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AS-2 Valuation of Inventories

Inventories are the assets that are:

 Held for sale in the ordinary course of business Eg. Tiger Biscuits

 In the process of production of such sale Eg. Biscuits Dough

 And in the form of materials or supplies to be consumed in the

production process or in the rendering of the services Eg. Maida, Sugar

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
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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.

For Example: The expected selling price of the inventory is Rs.5,000.

However, ABC Inc. needs to spend Rs.800 to complete the goods and an
additional Rs.200 for transportation expenses. Considering the available
information, the net realizable value of the inventory should be
calculated in the following way:

NRV = Rs.5,000 – (Rs.800 + Rs.200) = Rs.4,000

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.

For Example: Market price of Inventory item.

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What is Cost of Inventories?

The cost of inventories comprises of the following costs of:

 purchase

 conversion

 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.
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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

Fixed Costs

 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

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 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

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
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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.
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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.

For Example: Such items include automobiles, furniture, jewelry etc.

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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.

For Example: For instance, if a business sold 100 units of an item, and
75 units were originally purchased by the company at Rs.10.00 and 25
units were purchased at Rs.15.00, it cannot assign the Rs.10.00 cost
price to every unit sold. Only 75 units can be. The remaining 25 items
must be assigned to the higher price, the Rs.15.00.

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.
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Additionally, the weighted average is calculated periodically or on the
arrival of each new shipment as the case may be.

For Example:

For example, ABC is a retail company that purchases cloth from oversea
and sell to the local customer. During the month, ABC has the following
transaction:

 01 Jan 2022, purchase 1,000 units @ Rs. 12

 15 Jan 2022, purchase 1,500 units @ Rs. 15
 At the end of Jan, 2,000 units of clothes are sold, and 500 units
remain in the store

Total cost of inventory = (1,000 x Rs. 12) + (1,500 x Rs. 15) = Rs. 34,500

Total inventory quantity = 1,000 units + 1,500 units = 2,500 units

Weighted average cost = Rs. 34,500 / 2,500 units = Rs. 13.8 per units

Cost of Goods Sold = 2,000 units x Rs. 13.8 = Rs. 27,600

Inventory balance at end of Jan 202X = 500 units x Rs. 13.8 = Rs. 6,900
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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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1. The company deals in three products, A, B and C, which are neither
similar nor interchangeable. At the time of closing of its account for the
year 2002-03. The Historical Cost and Net Realizable Value of the items
of closing stock are determined as follows:

A. 88

B. 84

C. 76

D. 67

Answer: Individual Valuation will be done:

A: 28, B: 32, C: 16 Total: 76

2. X Co. Limited purchased goods at the cost of Rs.40 lakhs in

November 2022. Till March, 2006, 75% of the stocks were sold. The
company wants to disclose closing stock at Rs.10 lakhs. The expected
sale value is Rs.11 lakhs and a commission at 10% on sale is payable to
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the agent. Advise, what is the correct closing stock to be disclosed as at
31.3.2023.

A. 10,00,000

B. 9,90,000

C. 11,00,000

D. None of the above

Answer: B 9,90,000

Cost or NRV Whichever is lower. Here cost is Rs. 10,00,000 and NRV is
Rs 11,00,000 less 10% i.e. Rs. 9,90,000.

3. Items that are to be excluded in determination of the cost of

inventories as per AS2:

A. Abnormal amounts of wasted materials, labour

B. Custom Duty on imported Inventory

C. Storage cost at Factory Location

D. Carriage Inwards

Answer: A
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4. From the following information presented by P Ltd. ascertain the

value of stock to be included in Balance Sheet:
Cost Price of certain stock amounted to Rs 60,000; being obsolete, it
can be used for production purposes after incurring Rs 10,000 for
modification. The same could be used as a by-product for an existing
product, the purchase price for the same amounts to Rs 40,000.

A. 60,000

B. 40,000

C. 30,000

D. 50,000

Answer: C 30,000

Cost (60,000) OR NRV 30,000 whichever is less.

5. How will you deal with the following situation?

“A company deals in purchase and sale of timber and has included
notional interest charges calculated (on the paid-up share capital and
free reserves) in the value of stock of timber as at the Balance Sheet
date as part of cost of holding the timber”.
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Answer: Notional Interest is not allowed to be included in Valuation of
Inventories as this is not the actual cost which is incurred.