Accounting Standard 2 - Valuation of Inventories

 Accounting Standard 2 (AS 2) - Valuation of Inventories

Objective:

AS 2 prescribes the accounting treatment for inventories. It provides guidance on the determination of the value at which inventories are carried in the financial statements until the related revenues are recognized. It also provides guidance on the cost formulas that are used to assign costs to inventories.

Scope:

This standard applies to all enterprises except:

• Work in progress arising under construction contracts, including directly related service contracts.
• Work in progress arising 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, mineral oils, ores, and gases to the extent that they are measured at net realizable value (NRV) in accordance with well-established practices in those industries.

Key Points:

1. Definitions:
• Inventories: Assets held for sale in the ordinary course of business, in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in rendering of services.
• Net Realizable Value (NRV): 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.
• Cost: Includes all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.
2. Measurement of Inventories:
• Inventories should be valued at the lower of cost and NRV.
3. Cost of Inventories:
• Costs of Purchase: Purchase price, import duties, and other taxes (excluding those subsequently recoverable from tax authorities), transport, handling, and other costs directly attributable to the acquisition of finished goods, materials, and services.
• Costs of Conversion: Costs directly related to the units of production, such as direct labor, and a systematic allocation of fixed and variable production overheads.
• Other Costs: Other costs incurred in bringing the inventories to their present location and condition.
4. Cost Formulas:
• Cost of inventories should be assigned by using the First-In, First-Out (FIFO) or Weighted Average Cost 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.
5. Exclusions from the Cost of Inventories:
• Abnormal amounts of wasted materials, labor, or other production costs.
• Storage costs, unless they are necessary in the production process prior to a further production stage.
• Administrative overheads that do not contribute to bringing inventories to their present location and condition.
• Selling and distribution costs.
6. Disclosure:
• The accounting policies adopted in measuring inventories, including the cost formula used.
• The total carrying amount of inventories and its classification appropriate to the enterprise.
• The carrying amount of inventories carried at fair value less costs to sell.
• The amount of any write-down of inventories recognized as an expense.
• The amount of any reversal of any write-down that is recognized as a reduction in the amount of inventories recognized as expense.

Questions and Answers from Previous CA Exams, Revision Test Papers, and Solved Case Studies

May 2018:

Question: What are the key considerations in determining the cost of inventories according to AS 2?

Answer: The key considerations in determining the cost of inventories according to AS 2 include:

1. Costs of Purchase: These include the purchase price, import duties, taxes (excluding recoverable taxes), transport, handling, and other costs directly attributable to the acquisition.
2. Costs of Conversion: These include costs directly related to the production, such as direct labor, and a systematic allocation of fixed and variable production overheads.
3. Other Costs: These are costs incurred in bringing the inventories to their present location and condition.

November 2017:

Question: How should inventories be valued according to AS 2?

Answer: According to AS 2, inventories should be valued at the lower of cost and net realizable value (NRV). Cost includes all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. NRV 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.

May 2016:

Question: What is the treatment of abnormal amounts of wasted materials, labor, or other production costs in the cost of inventories as per AS 2?

Answer: According to AS 2, abnormal amounts of wasted materials, labor, or other production costs should be excluded from the cost of inventories. These costs are not considered to be part of the cost of bringing the inventories to their present location and condition and should be recognized as expenses in the period in which they are incurred.

Revision Test Paper (RTP) May 2019:

Question: XYZ Ltd. uses FIFO method for inventory valuation. At the year-end, the cost of inventory is Rs. 5 lakhs, but its NRV is Rs. 4.5 lakhs. How should XYZ Ltd. value its inventory?

Answer: According to AS 2, XYZ Ltd. should value its inventory at the lower of cost and NRV. Since the NRV of Rs. 4.5 lakhs is lower than the cost of Rs. 5 lakhs, the inventory should be valued at Rs. 4.5 lakhs in the financial statements.

Solved Case Study:

Question: A company incurs storage costs as part of its production process. Under what conditions can these costs be included in the cost of inventories as per AS 2?

Answer: Storage costs can be included in the cost of inventories as per AS 2 if they are necessary in the production process before a further production stage. If the storage costs are incurred after production is complete or for finished goods, they should be excluded from the cost of inventories and recognized as an expense in the period in which they are incurred.

November 2015:

Question: Explain the 'cost formulas' allowed under AS 2 for assigning costs to inventories.

Answer: AS 2 allows the following cost formulas for assigning costs to inventories:

1. First-In, First-Out (FIFO): Assumes that the items of inventory purchased or produced first are sold first, and the items remaining in inventory are those most recently purchased or produced.
2. Weighted Average Cost: The cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. This formula gives a measure that smooths out price fluctuations.

May 2014:

Question: What are the disclosure requirements under AS 2 regarding inventories?

Answer: AS 2 requires the following disclosures regarding inventories:

1. The accounting policies adopted in measuring inventories, including the cost formula used.
2. The total carrying amount of inventories and its classification appropriate to the enterprise.
3. The carrying amount of inventories carried at fair value less costs to sell.
4. The amount of any write-down of inventories recognized as an expense.
5. The amount of any reversal of any write-down that is recognized as a reduction in the amount of inventories recognized as expense.

November 2013:

Question: What is 'net realizable value' (NRV) and how is it determined according to AS 2?

Answer: Net Realizable Value (NRV) 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. According to AS 2, NRV is determined based on the most reliable evidence available at the time the estimates are made, taking into account fluctuations of price or cost directly relating to events occurring after the end of the period.