AS 2 - VALUATION OF INVENTORIES

Valuation of Inventories

Inventories should be valued at lower cost and net realizable value. Following are the steps for valuation of inventories: A. Determine the cost of inventories B. Determine the net realizable value of inventories C. On Comparison between the cost and net realizable value, the lower of the two is considered as the value of inventory.

A comparison can be made the item by item or by the group of items.

Let’s discuss the important items of Inventory valuation in detail:

A. Cost of Inventories. The cost of inventories includes the following

1. Purchase cost
2. Conversion cost
3. Other costs which are incurred in bringing the inventories to their present location and condition.

B. Cost of Purchase?While determining the purchase cost, the following should be considered:

1. Purchase cost of the inventory includes duties and taxes (except those which are subsequently recoverable from the taxing authorities)
2. Freight inwards
3. Other expenditure which is directly attributable to the purchase
4. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase

C. Cost of Conversion?Cost of conversion includes all cost incurred during the production process to complete the raw materials into finished goods. Cost of conversion also includes a systematic allocation of fixed and variable overheads incurred by the enterprise during the production process.

Following are the categories of conversion cost:

I. Direct Cost

All the cost directly related to the unit of production such as direct labor

II. Fixed Overhead Cost

Fixed overheads are those indirect costs which are incurred by the enterprise irrespective of production volume. These are the cost that remains relatively constant regardless of the volume of production, such as depreciation, building maintenance cost, administration cost etc.

The allocation of fixed production overheads is based on the normal capacity of the production facilities. In case of low production or idle plant allocation of these fixed overheads are not increased consequently.

III. Variable Overhead Cost

Variable overheads are those indirect costs of production that vary directly with the volume of production. These are the cost that will be incurred based on the actual production volume such as packing materials and indirect labor.

D. Other Cost

All the other cost which are incurred in bringing the inventories to the current location and condition. For (eg) design cost which is incurred for the specific customer order. If there are by-products during the production of main products, their cost has to be separately identified. If they are not separately identifiable, then allocation can be made on the relative sale value of the main product and the by-product. Some of the cost which should not be included are:

a. Cost of any abnormal waste materials cost

b. Selling and distribution cost unless those costs are necessary for the production process

c. A normal loss which occurs during the production process is apportioned over the remaining no of units and abnormal loss is treated as an expense

Methods of Inventory Valuation

The cost of inventories of items which?can be segregated for specific projects?should be assigned by specific identification of their individual costs (Specific identification method). All other items cost should be assigned by using the first-in, first-out (FIFO), or weighted average cost (WAC) formula. The formula used should reflect the fairest possible approximation to the cost incurred in bringing the items of inventory to their present location and condition.

However, when it is difficult to calculate the cost using above methods, Standard cost and Retail cost can be used if the results approximate the actual cost.

Accounting Disclosure

The following should be disclosed in the financial statements:

1. Accounting policy adopted in inventory measurement
2. Cost formula used
3. Classification of the of inventory such as finished goods, raw material & WIP and stores and spares etc
4. Carrying amount of inventories carried at fair value less sale cost
5. Amount of inventories recognized as expense during the period
6. Amount of any write-down of inventories recognized as an expense and its subsequent reversal if any.