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Accounting for Inventory

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Inventories are assets- held for sale within the ordinary course of business; in the process of production for such sale or assets in the form of materials; supplies to be consumed within the production process or in the rendering of services.

Indian Accounting Standard 2 provides the principles for measurement of inventories, recognition of inventories as expense and disclosure of inventories etc. The objective of the standard is to prescribe the treatment of accounting for inventories. While accounting for inventories an entity needs to recognize the costs and amount to be carried forward until the related revenues are recognized. The standard also deals with determination of cost and how it should be recognized as an expense subsequently, including any write-downs to net realizable value.

Ind AS-2 does not apply to the following:

  • Financial instruments
  • Biological assets associated with agricultural activity (i.e. living animals and plants) and agricultural produce at the point of harvest

How inventories are measured?
Inventories should always be valued at cost or net realizable value, whichever is lower

What does cost comprise of?
Cost comprises of the following:

  • Costs of purchase: It includes all the costs directly attributable to the purchase of finished goods, material or services. These costs are adjusted for any discounts and rebates. (I.e. purchase price, import duty etc.).
  • Costs of conversion: It includes 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.
  • Other costs incurred in bringing the inventories to their present condition and location.

Techniques for measurement of cost
It depends upon the sort of industry and therefore the method that best approximates the value.

Types of method Description Applicable industry
Standard cost It takes into consideration the normal levels of material, supplies, labour and efficiency. and capacity utilization Manufacturing
Retail method The cost of inventory is measured by reducing the sales value by an appropriate percentage of gross margins. Retail business

Cost formulas used for valuation of inventories
For determining the cost formula to be used for determining the inventory valuation firstly the character of the inventory must be defined. If the inventory isn’t ordinarily interchangeable and has been produced for a specific project then specific costs needs to be assigned to inventory. If otherwise, then the entity can use FIFO or Weighted Average cost formula to work out the cost of inventories.

FIFO method assumes that the inventory at the end of a period is the last purchased material as what’s 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 inventories that are similar in nature.

Net Realizable Value
It means deduction of the estimated costs of completion and the estimated costs necessary to form the sale, from estimated asking price, within the ordinary course of business

  • Inventories should always be valued at cost or net realizable 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 realizable value.
  • Inventories are usually written down to net realizable value item by item basis. However, in some circumstances it may also be appropriate to group similar or related items. On the basis of classification of inventory (for example, finished goods, or all the inventories in a particular operating segment), it’s not appropriate to write inventories down,
  • Net realizable 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 realizable value is based on the contract price.
  • For items that are written down to net realizable value a periodic assessment is conducted to ensure accuracy. If there is clear evidence of the increase in net realizable value then the amount of write-down is reversed

When Inventory cost should be recognized as an expense?
In the following circumstances the carrying amount or net realizable value will be recognized as an expense.

Circumstances Expense to be recognized in
Sale of inventories In the period in which related revenue is recognized
Write down or loss In the period the write down or loss occurs
Reversal of write down In the period in which reversal occurs

Disclosure Requirements
The financial statements shall disclose:

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

 At AJSH, we assist our clients in valuation of inventory including physical verification. If you would like to know more about the standard or have questions for inventory valuation, please click here.


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