AS 2 – Valuation of Inventories | Advanced Accounting for CA Intermediate PDF Download

Introduction

• This accounting standard applies to all companies regardless of their level (Level I, II, and III).
• It guides how inventories should be accounted for and determines their value in financial statements.
• Various methods of valuing inventory or closing stock significantly impact business revenue and assets.

Valuation of Inventories

Inventories are valued at the lower of cost and net realizable value. Here are the steps:

• Determine the cost of inventories
• Determine the net realizable value of inventories
• Compare the cost and net realizable value, choose the lower one as the inventory value

Definition

Inventory includes:

• Goods held for sale in the normal course of business (finished goods).
• Goods in the production process (work in progress).
• Raw materials consumed during production or service rendering (including consumable stores items).

Net Realisable Value (NRV):

Net realizable value is defined as the estimated selling price in the ordinary course of business minus the estimated costs of completion and the estimated costs necessary to make the sale.

Inventories should be valued at the lower of cost and net realizable value. The steps for valuation of inventories are:

• Determine the cost of inventories.
• Determine the net realizable value of inventories.
• Compare the cost and net realizable value and use the lower of the two as the inventory value.

This comparison can be made item by item or by group of items. (Refer to case studies at the end of the article).

Important Items in Inventory Valuation

A. Cost of Inventories

The cost of inventories includes:

• Purchase cost
• Conversion cost
• Other costs incurred to bring the inventories to their present location and condition

B. Cost of Purchase

When determining the purchase cost, consider:

• Duties and taxes (excluding those recoverable from taxing authorities)
• Freight inwards
• Other direct costs attributable to the purchase
• Trade discounts, rebates, duty drawbacks, and similar items deducted in determining purchase costs

C. Cost of Conversion

Cost of conversion includes all costs incurred to transform raw materials into finished goods and includes a systematic allocation of fixed and variable overheads.

Categories of conversion cost:

• Direct Cost: Costs directly related to the production unit, such as direct labor.
• Fixed Overhead Cost: Indirect costs incurred regardless of production volume, such as depreciation, building maintenance, and administration costs. Allocation is based on normal production capacity, without increasing fixed overheads during low production or idle periods.
• Variable Overhead Cost: Indirect costs that vary with production volume, such as packing materials and indirect labor.

D. Other Costs

Other costs incurred to bring inventories to their current location and condition, such as design costs for specific customer orders. If by-products are produced, their costs must be separately identified or allocated based on the relative sale value of the main product and the by-product. Exclude costs like:

• Costs of abnormal waste materials.
• Selling and distribution costs unless necessary for the production process.
• Normal loss during production is apportioned over remaining units, while abnormal loss is treated as an expense.

(Refer to case studies at the end of the article).

Methods of Inventory Valuation

• The cost of inventories for specific projects should be identified by their individual costs (Specific identification method).
• All other items' costs should be assigned using the first-in, first-out (FIFO), or weighted average cost (WAC) formula.
• The chosen formula must provide a fair approximation of the costs incurred in obtaining the inventory items in their current state.
• If it's challenging to determine costs using the above methods, Standard cost and Retail cost can be utilized if they closely match the actual costs.

Accounting Disclosure

• Accounting policy chosen for inventory measurement
• Cost formula applied
• Classification of inventory types like finished goods, raw materials & work in progress, and stores and spares
• Value of inventories stated at fair value less selling costs
• Expense amount from inventories during the period
• Expense from any inventory write-downs and potential reversals

Comparison between AS 2 and ICDS

Some of the Major Differences between Ind AS (IAS) and AS 2

• AS 2 does not cover the treatment of inventory for service providers, while IAS 2 provides detailed guidance on the cost of inventories for service providers.
• AS 2 mandates fewer disclosures in financial statements compared to IAS 2.
• Under AS 2, the cost of inventories excludes "selling and distribution costs," which are expensed in the period incurred. In contrast, IAS 2 specifically excludes only "selling costs," not "distribution costs."
• For inventory valuation, AS 2 allows the use of FIFO or WAC for goods that cannot be allocated to specific projects. IAS, however, requires a consistent formula for all inventories of a similar nature.

Case Studies and Examples

Examples:

NRV:

• Cost is 500 and NRV is 300 then Inventory value as per AS-2 is 300
• Cost is 500 and NRV is 600 then Inventory value as per AS-2 is 600
• Cost is 500, Sale Price is 700 and 30% commission, NRV is 490 (700-30%*700) then, Inventory value as per AS-2 is 490

Treatment of Normal loss and abnormal loss: Company A purchased 100 items at the cost of Rs.10 each. Of which 10% is normal loss in general, there were no sales in that period and closing stock was 80. Calculate the Inventory value: 

• Normal Loss = 100*10% = 10 
• Cost per item considering normal loss = 100*10/ 90 = RS 11.11 
• Abnormal Loss is 90-80 (Normal – closing stock) = 10 
• Cost of abnormal loss = Rs 111.11 
• Closing stock Value = Rs 888.89

Case Law Quick References: Some of the popular case laws and its important decision for references:

• Chainrup Samapatram vs. C.I.T. (24 I.T.R. 481, 485);
• C.I.T. vs. Chari & Ram (17 I.T.R. 1, 7);
• Utting & Co. Ltd vs. Hughes (8 I.T.R. Supp. 57, 60) 

The assessee can get an allowance in respect of future unrealised loss, the Department is not entitled, by putting on the stock the market value where it exceeds cost, to bring in and charge the unrealised notional profit , unless the assessee’s regular basis of valuation is the market rate right from the inception of his business.

To the same effect is the judgment in the case of C.I.T. vs. British Paints India Ltd (188 I.T.R. 44) it was held that it is a well-recognised principle of commercial accounting to enter in the profit and loss account the value of the stock-in-trade at the beginning and at the end of the accounting year at cost or market price, whichever is the lower.