Inventories

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.

The cost of inventories, as per AS 2, comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. [14] Costs of purchase include the purchase price, import duties and other taxes (other than those subsequently recoverable by the enterprise from the taxing authorities), and transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services. [3] Costs of conversion include direct labour, direct expenses, and a systematic allocation of fixed and variable production overheads incurred in converting materials into finished goods. [13] Costs generally excluded from the cost of inventories and recognised as expenses in the period in which they are incurred include: (a) abnormal amounts of wasted materials, labour, or other production costs; (b) storage costs, unless those costs are necessary in the production process before a further production stage; (c) administrative overheads that do not contribute to bringing inventories to their present location and condition; and (d) selling and distribution costs. [3]

As per Accounting Standard (AS) 2, 'Valuation of Inventories', inventories are assets: (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services. This definition encompasses various forms such as finished goods, work-in-progress, raw materials, stores, and spares.

Accounting Standard (AS) 2 mandates that inventories should be valued at the lower of their cost and net realisable value (NRV). [2, 14] 'Cost' is determined according to the principles laid out in AS 2, encompassing purchase, conversion, and other directly attributable costs. [14] 'Net Realisable Value' is defined as 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. [2, 14] This principle is crucial because it adheres to the accounting concept of prudence (conservatism), which dictates that assets should not be overstated and all known losses should be provided for. [3] By valuing inventories at the lower of cost or NRV, businesses ensure that anticipated losses from a decline in the value of inventories are recognised immediately, thus presenting a more realistic and fair view of the company's financial position and performance. [15]

AS 2 permits the use of specific cost formulas for inventory valuation:

1. Specific Identification Method: This method is used for items that are not ordinarily interchangeable and for goods or services produced and segregated for specific projects.
2. First-In, First-Out (FIFO) Method: This method assumes that the items of inventory that were purchased or produced first are sold first, and consequently, the items remaining in inventory at the end of the period are those most recently purchased or produced.
3. Weighted Average Cost Method: This method calculates the average cost of all items available for sale during a period, and this average cost is then used to determine the cost of goods sold and the value of ending inventory.
   The Last-In, First-Out (LIFO) method is explicitly not permitted under AS 2.

Net Realisable Value (NRV) is defined as 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. It represents the net amount that an entity expects to realise from the sale of inventory in the normal course of business. Inventories are written down to NRV when their cost is not expected to be recoverable due to damage, obsolescence, or a decline in selling prices.

The primary objective of AS 2 is to prescribe the accounting treatment for inventories. It provides guidance on determining the value at which inventories are carried in the financial statements until the related revenues are recognized. This includes the ascertainment of the cost of inventories and any write-down thereof to net realisable value.

Accounting Standard (AS) 2 mandates several key disclosures related to inventories in the financial statements. These include: (a) the accounting policies adopted in measuring inventories, including the cost formula used (e.g., FIFO, weighted average cost); (b) the total carrying amount of inventories and their classification appropriate to the enterprise (e.g., raw materials, work-in-progress, finished goods, stores and spares, loose tools); (c) the amount of inventories recognised as an expense during the period; (d) the amount of any write-down of inventories to net realisable value recognised as an expense in the period; and (e) the amount of any reversal of any write-down that is recognised as a reduction in the amount of inventories recognised as expense in the period. [2, 3, 15] These disclosures provide users of financial statements with crucial information to understand the impact of inventories on the entity's financial position and performance. [15]

According to AS 2, when inventories are sold, the carrying amount of those inventories should be recognized as an expense (commonly referred to as Cost of Goods Sold) in the period in which the related revenue is recognized. Additionally, any write-down of inventories to net realisable value and all losses of inventories are also recognized as an expense in the period the write-down or loss occurs. This aligns with the matching principle, where expenses are recognized in the same period as the revenues they help generate.

As per Accounting Standard (AS) 2, 'Inventories' are assets (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services. [2, 3] They are typically classified into categories such as Raw Materials (items to be used in production), Work-in-Progress (partially completed goods), Finished Goods (products ready for sale), Stores and Spares (consumables and maintenance items), and Loose Tools. [3]

First-In, First-Out (FIFO) assumes that the items of inventory that were purchased or produced first are sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced.

An error in the valuation of closing inventory has a significant impact on a company's financial statements. If closing inventory is overstated in the current accounting period, it leads to: (a) an overstatement of the Cost of Goods Sold (COGS) being understated, resulting in an overstatement of Gross Profit and consequently Net Profit; (b) an overstatement of current assets (inventory) and owner's equity in the Balance Sheet. [15] Conversely, if closing inventory is understated, it leads to: (a) an understatement of Gross Profit and Net Profit; (b) an understatement of current assets and owner's equity. [15] Importantly, this error has a self-correcting effect over two accounting periods. An overstatement of closing inventory in the current year becomes an overstatement of opening inventory in the subsequent year, which will then lead to an understatement of the subsequent year's Gross Profit and Net Profit. Similarly, an understatement in the current year will lead to an overstatement in the subsequent year. While the total profit over two periods remains correct, the profit for each individual period is misstated. [15]

As per AS 2, the cost of inventories comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.

Included Costs:

• Costs of Purchase: This includes the purchase price, import duties and other non-recoverable taxes, freight inwards, and other directly attributable costs of acquisition. Trade discounts, rebates, and similar items are deducted from the purchase price.
• Costs of Conversion: These include direct labour, direct expenses, and a systematic allocation of fixed and variable production overheads incurred in converting materials into finished goods.
• Other Costs: Costs incurred in bringing the inventories to their present location and condition, such as costs of designing products for specific customers.

Excluded Costs (expensed in the period incurred):

• Abnormal amounts of wasted materials, labour, or other production costs.
• Storage costs, unless those costs are necessary in the production process before a further production stage.
• Administrative overheads that do not contribute to bringing inventories to their present location and condition.
• Selling and distribution costs.

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

According to AS 2, inventories should be valued at the lower of cost and Net Realisable Value (NRV). This principle, often referred to as the 'lower of cost or market' rule, ensures that assets are not carried in the financial statements at an amount greater than their expected future economic benefits.