Valuation of Inventories
Inventories comprise of three elements. These are
- items of materials and supplies,
- items in process if any,
- and, items ready for sale, that is, finished goods (can also include goods purchased for trading)
Accounting Standard 2 lays down principles of measurement. As a broad rule, it can be said that inventories are to be carried at lower of Cost and Net Realisable Value (NRV).
The Standard addresses three issues.
The first is the cost at which inventories are to be recorded. The cost element in inventory is highly relevant, since the attributable expenditure is not recognised as expense until related inventories are actually sold. This expense is often referred to as cost of sales.
The second is the value at which items are to be carried, until these are sold, and the relative cost is recognised as expense.
The third is the circumstances in which the carrying amount of some items of inventory is written down below cost.
One important feature is that changes in inventory values affect both the results of operations and the financial position of the enterprise. Hence valuation and measure of inventory is a critical aspect in accounting for inventories.
Reporting entities should disclose in the financial statements
- accounting policy adopted in the valuation of inventories including cost formulae used and
- quantitative information duly classifying inventory under different classes.
The Accounting Standard 2, in its present revised form, is effective in respect of accounting periods commencing on or after 1st April 2021, and is applicable to all Corporate and non-corporate reporting entities in Levels I to IV categories.
MEANING OF INVENTORIES
The definition paragraph provides that inventories are assets –
- held for sale in the ordinary course of business;
- in the process of production for such sale; or
- in the form of materials or supplies to be consumed in production process or in the rendering of services (Paragraph 3)
- goods purchased and held for resale, namely, stock held by a trader, or land held for sale
- goods produced and held ready for disposal,
- what is under production – work in process, and
- materials and supplies awaiting use in production process.
ACCOUNTING STANDARD 2 – PRINCIPLE OF VALUATION
The key operative prescription is Inventories should be valued at the lower of cost and net realisable value. The process, therefore, involves determination of two independent elements. First is the ‘cost’. Second is the ‘net realisable value’. On a comparison of these two values and based on practical prudence, a lower value is required to be selected, where appropriate.
SEGMENT A: COST
The Standard lays down that there are three components,
- All costs of purchase,
- Costs of conversion and
- Other costs incurred in bring the inventories to their present location and condition (justifiably allocable costs).
- Cost of Purchase:
In the area of cost of purchase, we need to make two adjustments. One: Rebates, discount, etc., where received are to be adjusted against cost. Two: If duties or taxes paid such as GST, are subsequently recoverable from either out of proceeds of onward sale, or from tax authorities, do not form part of cost. Therefore, these are excluded.
In a typical case of materials purchased, the cost of inputs comprising various elements will include basic price, GST (to the extent not recoverable) trade discounts, insurance and freight, commission, in-transit storage, material testing, etc.
- Cost of Conversion:
The cost-elements to be considered in the determination of costs of conversion are
- Direct labour and
- Production overheads.
Alongside, the reporting entity has to lay down proper procedure for allocation of joint costs.
Direct labour costs are those that are specifically attributable to units of production completed or in the course of production. Labour costs are incurred continuously in relation to progress of production. These costs are captured, in the normal course, at finished product stage, and WIP stage at a given point of time. Allocation is made on the bases of normal operating conditions.
Allocation of fixed production overheads to inventories is based on normal capacity of production facilities. Normal capacity is the production expected to be achieved on an average over a number of periods under normal circumstances.
- Other costs:
There may be certain other costs that can form part of cost of inventories. These should be such as necessarily incurred in bringing the inventory to its present location and condition.
- Techniques of measurement of costs:
The Accounting Standard 2 lays down two techniques – namely, standard cost method or retail inventory method. As per CIMA definition, Standard Cost is the predetermined cost calculated in relation to a prescribed set of working conditions, correlating technical specifications and scientific measurements of material and labour to the prices and wage rate expected to apply during the period to which the standard costs intended to relate, with an addition of an appropriate share of budgeted overhead. Standard Cost, therefore, is the predetermined cost based on attainable efficiency standards for a given volume.
Retail inventory method is an inventory costing method, which uses a cost ratio to reduce ending inventory, valued at retail, to cost. This method does not enable us to determine the actual cost of items forming part of inventory. However, by applying this technique, an amount — which is a close approximation to cost – can be derived.
Many practical difficulties arise in the valuation of stock, where high volumes of various items of stock are involved. Often, entities engaged in retail trade, experience this situation. This involves a three step process.
- Estimate value of ending inventory at retail prices (most likely sale price).
- Determine a relationship between cost and retail prices – gross margin.
- Applying the gross margin percentage(s) so ascertained to retail price of inventory (or sub-divided groups) in order to measure its cost.
Basically, this is a reverse mark-up process and does not necessarily indicate the actual cost. There are constraints.
It is important that Retail Method enables an entity to take the physical stock at marked up prices, and expedites the process of valuation of closing stock without having to refer to back up records such as purchase invoices. Retail method provides results that are often found useful when determining insurance coverage and settlements.
- Cost formula:
Costs do not remain static, but do vary from time to time. Also, several types of cost formulae can be used. In inventory valuation, therefore, the crucial question is, in the context of flow of production, which items of inventory have been sold, and which items continue to remain in inventory. In this backdrop, inventory valuation depends on cost flow assumptions, such as FIFO, LIFO, HIFO, base stock method, weighted average cost method etc.
Two aspects are critical. Entities engaged in manufacture of capital goods (textile machinery, turbo or hydro generating sets etc.) plan their production based on specific orders in hand. Exportable items are produced to meet exclusive customer specifications. Many spinning-units in textile industry produce yarn in conformity with the specifications prescribed by one or more buyers.
In the case of fast-moving-consumer-goods industry, (detergents, cosmetics etc.) or in electronic-entertainment industry (TV, DVD etc.) large-scale production is taken up, notwithstanding the fact that a differentiating variety is consciously introduced to boost sales. Even in the case of consumer products, there may be special categories, such as Hotel Towels or Soaps of special size or shape, duly branded with Hotel Name and these are not ordinarily interchangeable.
Inventories falling under the first category can be designated as those not interchangeable amongst buyers (or where the finished products cannot be interchanged) and those under the second category is interchangeable with reference to end-users. Where there is a direct link between production and end-user for whose specific requirement an item is produced, these are classified as items ‘not ordinarily interchangeable’. The standard prescribes cost formula depending on this one-on-one relationship.
Specific Identification Method:
Cost of inventories of items that are not ordinarily interchangeable and for goods or services produced and segregated for specific projects, should be assigned by specific identification of their individual costs.
Some examples include items of jewelry, designer wear, boilers, turbo generators, furniture making, assembling desk top variety of computers, interior decorations, and materials used in some construction contracts. Where such specific cost method is not applicable, either FIFO or Weighted Average Cost method is used. (HIFO or LIFO methods are not permitted now).
When the stores-in-charge receives a request for issue of materials, he can issue (i) oldest goods first, (ii) goods that arrived last, first, (iii) those items which to which the access is the easiest, or (iv) even randomly.
FIFO merely serves one objective. Cost incurred for the ‘earliest purchase’ is first used for accounting purposes. There is no single, definite answer to a question as to which of these methods is correct. Each entity may have its own internal control procedures to ensure consistency.
FIFO method is founded on the assumption that materials and supplies, which are purchased first (oldest goods first), are consumed first in the production process. Issues are priced in the sequence of incoming order of purchases. The flow of cost of materials will also thus be in the same order. The ending inventory will reflect the cost of goods recently purchased or produced. In order that FIFO method is efficiently applied, it is essential to maintain separate records for each category of input.
Weighted Average Cost method (WAC)
Main features of this method, also known as Cumulative Weighted Average method include
(i) This method yields a weighted average value of cost, for each identifiable class of item in stores. Issues are priced at the weighted average value of unit cost. This is computed by dividing the total cost of material in stock by the total quantity of material in stock.
(ii) The weighted average cost is determined each time when fresh materials arrive on purchase, and average unit cost changes progressively, on each occasion when purchase is made. For convenience, the weighted average unit cost is also derived at a given periodicity (say once a month), depending on periodicity at which purchases are made.
And, (iii) the average cost at any time is, thus, the balance value figure divided by the balance units figure.
SEGMENT B: Net Realisable Value:
The main principle laid down is that inventories should be valued at lower of cost and net realisable value. Net realisable value (NRV) is defined as 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. NRV is not the same as market value or fair value. NRV is entity-specific, and denotes what the entity expects to get from sale.
Presentation and Disclosure:
The Accounting Standard 2 prescribes two disclosure requirements.
First is: The entity should disclose accounting policies adopted in measuring inventories, including the cost formulae used.
Second is the total carrying amount of inventories and its classification appropriate to the enterprise should be disclosed.
These disclosure requirements are simple focusing on the necessity that inventories should be sub-classified on the face of Balance Sheet, or by way of supplementary schedules forming part of notes on accounts. Classified presentation will indicate the amounts held in each of the main categories that constitute inventories. It is now customary for entities to follow the classifications laid down in Schedule III. Accounting policies relating to valuation of inventories should be in alignment with the prescriptions in the Standard. Many instances of deviations, such as work-in—progress being valued only at cost. The recommended approach is to make a statement that would be complete in all respects.
Click here to read the text of Accounting Standard 2
Next article – Select Specimen Disclosures
Chartered Accountant, Author and Accounting Standard Expert