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Accounting Standard 2

Inventories – FAQs

By January 20, 2023June 26th, 2024No Comments

Meaning of Inventories (Refer Para 3)

Inventories – FAQs and answers are given below

1. An entity is engaged in providing and maintaining a “pipeline” service for transport of crude oil, although the entity itself does not produce the item. To meet the requirements of users, and at the time of commencement of service, the entity ensures that the pipeline is full so that there is no bottleneck in transportation of oil.    What is the accounting treatment of crude oil held in the pipeline?

The crude oil in pipeline is treated as materials and supplies to be consumed in the process of production or rendering of services.   It is inventory and measured at its cost.  There is no need for periodical revaluation as there is no monetary transaction.

2. How will an entity trading in Crypto Currency, account for this item? 

An entity engaged in trading in crypto currency is to account for it as an item of inventory.  Where it is not held for trading, it should be treated as an intangible asset, and tested for impairment periodically.

3. How will an entity holding Shares or debentures held as stock in trade account for these items?

Shares and debentures held as stock in trade are to be recognised and measured as current investments under AS 13 (Investments).  Current investments are to be valued at lower of cost and fair value in the market.  The principles for valuation under both AS 2 for inventories and AS 13 for current investments are similar.

4. How will an entity holding plots of land, account for those holdings?

An entity can hold land for different purposes.  If these are held for sale, then such plots of land are treated as inventory.  If these are held for use for construction of buildings or similar assets for its long-term use, then, these are accounted for as PPE.   If the plots of land are held for capital appreciation, then these are accounted for long term investments under AS 13 (Investments).

5. How does a distributor account for stocks that are in transit on consignment basis?

Let us assume that the distributor is the buyer.   The crux is where does the risk and rewards lie?  If the transfer to the distributor does not result in transfer of ownership, then, the goods are to be treated as the manufacturer’s inventories and should not be included in the books of accounts of distributor.  In the other case, it would be treated as distributor’s goods in transit and accounted for as such.  

6. How does a construction contractor account for his WIP?

This item is outside the purview of the Standard, and is covered by AS 7 (Construction Contracts).

7. How does an agriculturist value his stocks ready for harvest, but not harvested?

The Standard is not applicable to 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 policies in those industries.  Net realisable value in these cases, may be more or less than cost.

8. A manufacturing entity is holding various items of spares and stores.  What accounting treatment would apply?

Spares are usually carried as inventory and the amount of spares consumed in a period is charged to P&L. Major spare parts (where use is > one period) if they qualify to be recognised as FA should be capitalised (in accordance with Revised AS 10 Property, Plant and Equipment). Similarly if spares can be used only in connection with another item of FA, these can also be capitalised. Servicing and Standby equipment, if they meet recognition criteria laid down in can be capitalised.   The entity should first identify the class of stores and spares and adopt the accounting treatment. 

9. An entity is engaged in purifying water and providing drinkable water to public.  It supplies water to consumers in water containers of 35 Litre size. The customers return the used containers.  How does the entity account for these reusable water containers?

Often, containers are used to pack the finished products.  Customers, who purchase finished products packed in special types of reusable container, are often vested with an option to return the containers to the suppliers of finished products for a nominal consideration for reuse. Such reusable containers do not form a part of inventories.  These are to be treated as fixed assets and are depreciated during its useful life if and where these containers are expected to be used during more than one period.   

10. An entity purchases raw materials in duly packaged drums.  The drums are rendered empty when the raw materials are consumed, and are sold or discarded later. How does the entity account for these drums in hand?

Unless the value is material, empties or drums do not constitute a part of inventories. Where materiality warrants, these can be presented as a separate line item. In such a case, the carrying amount of empties and drums should be net realisable value, since cost cannot be estimated.   

Cost of purchase (Refer Para 4.1):

11. A retailer procures goods from manufacturer, for onward sale to end users.  The manufacturer supplier grants discounts and rebates, comprising two parts.  First a 10% prompt payment discount if the dues are paid within 30 days, and second an additional five % rebate based on volume of purchase.  What is the accounting treatment?

It is not clear if the retailer acts as Principal or Agent.  This should be decided first. Assuming that the retailer is Principal, then, he makes an estimate of prompt payment discount that may accrue on purchases (example, he may estimate that the discount would be available in 90% of cases) and make a downward reduction in inventory cost. Similarly volume rebate is also estimated and deducted from cost.   

On the other hand, if the retailer is the Agent, then he does not purchase the goods, and the rebate will form part of his basic revenue, namely, commission.  Other areas to be considered include (i) rebates anticipated but not earned, (ii) manner of allocation of rebates to the sold, and unsold units.

12. A manufacturer experiences loss of wastage of materials, during production process.  Can he include the cost of wasted materials also as a part of good stock?

It is to be seen if the wastage is normal and not avoidable or is it avoidable.  In the first case, the cost is include and in the latter case, cost of wasted material is not included.

Cost of conversion (Refer Para 4.2):

13. How does an entity apply the principle of normal operating capacity under normal conditions, in allocating overheads?

Assume that for a manufacturer, the normal annual capacity is 2400 units.  And the allocable overheads amount to Rs. 4,80,000/-.  Allocation per unit is Rs.200/-If in a given year, if due to lack of demand, the production is curtained to 2000, the allocation to units would be 2000 x 200 = Rs.4,00,000.  Balance of Rs.80,000 would have to be absorbed as expense in P&L.  

If in the next year, the demand swings up, and the production is 3000 units, then the allocation per unit is restricted to Rs.160 per unit only, so that the justifiably allocable overheads are fully absorbed through inventory.  This method of allocation is possible only if there is a single product in production.

14. How does an entity apply the principle of allocation of overheads?

By way of labour hour or machine hour rate; it can be in proportion to labour costs; in proportion to material costs, or in proportion to prime costs; and can also be distributed based on units produced, as shown in “a” above.

15. How does an entity apply the principle of allocation if there are joint products or by products?

The general practice is to allocate overheads to joint costs (to more than one product), based on relative sales-value. This is done when production of each product is identifiable and production is completed.  

16. How does an entity apply the principle of allocation if there are by-products?

When the value of by products is material, then, by product is treated as joint-product and principle shown in “c” is applied.  However, in most cases, the value is not material.  In such cases, the net realisable value is estimated, and is deducted from cost of the product.

Other costs (Refer Para 4.3):

17. An entity acquires a petrol station area presently in disuse, and seeks permission from Government authorities to develop this land and sell it as residential plots.  Government permission is granted on condition that the entity will develop a nearby area as park for public use.   How does the entity account for expenditure on development of the park for public use?

The expenditure is in the nature of unavoidable attributable expenditure in bringing the inventory (plots for sale) to its present condition and location. But for development of park, the inventory cannot be sold.  Accordingly, these are treated as other costs that can form part of inventory cost.

18. An entity incurs distribution and transportation costs associated with moving inventory.  How are these costs accounted for?

To the extent costs are incurred for transporting the goods from primary warehouse, to the first sale point, the costs can be capitalised to inventories. However, costs of moving inventories from one point of sale, to another point cannot be capitalised – because the inventory is already in a location and condition fit for sale.

19. An entity incurs borrowing costs.   Can these costs be capitalised to inventory?

We need to apply AS 16 (Borrowing Costs).  This Standard clearly lays down that inventories that are manufactured or otherwise produced over a short period time (less than 12 months for making it ready), cannot be capitalised because the inventories would not fall within the ambit of “qualifying assets”.

If however, where the entity is engaged in manufacture of capital goods where the production and development time to make it ready for use or sale is substantial (12 months or more), then such borrowing costs can be capitalised.

20. An entity imports its requirements of inputs and materials.  The invoice is in foreign currency.   Between the time of arrival of inventory and the time for making payments, there has been a fluctuation in exchange rates.  How does the entity account for such exchange differences?

Where invoices are in foreign currency, exchange differences arising between transaction and settlement dates, cannot be added to inventory.  Exchange differences are absorbed as costs (or income) in P&L directly.

21. In the process of manufacturing, an entity is required to transfer the partially completed product from one department for completion to another department.  At that point, the entity applies transfer pricing methodology.  How does the entity determine the cost of end product?

The profit attributable under transfer pricing is to be eliminated (internal profit) and only the actual cost is to be reckoned.

22. An entity is incurring storage costs for its inputs and materials.  How does it account for such costs?

Generally, storage costs are not added to cost of inventory.  However, where storage itself forms a part of process of production, then such costs are costs inevitably attributable to bringing the inventory to its present location and condition, and can, therefore, be included.

23. An entity is incurring demurrage costs for its inputs and materials.  How does it account for such costs?

Similar approach is needed. As a matter of general rule, demurrage costs cannot form a part of costs added to cost of inventory.  However, where demurrage is consciously incurred, in order to meet certain circumstances, then, such costs are added.

24. How does an entity incurring selling and distribution costs, account for the same?  Can these be included as inventory costs?

These are clearly outside the purview of inclusion. That there could be any debate or dispute at least on this item, is a remote possibility.  Occasions do arise when it is difficult to distinguish between distribution costs and other costs.  

Distribution costs comprising the expression ‘selling and distribution costs’ would include only those costs which are incurred for moving the goods from the premises of the seller, whether from the factory or from the stock yard of the seller, to the premises of the buyer.  [In other words, distribution costs should be construed to mean ‘freight outwards’, and costs incurred ‘after’ sale for moving the goods from seller’s location to the buyer’s location].

Costs incurred by an entity for transporting goods from the point of production to the point of stockyards (from where sale is to be made) do not fall within the ambit of ‘freight outwards’ but these represent handling costs.

A mere (erroneous!) classification of certain costs under the head selling expenditure is not relevant for determining whether or not the cost of carrying out this activity should be included in the cost of inventories.  In other words, the nomenclature of the activity or the place where the activity is carried out is not relevant.

The test is whether such activity contributes to bring the inventories to their present location and condition.  

Techniques of measurement (Refer Para 4.4):

25. An entity is applying retail inventory method, and to this end, computes trading profit by applying gross margin on sales, to derive the value of ending inventory. Does it comply with retain inventory method?

No this is inappropriate. The temptation to compute trading profit by applying gross margin on sales, to derive the value of ending inventory must however be resisted, and one should not take this wrong route.   

26. An entity applies 1/3rd on cost by way of mark up for sale.   If the end inventory is valued at Rs.45,344 what should be the mark down? 

The mark down is 1/4th on retail value, i.e., Rs. 11,334.  The end inventory is taken at Rs.34,000

27. An entity applies two-level mark-ups, namely, at first level a mark up of 26.66% and in the second level, an additional mark up of 6.66%.   Assuming the value of end-level inventory is estimated at Rs.45,344, what would be the cost as per retail inventory method?

In some circumstances, this method is called mark-up cancellations also.  The first mark down is 5% of retail value, (95% of 45,344) being Rs.43,068 and in the second level mark down is 21.06% of that value, thus, resulting in cost being derived at Rs. 34,000 under retail method

28. How does an entity account for costs, when goods are bought on FOB basis, and on CIF basis?

In the case of FOB transactions, buyer has to incur freight and transportation costs, and hence get included as a part of value of inventory.  In the case of CIF transactions, Freight and transportation costs get automatically loaded in the invoice, and therefore form a part of value of inventory, without any need for any specific addition for transportation costs.

Cost formulae (Refer Para 4.5):

29. After adopting FIFO for say three years, can an entity change from FIFO to Weighted Average or any other acceptable method? 

The answer is yes.  But the related issue is whether such a change is, a change in accounting policy or a change in accounting estimate?  Sometimes it is argued that such a change is merely an accounting estimate.  There are two reasons: 

(i) The Standard provides that for items that are “ordinarily interchangeable” specific identification approach is not appropriate.  The use of cost formulae is not merely a method of estimating the aggregate actual cost of individual items, because otherwise, a specific identification approach would be rendered inappropriate. 

(ii) The Standard also requires disclosure of accounting policies used for measuring inventories, including cost formula used. Therefore, on balance, a change in cost formulae is a change in accounting policy. 

Net Realisable Value (Refer to Segment B):

30. What is the process of estimating NRV?

Generally, NRV is estimated on item-by-item basis, and in some cases, by grouping items of similar or related inventories.  Such a grouping is made when the items relate to the same product line and have similar purpose or end-user, and are produced and marketed in the same area, and when it is found that it not practical to separate the items and evaluate its NRV separately.  These are estimates.  Such estimates are to be based on most reliable available evidence, taking into account what the entity expects to realise.

The four key elements embedded in this exercise are (i) estimating the selling price, (ii) such a selling price should be in the ordinary course of business, (iii) estimating the costs of completion of work in progress if any, and (iv) estimating the costs necessarily to be incurred to effect and complete the sale.

31. How does an entity estimate the NRV for items ready for sale?

Based on the entity’s expectations on what is the expectation of realization, two adjustments are made.  One is completion cost if applicable, and two is the costs for making the sale. It is inferred that the item are not partially completed.  If these were only partially completed, the cost of completing the item and making it ready for sale is taken into account. 

From the estimated realisable value, the entity reduces (i) estimated costs of making the sale, and (ii) estimated costs of completing the item  if these are partially completed. 

32. What should be the approach, when the entity has concluded “firm price contracts” for goods to be sold?

In most businesses, it is the normal practice to have in place, contracts for sale of items at a firm, pre-agreed price.  Such contracts are also likely to carry firm delivery dates.  If inventory is held specifically to satisfy ‘firm’ sales or service contracts, the net realisable value of the quantity held to meet the contract, should be based on the contract price.

If quantity held is beyond the requirements of contracts already entered into, the net realisable value of the excess inventory must be based on general selling prices (GSP). The inherent principle here is that the losses likely to arise from a firm-price contract should be accounted for (reduced) in estimating net realisable value of those contracts.  

33. What is an onerous contract, and what approach does an entity adopt in determining NRV of items covered by such onerous contracts? 

An ‘onerous contract’ is a contract to which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.  Thus, for a contract to qualify as an onerous contract, the unavoidable costs of meeting the obligation under the contract should exceed the economic benefits expected to be received under it.  

The unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost fulfilling it and any compensation or penalties arising from failure to fulfil it.   These unavoidable costs should be reckoned in estimating the NRV of items held under onerous contracts and generally a provision is made.

34. Is it necessary to take into account impact of events after reporting date, in estimating NRV? 

Yes. An estimate of NRV should be supported by meaningful and reliable evidence.  In a very broad sense, prices indicated in the invoices raised by the entity during the period immediately following the valuation date can be taken as evidence and a good indicator of NRV at that date.

Estimates of NRV are based on most reliable evidence available at the time the estimates are made as to the amount, the inventories are expected to realise. These estimates take into consideration fluctuations of price or cost directly relating to events occurring after the balance sheet date to the extent that such events confirm the conditions existing at the balance sheet date.  

35. When does an entity write down the cost of inventory to net realisable value? Also, having written down once, can such a write down be reversed? 

This is done when the NRV of an item of an inventory is less than its cost. In such circumstances, an entity writes down the excess of cost over NRV to P&L. The write-downs can be reversed.  But it should be ensured that the new carrying amount is lower of the cost and revised NRV, and in any case, the quantum of reversal does not exceed the original amount written down.

36. Having adopted the principles of valuation of inventory, how does an entity tackle the expenses incurred at the end of reporting period?

The entity should recognise as expense (a) cost of inventories sold, (b) amount of write-downs if any to NRV. Amounts represented by reversal of write-downs are recognised in P&L.  If the inventory items were to be used by the entity itself rather than being sold, then, the cost of such items of inventory is capitalised as a part of cost of another asset, and depreciation on such assets is recognised as expense.

37. What should be the periodicity at which an entity should estimate NRV and make adjustments to inventory? 

The simple ruling is that NRV should be assessed at each balance sheet date.   Although not explicit, this ruling implies that the periodicity of assessment of NRV should coincide with the preparation of financial statements, including interim financial reports if applicable.

38. What should be the approach of an entity in applying the principle of lower of cost and NRV, in situations where items are interchangeable, and where items are not?

NRV should be estimated on individual item basis, when items are not interchangeable. In other cases, it can be grouped, provided, such a grouping would also throw up results that closely approximate to results if items were to be evaluated individually.

39. Is the principle of lower of cost and NRV is followed for all classes of inventory invariably?

Items covered under a class or group of materials and supplies are not written down below cost, unless certain pre-requisites are met. 

(a) Materials and other supplies held for use in the production of inventories are not written down below cost if the finished products in which they will be incorporated, are expected to be sold at or above cost

(b) however, when there has been a decline in the price of materials and it is estimated that the cost of finished products will exceed net realisable value, the materials are written down to net realisable value.  In such circumstances, the replacement cost of the materials may be the best available measure of their net realisable value. 

In other words, we can say, that ‘Cost’ should be the basis for valuation of raw materials (inputs in the form of materials and supplies), subject to the foregoing exception. 

40. What accounting changes need to be made for purposes of Tax?

Whereas the Standard provides that GST or similar taxes and duties paid — should not be included in cost, if and where these are subsequently recoverable from either Government or from other parties.  Contrary to this status, such duties paid are includible in the cost of inventory for the purpose of computation of income.   This dichotomy to be handled in the financial statements or income computation statement appropriately.

  • Know more about inventory valuation principles, including cost components like purchase and conversion, methods such as FIFO and Weighted Average Cost, and disclosure rules in Understanding Accounting Standard 2– Click here
  • Explore transparent accounting practices with leading entities’ inventory valuation methods, including Specific Identification, FIFO, and Weighted Average, in the Disclosure of Accounting Policies– Click herere
  • Assess the compliance and audit checklist for inventories, ensuring adherence to accounting policies, valuation principles, cost determination accuracy, cost formula adoption, NRV estimation, and disclosure adequacy as per AS 2- Click here
CA. S D Bala

Chartered Accountant, Author and Accounting Standard Expert