Why is valuation of inventory so important? From a lay man’s perspective there can be two reasons. Firstly since the closing stock of the previous year becomes opening stock of the current year and it goes because of the going concern concept. Secondly it affects he gross profits. If you’re closing stock is valued high in one year, gross profit for that year will be high. But in the next year since it becomes the opening stock, gross profit can be comparatively low. Thus it always becomes an issue as to at what value should the closing stock be valued. This standard comes into picture at the end of the year when a company holds certain amount of stock which is not sold. It has to be represented in the Balance Sheet at such a value till the time revenue is recognized from such stock. In this article we will try to draw a fictitious story to explain the core concepts of the exceptions to Accounting Standard 2 issued by ICAI, concept of inventory, concepts of cost and its inclusions and meaning of net-realizable value.
Suppose that you are a proprietor of a printing press lets name it ABC Printers. A typical business cycle would be ordering of raw materials like paper, ordering of consumables like ink, converting raw material into finished goods with the help of printing machines and labour, ordering of packing boxes, packing of the finished goods with the help of labour and finally transportation of finished goods to the destination of the customer. Following costs can be assumed. You order paper at a cost of Rs. 100 per kg. It attracts Octroi at Rs. 2 per kg. The Vat on purchases is 12.5%. Your labour cost is Rs. 20 per hour for printing department and Rs. 5 per hour in packing department. Ink costs you Rs. 12 per kg and packing boxes costs you Rs. 10 per box. Transportation is paid by the customer. It is 31st of March today. You have just received an order today for printing of 1000 leaflets of Rs. 5 each. One of the order of 2000 leaflets is being printing on 31st of March and you intend to pack it on 1st of April. Since labour is short on 31st of March, a completed order of 500 leaflets will be dispatched by you on 1st April. For simplicity we are ignoring the fixed costs of department.
Exceptions to Accounting Standard - 2:
Since it is a sole proprietorship printing business, you are not involved into business of construction, you are a manufacturer and not a service provider, and you have not held any shares or debentures as stock nor are you a producer holding inventories of livestock, agricultural products and forest products etc. Above all are the exceptions to AS-2. Now since your business is such that you do not fall into any of the exception categories, you need to understand the AS-2 properly for valuing your inventory.
Concept of Inventory:
For you the inventory is paper, ink and packing boxes which you stock in large quantity so that once you receive the order you can execute it with minimum time and generate revenue. Paper would be a part of inventory as it is held for sale and is going to be used in the production process. Ink and packing boxes are consumables that are going to be consumed in the production process. You also hold some of the spare parts like bolts that relate to you printing machinery so that your production is not hampered. Since this spares are not for re-sale and can be used only with your machinery, it will not be included in you inventory. The order of 2000 leaflets will be your work-in-progress and that of 500 leaflets will be your finished goods.
Concepts of Costs:
With respect to your printing press, raw material will be valued at the purchase price including the Octroi and Vat of purchases at 12.5%. If on sale, if you a registered dealer and have a VAT registration number then Vat on purchase (rate) will be reduced by the rate which at which you will collect the Vat from your customer. Suppose the Vat on sale is 4%. Than in inventory valuation the Vat would be 8.5%.
With respect to your order of 2000 leaflets, we can term it as work-in progress and it will be valued at the cost of purchase of raw material paper as above + the amount paid for the ink and the labour hours involved in the printing department. In this equation the first component is the cost of purchase and the second is the cost of conversion till date.
With respect to 500 leaflets, which can be referred to as finished goods, it will be cost of purchase + cost of conversion + other costs like packing and transportation. The third component of the cost can be called as the cost in order to bring the goods to their present location and condition.
Fixed overheads are ignored in the case but it will be added to each such cost on the rate estimated by the management based on normal capacity. If there are some sheets of paper that have been wasted in the printing process, the cost of storing the paper in a warehouse, cost of watchman at the warehouse and selling costs, they would not be included in the cost of inventories.
Obviously there is always a shortage of space in every small firm. Paper will be stack one above the other. The first that arrives will be below followed by the others above it. You will account the first stock of paper that you receive and then for others as and when you receive. Thus in your books of account the first stock of paper will be used for printing first then others. But this actually does not occur in real life situations because the paper which is on the top is taken first than the paper at the bottom. You can think of it as when we have to demolish a building, we start from the top and not from the bottom. But when we want to purchase the building we start reviewing it from bottom. Thus the accounting for inventory as per FIFO is more theoretical than practical.
This method is more appropriate with respect to inventory valuation as the fluctuations are considered. You can think of it as an investor who invest in a stock at one go and the other who invests in a stock slowly every month. The other investor is at an advantage as he can average out in case of fluctuations of the stock prices.
Meaning of Net Realizable Value:
This is majorly based on estimates. Estimates are made by the management and it’s their duty to used the most reliable one and disclose the same in financial statement.
Over here we try to explain the concept of valuation of inventories rule, “Inventories are valued at lower of cost or NRV”.
We can think of this rule as the one which is applicable only in case of damaged, obsolete and goods which we expect to sell at loss. If we expect the inventory to sell at above the cost, naturally the NRV is going to be high and hence they will be valued at the cost. In case of damaged, obsolete goods which we are ready to sell it at loss, naturally the NRV is less and hence will be valued at NRV and not at the cost. Let’s understand it with our printing press example as on 31st March. Paper will always be valued at the cost and it will not be written down below the cost as we expect to complete the production cycle and sell the printed paper at an amount higher than the cost. But suppose the warehouse in which the paper was stored had a leakage problem on 31st March and as a result you’re certain stock of paper became wet; this stock cannot be used as a raw material in the printing process and can only be sold as scrapped. In such a case on 31st of March you will estimate based on reliable evidence, the scrap value that you can receive from such wet stock of paper, and you will value your wet paper at that price.