Indian Accounting Standard 2 - Inventories

Inventories are assets:

1. held for sale in the ordinary course of business;
2. in the process of production for such sale; or
3. in the form of materials or supplies to be consumed in the production process or in the rendering of services.

The Objective of the Standard

The objective of this standard is to prescribe the method of accounting for inventories. While accounting for inventories an entity needs to recognise the costs and amount to be carried forward until the related revenues are recognised. The standard also states how the cost should be determined and how it should be recognised as an expense subsequently, and write-downs to net realisable value.

Exclusions to the Scope of this Standard

This standard does not apply to the following :

• Financial instruments.
• Biological assets such as animal and plants used for agricultural activities.

This standard also does not apply to the measurement of the following inventories:

• Agricultural and forest products, agricultural produce after harvest, and minerals and mineral products that are measured at net realisable value.
• Commodity trades which are conducted by brokers that are measured at fair value less costs to sell.

In both these cases, if there is any change in the value of inventories, it will be recognised in profit or loss. The exclusion to the above is only to the extent of measurement of inventories.

How are Inventories Measured?

Inventories are measured at cost or NRV, whichever is lower.

What Does Cost Comprise of?

Cost comprises of the following:

• Costs of purchase.
• Costs of conversion.
• Other costs incurred in bringing the inventories to their present condition and location.

Cost of purchase includes all the costs directly attributable to the purchase of finished goods, material or services. These costs are adjusted for any discounts and rebates. Example of such costs are purchase price, import duty, taxes, transport, handling, and other costs.

Costs of conversion include all costs that are directly related to the unit of production. It also includes a systematic allocation of fixed and variable overheads that are incurred in the conversion of raw materials to finished goods.

• Fixed costs are costs incurred that are not dependent on the volume of production. Fixed production overheads are allocated on the basis of normal capacity. Normal capacity is the average production. Example: Depreciation
• Variable overheads are the indirect costs that vary directly or near directly with the volume of production. Variable production overheads are allocated to each unit of production on the basis of the actual use of production. Example: Indirect material costs.

For joint products, the cost is allocated on the basis of their sale value when the products become separately identifiable.

Other costs will be included in the cost of inventories only if it is incurred in bringing the inventories to their present location and condition. Other costs will be expenses out such as administrative costs, storage costs, and selling costs.

Techniques for the Measurement of Cost

The techniques for measurement of the cost depends on the type of industry and the method that best approximates the cost.

Cost Formulas Used for Valuation of Inventories

For determining the cost formula to be used for determining the inventory valuation firstly the nature of the inventory needs to be defined. If the inventory is not ordinarily interchangeable and has been produced for a particular project then specific costs have to be assigned to inventory. If otherwise, then the entity can use FIFO or Weighted Average cost formula to determine the cost of inventories.

FIFO method assumes that the inventory at the end of a period is the last purchased material as what is purchased first is sold first. Weighted average cost formula is based on the average cost of similar natured inventories. The entity must use the cost formulas consistently for all inventory that is similar in nature.

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 sale.

• Inventories should always be valued at cost or net realisable value, whichever is lower. In cases where the inventory is damaged, obsolete, or overvalued as compared to the market, an entity has to write down the inventory to net realisable value.
• Write down of inventories can be item to item or group of items. Grouping of items has to be if the inventories have similar end use or belong to the same product line.
• Net realisable value is estimated on the basis of the reliable evidence available at the time of estimation. Estimates also take into consideration the purpose for which the inventory is held. For example, if the inventory held is for a particular contract then the net realisable value is based on the contract price.
• For items that are written down to net realisable value a periodic assessment is conducted to ensure accuracy. If there is clear evidence of the increase in net realisable value then the amount of write-down is reversed.

When Should Inventory Cost be Recognised as an Expense?

In the following events, the carrying amount or net realisable value will be recognised as an expense.

Disclosure Requirements

The financial statements shall disclose:

• The accounting policies used in measuring the inventories and the cost formula.
• The total carrying amount and the amount as per classifications of the entity.
• The inventory amount recognised as an expense.
• The amount of any write-down of inventories recognised as an expense in the period of write-down and also the amount of reversal of write-downs.
• The circumstances that led to the reversal of write-down of inventories.
• The carrying amount of inventories pledged as security.