The major issue faced by business entities is to determine the cost at which inventories must be valued as an asset in the financial statements. Accounting Standard 2 (AS 2) deals with the accounting treatment of inventories by the business entities.
It provides details with regards to the items that comprise inventory and various costs associated with such an inventory. Furthermore, it also prescribes various methods that an entity can use to determine the cost of its inventory.
Here is a detailed look at AS 2 and the various concepts that are covered under it.
What are Inventories?
Inventories are the assets that are:
- Held for sale in the ordinary course of business
- In the process of production of such sale
- And in the form of materials or supplies to be consumed in the production process or in the rendering of the services
Such inventories are recorded at either cost or net realisable value, whichever is lower.
In order to understand this measurement of inventory, let’s have a look at the definitions of concepts like net realisable value, fair value and cost of inventory.
What is Net Realisable Value?
Net Realisable Value is the value that can be obtained on the sale of the asset less the costs incurred for completing as well as making such a sale. In other words, it is the selling price of inventory in the normal course of business less the approximate cost associated with completion and sale of such inventory.
What is Fair Value?
Fair value of inventory is the amount for which inventory can be exchanged between willing and knowledgeable buyers and sellers in a market place. This exchange, however, must be an arm’s length transaction.
Thus, Net Realisable Value of inventory may or may not be equal to the Fair Value less cost of selling of the inventory.
What is Cost of Inventories?
The cost of inventories comprises of the following costs of:
- bringing inventory into current location and condition
Let’s have a look at each of these individually.
1. Cost of Purchase
The cost of purchase of inventories includes the following costs:
- purchase or buying price of inventories
- import duties and other taxes if any (this does not include the duties and taxes which can later be recovered by the business entity from the concerned tax authority)
- transport, handling and other costs directly associated with the purchase of materials, finished goods and services.
It must be noted that trade discounts, rebates and items of similar nature are reduced while calculating the cost of purchase.
2. Cost of Conversion
Cost of conversion of inventories comprises of costs that are directly associated with converting the raw material into finished goods. For example direct labor. Such costs are bifurcated into two types:
- fixed cost of production and
- variable costs of production
- These are the indirect costs of production that do not change with the change in the level of output. For example depreciation, management and administration expense, factory building maintenance etc.
- Fixed production cost is allocated to the conversion cost based on the normal production capacity of a business entity. Normal production capacity is nothing but the amount of production likely to be achieved on an average over the number of seasons or production periods under normal circumstances. This also takes into consideration loss of capacity from planned maintenance.
Variable Production Costs
- Variable costs, on the other hand, are the costs that vary with the volume of output. For instance indirect labour, materials etc.
- Such costs are allocated to conversion cost based on the actual utilization of the production facilities.
There can be cases where a production process involves manufacturing of more than one product being produced at the same time. In such cases it gets difficult to identify the cost of conversion associated with the products individually. For instance, production of joint products or cases where production of a main product also results in a byproduct. Therefore, conversion cost in such cases is allocated on a rational and consistent basis.
Other costs also form a part of the inventory to the extent that such costs contribute to bringing the inventories to their current condition and location.
Therefore, the three types of costs mentioned above are considered while calculating cost of inventory. However, there are some costs that are not included while estimating cost of inventory. These are rather recognized as expenses in the period in which these are incurred. The examples of such costs are as follows:
- abnormal amount of waste material, labour or other production costs
- storage costs, besides costs that are essential in the production process before an upcoming production stage
- administrative overhead cost of the nature that are not responsible for getting the inventory in the current location and condition
- selling costs
What are the Cost of Inventories of a Service Provider?
The cost of inventories for a service provider are measured at the cost of production. These costs mainly include labor cost and cost of personnel who are directly involved in providing the service. This includes supervisory personnel and overhead costs related to providing such a service.
Costs associated with labour and other costs with respect to sales and general administration are not included in cost of inventory. However, such costs are recognized as expenses in the period in which they are incurred.
Further the cost of inventories of a service provider also does not include profit margins or overheads not attributable to such a service. These are often taken into consideration in the prices demanded by the service providers.
Methods of Inventory Valuation
The various methods for inventory valuation include:
1. Specific Identification Method
In order to apply specific identification method, it is necessary that each item sold and each item in closing inventory are easily identifiable. Such a method is applicable only in cases where it is possible to physically differentiate the various purchases made by the business.
Thus, items sold at a specific cost during the accounting period can be included in the cost of goods sold. And the costs of particular items left or in hand can be included in the closing inventory. Companies manufacturing or handling expensive, easily distinguishable items can successfully use this valuation method. Such items include automobiles, furniture, jewelry etc.
2. First In First Out (FIFO)
The First In First Out Method assumes that the goods are consumed in the sequence in which they are purchased. That is to say the goods purchased first are consumed first in a manufacturing concern and are sold first in case of a merchandising firm.
Consequently, under this method, goods purchased recently form a part of the ending inventory.
3. Weighted Average Cost Method (WAC)
Under this method, the average cost of each item available for sale is computed. Such a cost is calculated by taking the weighted average of similar items available at the beginning of the year and cost of similar items purchased or manufactured during the year. Further, the units under costs of goods sold and the closing inventory are taken at the average cost so calculated.
Additionally, the weighted average is calculated periodically or on the arrival of each new shipment as the case may be.
Disclosure in Financial Statements
As per Accounting Standard 2 (AS 2), the financial statements must disclose the following details with regards to inventories:
- accounting policies used to measure inventories. This also includes the method of inventory valuation followed.
- amount of inventories taken as an expense in a given period
- total carrying amount of inventories and carrying amounts in classification such as raw material, work in progress, finished goods and spares as is applicable to the entity
- carrying amount of inventories carried at fair value less cost to sell
- any amount of write down of inventory recognized as an expense in the period
- any amount of reversal of a write down that is identified as a reduction in the amount of inventories identified as an expense in the period
- events that lead to a reversal of write down of inventories
- carrying amount inventories pledged as a security for liabilities
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