
property held for resale. Inventories also include 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 spare parts, servicing equipment and standby equipment 
which meet the definition of property, plant and equipment as per AS 10 (Revised), 
Property, Plant and Equipment. Such items are accounted for in accordance with 
Accounting Standard (AS) (Revised) 10, Property, Plant and Equipment.  
Following are excluded from the scope of AS 2 (Revised).  
(a) Work in progress arising under construction contracts, i.e. cost of part 
construction, including directly related service contracts, being covered under 
AS 7, Accounting for Construction Contracts; Inventory held for use in 
construction, e.g. cement lying at the site should however be covered by AS 2 
(Revised).  
© The Institute of Chartered Accountants of India
Page 3


 
 
 
 
LEARNING OUTCOMES 
 
 
ASSETS BASED 
ACCOUNTING 
STANDARDS 
 
UNIT 1: ACCOUNTING STANDARD  2  
VALUATION OF INVENTORY 
 
After studying this unit, you will be able to comprehend  the 
? Definition of Inventory; 
? Measurement of Inventories;  
? What is included in Cost of Inventories;  
? Exclusions from the Cost of Inventories;  
? Cost Formulas;  
? Techniques for the Measurement of Cost. 
 
 
 
 
    
 
CHAPTER 
 
 
5 
© The Institute of Chartered Accountants of India
ADVANCED ACCOUNTING 
 
 
 
 5.2 
1.1 INTRODUCTION 
The accounting treatment for inventories is prescribed in AS 2 (Revised) 
‘Valuation of Inventories’, which provides guidance for determining the value at 
which inventories, are carried in the financial statements until related revenues 
are recognised. It also provides guidance on the cost formulas that are used to 
assign costs to inventories and any write-down thereof to net realisable value.  
1.2 INVENTORIES 
AS 2 (Revised) defines inventories as assets held  
• for sale in the ordinary course of business, or 
• in the process of production for such sale, or  
• for consumption in the production of goods or services for sale, including 
maintenance supplies and consumables other than machinery spares, servicing 
equipment and standby equipment meeting the definition of Property, plant 
and equipment.  
Inventories encompass goods purchased and held for resale, for example 
merchandise (goods) purchased by a retailer and held for resale, or land and other 
property held for resale. Inventories also include 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 spare parts, servicing equipment and standby equipment 
which meet the definition of property, plant and equipment as per AS 10 (Revised), 
Property, Plant and Equipment. Such items are accounted for in accordance with 
Accounting Standard (AS) (Revised) 10, Property, Plant and Equipment.  
Following are excluded from the scope of AS 2 (Revised).  
(a) Work in progress arising under construction contracts, i.e. cost of part 
construction, including directly related service contracts, being covered under 
AS 7, Accounting for Construction Contracts; Inventory held for use in 
construction, e.g. cement lying at the site should however be covered by AS 2 
(Revised).  
© The Institute of Chartered Accountants of India
 
 
 
 
 ASSETS BASED ACCOUNTING STANDARDS 
 
 
    
 
 5.3 
 
(b) Work in progress arising in the ordinary course of business of service providers 
i.e. cost of providing a part of service. For example, for a shipping company, 
fuel and stores not consumed at the end of accounting period is inventory but 
not costs for voyage-in-progress. Work-in-progress may arise for different 
other services e.g. software development, consultancy, medical services, 
merchant banking and so on.  
(c) Shares, debentures and other financial instruments held as stock-in-trade. It 
should be noted that these are excluded from the scope of AS 13 (Revised) as 
well. The current Indian practice is however to value them at lower of cost and 
fair value.  
(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, e.g. where sale is assured under a forward contract or a government 
guarantee or where a homogenous market exists and there is negligible risk of 
failure to sell.  
The types of inventories are related to the nature of business. The inventories of a 
trading concern consist primarily of products purchased for resale in their existing 
form. It may also have an inventory of supplies such as wrapping paper, cartons, 
and stationery. The inventories of manufacturing concern consist of several types 
of inventories: raw material (which will become part of the goods to be 
produced), parts and factory supplies, work-in-process (partially completed 
products in the factory) and, of course, finished products.  
At the year end every business entity needs to ascertain the closing balance of 
Inventory which comprise of Inventory of raw material, work-in-progress, finished 
goods and miscellaneous items. The cost of closing inventory, e.g. cost of closing 
stock of raw materials, closing work-in-progress and closing finished stock, is a 
part of costs incurred in the current accounting period that is carried over to next 
accounting period. Likewise, the cost of opening inventory is a part of costs 
incurred in the previous accounting period that is brought forward to current 
accounting period.  
Since inventories are assets, and assets are resources expected to generate future 
economic benefits to the enterprise, the costs to be included in inventory costs, 
© The Institute of Chartered Accountants of India
Page 4


 
 
 
 
LEARNING OUTCOMES 
 
 
ASSETS BASED 
ACCOUNTING 
STANDARDS 
 
UNIT 1: ACCOUNTING STANDARD  2  
VALUATION OF INVENTORY 
 
After studying this unit, you will be able to comprehend  the 
? Definition of Inventory; 
? Measurement of Inventories;  
? What is included in Cost of Inventories;  
? Exclusions from the Cost of Inventories;  
? Cost Formulas;  
? Techniques for the Measurement of Cost. 
 
 
 
 
    
 
CHAPTER 
 
 
5 
© The Institute of Chartered Accountants of India
ADVANCED ACCOUNTING 
 
 
 
 5.2 
1.1 INTRODUCTION 
The accounting treatment for inventories is prescribed in AS 2 (Revised) 
‘Valuation of Inventories’, which provides guidance for determining the value at 
which inventories, are carried in the financial statements until related revenues 
are recognised. It also provides guidance on the cost formulas that are used to 
assign costs to inventories and any write-down thereof to net realisable value.  
1.2 INVENTORIES 
AS 2 (Revised) defines inventories as assets held  
• for sale in the ordinary course of business, or 
• in the process of production for such sale, or  
• for consumption in the production of goods or services for sale, including 
maintenance supplies and consumables other than machinery spares, servicing 
equipment and standby equipment meeting the definition of Property, plant 
and equipment.  
Inventories encompass goods purchased and held for resale, for example 
merchandise (goods) purchased by a retailer and held for resale, or land and other 
property held for resale. Inventories also include 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 spare parts, servicing equipment and standby equipment 
which meet the definition of property, plant and equipment as per AS 10 (Revised), 
Property, Plant and Equipment. Such items are accounted for in accordance with 
Accounting Standard (AS) (Revised) 10, Property, Plant and Equipment.  
Following are excluded from the scope of AS 2 (Revised).  
(a) Work in progress arising under construction contracts, i.e. cost of part 
construction, including directly related service contracts, being covered under 
AS 7, Accounting for Construction Contracts; Inventory held for use in 
construction, e.g. cement lying at the site should however be covered by AS 2 
(Revised).  
© The Institute of Chartered Accountants of India
 
 
 
 
 ASSETS BASED ACCOUNTING STANDARDS 
 
 
    
 
 5.3 
 
(b) Work in progress arising in the ordinary course of business of service providers 
i.e. cost of providing a part of service. For example, for a shipping company, 
fuel and stores not consumed at the end of accounting period is inventory but 
not costs for voyage-in-progress. Work-in-progress may arise for different 
other services e.g. software development, consultancy, medical services, 
merchant banking and so on.  
(c) Shares, debentures and other financial instruments held as stock-in-trade. It 
should be noted that these are excluded from the scope of AS 13 (Revised) as 
well. The current Indian practice is however to value them at lower of cost and 
fair value.  
(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, e.g. where sale is assured under a forward contract or a government 
guarantee or where a homogenous market exists and there is negligible risk of 
failure to sell.  
The types of inventories are related to the nature of business. The inventories of a 
trading concern consist primarily of products purchased for resale in their existing 
form. It may also have an inventory of supplies such as wrapping paper, cartons, 
and stationery. The inventories of manufacturing concern consist of several types 
of inventories: raw material (which will become part of the goods to be 
produced), parts and factory supplies, work-in-process (partially completed 
products in the factory) and, of course, finished products.  
At the year end every business entity needs to ascertain the closing balance of 
Inventory which comprise of Inventory of raw material, work-in-progress, finished 
goods and miscellaneous items. The cost of closing inventory, e.g. cost of closing 
stock of raw materials, closing work-in-progress and closing finished stock, is a 
part of costs incurred in the current accounting period that is carried over to next 
accounting period. Likewise, the cost of opening inventory is a part of costs 
incurred in the previous accounting period that is brought forward to current 
accounting period.  
Since inventories are assets, and assets are resources expected to generate future 
economic benefits to the enterprise, the costs to be included in inventory costs, 
© The Institute of Chartered Accountants of India
ADVANCED ACCOUNTING 
 
 
 
 5.4 
are costs that are expected to generate future economic benefits to the 
enterprise. Such costs must be costs of acquisition and costs incurred in bringing 
the assets to their present (i) location of the inventory, e.g. freight incurred to 
carry the materials to factory and (ii) conditions of the inventory, e.g. costs 
incurred to convert the materials into finished stock. The costs incurred to 
maintain the inventory, e.g. storage costs, do not generate any extra economic 
benefits for the enterprise and therefore should not be included in inventory 
costs unless those costs are necessary in production process prior to a further 
production stage.  
The valuation of inventory is crucial because of its direct impact in measuring 
profit/loss for an accounting period. Higher the value of closing inventory lower is 
the cost of goods sold and hence higher is the profit. The principle of prudence 
demands that no profit should be anticipated while all foreseeable losses should 
be recognised. Thus, if net realisable value of inventory is less than inventory cost, 
inventory is valued at net realisable value to reduce the reported profit in 
anticipation of loss. On the other hand, if net realisable value of inventory is more 
than inventory cost, the anticipated profit is ignored and the inventory is valued 
at cost. In short, inventory is valued at lower of cost and net realisable value. The 
standard specifies (i) what the cost of inventory should consist of and (ii) how the 
net realisable value is determined.  
Abnormal gains or losses are not expected to recur regularly. For a meaningful 
analysis of an enterprise’s performance, the users of financial statements need to 
know the amount of such gains/losses included in current profit/loss. For this 
reason, instead of taking abnormal gains and losses in inventory costs, these are 
shown in the Profit and Loss statement in such way that their impact on current 
profit/loss can be perceived.  
Part I of Schedule III to the Companies Act, 2013 prescribes that valuation method 
should be disclosed for inventory held by companies.  
1.3 MEASUREMENT OF INVENTORIES  
Inventories should be valued at lower of cost and net realisable value. 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 Institute of Chartered Accountants of India
Page 5


 
 
 
 
LEARNING OUTCOMES 
 
 
ASSETS BASED 
ACCOUNTING 
STANDARDS 
 
UNIT 1: ACCOUNTING STANDARD  2  
VALUATION OF INVENTORY 
 
After studying this unit, you will be able to comprehend  the 
? Definition of Inventory; 
? Measurement of Inventories;  
? What is included in Cost of Inventories;  
? Exclusions from the Cost of Inventories;  
? Cost Formulas;  
? Techniques for the Measurement of Cost. 
 
 
 
 
    
 
CHAPTER 
 
 
5 
© The Institute of Chartered Accountants of India
ADVANCED ACCOUNTING 
 
 
 
 5.2 
1.1 INTRODUCTION 
The accounting treatment for inventories is prescribed in AS 2 (Revised) 
‘Valuation of Inventories’, which provides guidance for determining the value at 
which inventories, are carried in the financial statements until related revenues 
are recognised. It also provides guidance on the cost formulas that are used to 
assign costs to inventories and any write-down thereof to net realisable value.  
1.2 INVENTORIES 
AS 2 (Revised) defines inventories as assets held  
• for sale in the ordinary course of business, or 
• in the process of production for such sale, or  
• for consumption in the production of goods or services for sale, including 
maintenance supplies and consumables other than machinery spares, servicing 
equipment and standby equipment meeting the definition of Property, plant 
and equipment.  
Inventories encompass goods purchased and held for resale, for example 
merchandise (goods) purchased by a retailer and held for resale, or land and other 
property held for resale. Inventories also include 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 spare parts, servicing equipment and standby equipment 
which meet the definition of property, plant and equipment as per AS 10 (Revised), 
Property, Plant and Equipment. Such items are accounted for in accordance with 
Accounting Standard (AS) (Revised) 10, Property, Plant and Equipment.  
Following are excluded from the scope of AS 2 (Revised).  
(a) Work in progress arising under construction contracts, i.e. cost of part 
construction, including directly related service contracts, being covered under 
AS 7, Accounting for Construction Contracts; Inventory held for use in 
construction, e.g. cement lying at the site should however be covered by AS 2 
(Revised).  
© The Institute of Chartered Accountants of India
 
 
 
 
 ASSETS BASED ACCOUNTING STANDARDS 
 
 
    
 
 5.3 
 
(b) Work in progress arising in the ordinary course of business of service providers 
i.e. cost of providing a part of service. For example, for a shipping company, 
fuel and stores not consumed at the end of accounting period is inventory but 
not costs for voyage-in-progress. Work-in-progress may arise for different 
other services e.g. software development, consultancy, medical services, 
merchant banking and so on.  
(c) Shares, debentures and other financial instruments held as stock-in-trade. It 
should be noted that these are excluded from the scope of AS 13 (Revised) as 
well. The current Indian practice is however to value them at lower of cost and 
fair value.  
(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, e.g. where sale is assured under a forward contract or a government 
guarantee or where a homogenous market exists and there is negligible risk of 
failure to sell.  
The types of inventories are related to the nature of business. The inventories of a 
trading concern consist primarily of products purchased for resale in their existing 
form. It may also have an inventory of supplies such as wrapping paper, cartons, 
and stationery. The inventories of manufacturing concern consist of several types 
of inventories: raw material (which will become part of the goods to be 
produced), parts and factory supplies, work-in-process (partially completed 
products in the factory) and, of course, finished products.  
At the year end every business entity needs to ascertain the closing balance of 
Inventory which comprise of Inventory of raw material, work-in-progress, finished 
goods and miscellaneous items. The cost of closing inventory, e.g. cost of closing 
stock of raw materials, closing work-in-progress and closing finished stock, is a 
part of costs incurred in the current accounting period that is carried over to next 
accounting period. Likewise, the cost of opening inventory is a part of costs 
incurred in the previous accounting period that is brought forward to current 
accounting period.  
Since inventories are assets, and assets are resources expected to generate future 
economic benefits to the enterprise, the costs to be included in inventory costs, 
© The Institute of Chartered Accountants of India
ADVANCED ACCOUNTING 
 
 
 
 5.4 
are costs that are expected to generate future economic benefits to the 
enterprise. Such costs must be costs of acquisition and costs incurred in bringing 
the assets to their present (i) location of the inventory, e.g. freight incurred to 
carry the materials to factory and (ii) conditions of the inventory, e.g. costs 
incurred to convert the materials into finished stock. The costs incurred to 
maintain the inventory, e.g. storage costs, do not generate any extra economic 
benefits for the enterprise and therefore should not be included in inventory 
costs unless those costs are necessary in production process prior to a further 
production stage.  
The valuation of inventory is crucial because of its direct impact in measuring 
profit/loss for an accounting period. Higher the value of closing inventory lower is 
the cost of goods sold and hence higher is the profit. The principle of prudence 
demands that no profit should be anticipated while all foreseeable losses should 
be recognised. Thus, if net realisable value of inventory is less than inventory cost, 
inventory is valued at net realisable value to reduce the reported profit in 
anticipation of loss. On the other hand, if net realisable value of inventory is more 
than inventory cost, the anticipated profit is ignored and the inventory is valued 
at cost. In short, inventory is valued at lower of cost and net realisable value. The 
standard specifies (i) what the cost of inventory should consist of and (ii) how the 
net realisable value is determined.  
Abnormal gains or losses are not expected to recur regularly. For a meaningful 
analysis of an enterprise’s performance, the users of financial statements need to 
know the amount of such gains/losses included in current profit/loss. For this 
reason, instead of taking abnormal gains and losses in inventory costs, these are 
shown in the Profit and Loss statement in such way that their impact on current 
profit/loss can be perceived.  
Part I of Schedule III to the Companies Act, 2013 prescribes that valuation method 
should be disclosed for inventory held by companies.  
1.3 MEASUREMENT OF INVENTORIES  
Inventories should be valued at lower of cost and net realisable value. 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 Institute of Chartered Accountants of India
 
 
 
 
 ASSETS BASED ACCOUNTING STANDARDS 
 
 
    
 
 5.5 
 
the sale. The valuation of inventory at lower of cost and net realisable value is 
based on the view that no asset should be carried at a value which is in excess of 
the value realisable by its sale or use.  
 
Example 1 
Cost of a partly finished unit at the end of 20X1-X2 is ` 150. The unit can be 
finished next year by a further expenditure of ` 100. The finished unit can be sold at 
` 250, subject to payment of 4% brokerage on selling price. Assume that the partly 
finished unit cannot be sold in semi-finished form and its NRV is zero without 
processing it further. The value of inventory will be determined as below: 
 `  
Net selling price 250 
Less: Estimated cost of completion (100) 
 150 
Less: Brokerage (4% of 250) (10) 
Net Realisable Value 140 
Cost of inventory 150 
Value of inventory (Lower of cost and net realisable value) 140 
  
 
Inventories
Raw Materials
At cost (if 
finished goods 
are sold at or 
above cost), 
otherwise at 
replacement 
cost
Finished Goods and 
Work in progress
Lower of the following
Cost
Cost of 
Purchase
Cost of 
Conversion
Other 
Costs
Net Realisable 
Value
Realisable Value 
Less Selling 
Expenses less 
estimated cost of 
completion
© The Institute of Chartered Accountants of India