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AS 2 Valuation of Inventory

The accounting treatment for inventories is prescribed in AS 2 valuation of inventory, which provides guidance for determining the value at which inventories are carried out in the financial statement until related revenues are recognized.
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Determination of value at which inventories are carried in the financial statements.

This AS 2 Valuation of Inventory is not applicable in the following cases
  • Work in progress under construction contracts, including directly related service contracts (It is specifically covered by AS-7 construction Contracts)
  • Work in progress in the ordinary course of business of service providers;
  • Shares, debentures and other financial instruments held as stock-in- trade
  • Producers’ inventories of livestock, agricultural and forest products, and mineral oils,ores and gases to the extent that they are measured at net realizable value in accordance with well established practices in those industries.

Key Terms used in AS 2 Valuation of Inventory:

Inventories : It is an asset:
  • Held for sale in ordinary course of business(Finished Goods)
  • In the process of production for such sale (WIP and Raw material)
  • In the form of materials or supplies to be consumed in the production
  • process or in the rendering of services (Stores, spares and consumables)
Net realizable value
It 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.

Measurement of Inventories
Inventories should be valued at the lower of cost and net realizable value.

Composition of cost
Cost consists of :
  • Purchase Cost
  • Conversion Cost
  • Other cost incurred in bringing the inventories to the present location and condition.
Purchase Cost
It comprises of
  • Purchase price
  • Duties and taxes (other than those subsequently recoverable)
  • Freight inwards
  • Any other expenditure directly attributable to the acquisition
  • Trade discounts, rebates, duty drawbacks and other similar items are deducted.
Cost of conversion
The costs of conversion of inventories include costs directly related to the units of production, such as direct labour, direct material and direct expenses. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods.

Fixed production overheads:
They are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings.

Variable production overheads:
They are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labor.

Allocation of fixed production overheads:
  • Allocation is based on the normal capacity.
  • Normal capacity is the production expected after taking into account the loss of capacity resulting from planned maintenance.
  • The actual level of production may be used if it approximates normal capacity.
Amount of fixed production overheads allocated to each unit of production in case of
  • Low Production: It is not increased as a consequence of low production or idle plant. Un-allocated overheads are recognized as an expense in the period in which they are incurred.
  • High Production: In case of abnormally high production, the amount of fixed production overheads allocated to each unit of production is decreased so that inventories are not measured above cost.

Allocation of variable production overheads:
Variable production overheads are assigned to each unit of production on the basis of the actual use of the production facilities.
  • If it results in Joint Products: When the costs of conversion of each product are not separately identifiable, they are allocated between the products on a rational and consistent basis. The allocation may be based, on the relative sales value when the products become separately identifiable.
  • If it results in By-Products: By-products as well as scrap or waste materials, by their nature, are immaterial. When this is the case, they are often measured at net realizable value and this value is deducted from the cost of the main product. As a result, the carrying amount of the main product is not materially different from its cost.
  • Cost incurred to bring the inventory to present location and condition
  • Interest and borrowing cost, it is usually not considered to be incurred in the process to bring it to present location and condition. It is included in the cost only when the inventory takes substantial period of time to get ready for intended sale. Example – Grape Wine.
  • Though standard is silent, treatment of amortization of intangibles should be taken as a part of inventory costs.
  • Exchange differences will not form part of inventory costs as per Indian GAAP.
Cost Formula
When the goods lying in the stock can be specifically identified the cost is determined specifically as segregated for producing or purchasing such goods. Where specific identification method cannot be applied, the costs of inventories are determined using:
  • First In First Out Method (FIFO Method)
  • Weighted Average Cost Method (WAC Method)
Other Techniques of cost measurement
  • Standard Cost- Standard Cost can used instead of actual cost. It takes into account normal level of consumption of material , labour , efficiency & capacity utilization. It must be reviewed on timely basis.
  • Retail Method- In retail business, it is difficult to ascertain cost of individual item and the inventories are rapidly changing with similar margins marking it impracticable to use other methods. In such a case retail method is used.
Net Realizable Value
It is the estimated selling price in ordinary course of business, less estimated cost of completion and estimated cost necessary to make the sale.

Estimation of Net Realizable Value
NRV is estimated as under:
  • If finished product is sold at or above cost- Estimated realizable value of raw material and supplies is considered more than its cost. Therefore inventory of raw materials will be valued at cost.
  • If finished product is sold below cost- Estimated realizable value of raw material and supplies is equal to the replacement price of raw material. The inventory of raw materials will be valued at replacement price.
Following disclosures as per AS 2 are to be made in Financial statements of the enterprise:
  • Accounting policy adopted to measure value of the inventories
  • Cost formulae used
  • Total carrying amount of inventories
  • Classification adopted by enterprise.
In this post we learn that AS 2 deals with valuation of inventory and how we need to do valuation of inventory in the financial statement on the closing date. what are the inventories,how valuation is done for raw material ,work in progress(WIP) and finished goods in case of manufacturers and in case of traders finished goods as inventory.

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