Inventory Valuation….AS-2 Versus Development of CAS for valuation of Inventory:A case in Point.
Financial Accounts require Valuation of Inventories for the purpose of arriving at Trading or Manufacturing profit.Normally Accounting Standards prescribes that the valuation of inventory should be based on market rate or Cost which ever is lower as a principle of conservatism.
To arrive at market value of inventory we simply need the market price of per unit of the inventory multiplied by the units of inventory(finished goods and finished goods equivalents).
If we have to arrive at the cost of the inventory then there is a whole lot of system that has to be in place, this system is primarily the zone of cost accounting and not financial accounting, it could be called as material tracking system, Inventory records or whatever.
The simplest way of valuing inventory at cost is to identify the inventory with the purchase invoice and assign value. But this is over simplistic and here is where one finds the cost insights very absent In the financial information system.
A cost Accounting system travels through the processes ,while the financial accounting system travels through the transactions, ignoring entirely the business operations and that is where it miserably fails to reflect the concerns of efficiency and sustainability.
The Cost Travels with processes and the time, while a financial transaction is fixed at the transaction stage and is historical.
That is why in cost accounting system we talk of overheads and identify them to allocate and absorb.The fundamental difference between the recognitions in the financial accounting and cost accounting is its nature of recognition.
Financial accounting classifies transactions for recognition as Capital and revenue(and deferred which is in-between).
Cost accounting recognizes a transaction as direct and indirect in terms of cost incurred and classifies these expenditure into material, labour and overheads. Thus a comprehensive view can emerge only when businesses appreciate the importance of Cost accounting.
Materials are valued the moment it enters into the business processes and at each stage of its time and space occupation its value is increased or depleted and hence a true value of material can emerge only when a comprehensive cost system is in place.
The purpose of inventory valuation for a financial accountant is only to arrive at a gross profit during the accounting period,where as the purpose of cost accounting is entirely different it takes into account the valuation of output(finished,semi-finished and other in-process material) through the input contribution at different stages so as arrive at the cost of product or service or the processes.
Objective and scope of AS 2:
Objective
A primary issue in accounting for inventories is the determination of the value at which inventories are carried in the financial statements until the related revenues are recognised. This Statement deals with the determination of such value, including the ascertainment of cost of inventories and any write-down thereof to net realisable value.
Scope
1. This Statement should be applied in accounting for inventories other than:
(a) work in progress arising under construction contracts, including directly related service contracts (see Accounting Standard (AS) 7, Accounting for Construction Contracts);
(b) work in progress arising in the ordinary course of business of service providers;
(c) shares, debentures and other financial instruments held as stock-in-trade; and
(d) producers' inventories of livestock, agricultural and forest products, and mineral oils, ores and gases to the extent that they are measured at net realisable value in accordance with well established practices in those industries.
Cost Accounting very relevant for all business which has closing stock of goods and services and Cost accountants are very relevant for all the businesses:
The entire section below will suggest that valuation of inventory heavily depends on a fool-proof installation of a cost accounting system and financial accounting cannot capture these and the substantiated in the section that follows below,still some stakeholders view a costing system installation involves additional cost,whereas already they are subject to such a system since financial accounting system is incomplete in itself to reflect gross profit from operations without a cost information system:
AS 2
Cost of Inventories
6. The cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.(financial accounting information ignores this since it is irrelevant for a transactional accounting,which at best can reflect purchase invoices)
Costs of Conversion
8. The costs of conversion of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labour.
9. The allocation of fixed production overheads for the purpose of their inclusion in the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on an average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. The actual level of production may be used if it approximates normal capacity. The amount of fixed production overheads allocated to each unit of production is not increased as a consequence of low production or idle plant. Unallocated overheads are recognised as an expense in the period in which they are incurred. In periods 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. Variable production overheads are assigned to each unit of production on the basis of the actual use of the production facilities.
10. A production process may result in more than one product being produced simultaneously. This is the case, for example, when joint products are produced or when there is a main product and a by-product. 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, for example, on the relative sales value of each product either at the stage in the production process when the products become separately identifiable, or at the completion of production. Most 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 realisable 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.
AS 2
Other Costs
11. Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include overheads other than production overheads or the costs of designing products for specific customers in the cost of inventories.
12. Interest and other borrowing costs are usually considered as not relating to bringing the inventories to their present location and condition and are, therefore, usually not included in the cost of inventories.
Exclusions from the Cost of Inventories
13. In determining the cost of inventories in accordance with paragraph 6, it is appropriate to exclude certain costs and recognise them as expenses in the period in which they are incurred. Examples of such costs are:
(a) abnormal amounts of wasted materials, labour, or other production costs;
(b) storage costs, unless those costs are necessary in the production process prior to a further production stage;
(c) administrative overheads that do not contribute to bringing the inventories to their present location and condition; and
(d) selling and distribution costs.
Now let us look at the real Cost accounting compliance:
CAS 1 on classification of cost exhaustively deals with how cost is identified and classified to product.
Visit here for CAS 1: https://www.icwai.org/icwai/members-resources.asp?type=CAS see also CAS 3 and CAS 4.
Cost Accounting Record rules require the following:
I. Materials (Other than Stores)
(a) Adequate record shall be maintained showing receipts, issue and balances both in quantity and value of
each item of material and components required for the manufacture of room air-conditioners. The basic on
which the value of the purchase and issues have been calculated shall be clearly indicated in the cost records or,
if so desired by the company, in a separate manual of production, if any, maintained by the company or in footnotes
of separate explanatory notes to the cost statements for the relevant period. Such basic shall be applied
consistently throughout the relevant period. The value shall include all direct charges up to work such as freight
and insurance. Any wastage whether in storage, transit or for other reason shall be separately and the method of
dealing with such wastage in the calculation of costs indicated in the cost records by way of foot-notes or
explanatory notes or in some other suitable manner.
(b) If the value of materials consumed is determined on any basic other than actuals the method adopted
for such valuation as well as the method of recording such consumption with actuals and the treatment of
variations, if any, shall be disclosed in the cost records, by way of foot-notes, explanatory notes or in any other
suitable manner.
(c) Manufactured Components
(i) In the case of major components manufactured by the company itself such as coil, blower and
compressor, separate records shall be maintained showing the cost of manufacture of such components in such
detailed as may enable the company to fill up necessary particulars in proforma ‘A’ of schedule II or in a
proforma as near thereto as may be possible.
(ii) [Omitted]6
(iii) Any wastage, whether in storage or for other reason shall be showing separately and the method of
dealing with such losses in the calculation of costs indicated in the cost records by way of foot-notes,
explanatory notes or in other suitable manner.
(iv) Records of quantity manufactured, accepted and rejected shall be kept separately for each batch of
components and the method of dealing with losses on account of rejection in the calculation of costs shall be
indicated in the cost records by way of foot-notes, explanatory notes or in the suitable manner.
III. Stores and Spare Parts
(a) Detailed and adequate records shall be maintained to show the receipt, issue and balances, both in
quantity and value of various stores and spare parts required for repairs and maintenance and loose tools
required in the manufacture of room air-conditioners. The value shown shall include all direct charges up to
works such as freight and insurance. The value of the issues and balances of stores and parts may, if the
company so desires, be recorded monthly or at such shorter intervals as the company decided, or kept in the
form of control accounts for main groups of the stores provided, in the later case, the value of the balances
according t such control accounts are reconciled periodically at least once a year, with the value of the quantity
shown by the quantity accounts for each item of stores.
The value of stores etc. consumed shall be charged to the relevant heads such as manufacturing, repairs
to plants and maintenance of vehicles, capital items etc. The value of stores charged to manufacturing unit or
cost centres and to products, if any, manufactured therein. Stores issued for capital works, such as additions to
plant and machinery or other assets shall also be separates and shown under relevant capital heads. Stores shall
be valued on a reasonable basic and consistently applied during the relevant period. The records shall also
indicate the method of valuation adopted. Any wastage, whether in storage, transit, or due to other reasons shall
be shown separately. The method of dealing with such losses in the calculation of costs shall also be indicated in
the cost records or in footnotes, explanatory notes or in other suitable manner.
1. MATERIALS AND COMPONENTS:
(1) Proper records shall be maintained showing separately all receipts, issues and balances both in
quantities and cost of each item of raw material like CRC sheets, Copper, Aluminium, GI sheets, including
bought out components like Pipes, compressor, thermostat, condenser coil, evaporator coil, etc. required for the
production of each type of airconditioners and components thereof. These records shall contain such details so
as to enable the company to determine the quantity and cost of receipt (including all direct charges upto the
works such as freight and insurance in respect of major raw material), issues and balances in quantity as well as
value of each item of all such raw materials. The basis on which the said quantities and costs of issue and
consumption have been calculated shall be indicated in the cost records and followed consistently. In case of
imported raw materials records shall be maintained showing separately details such as FOB value, overseas
freight, insurance, custom duty and inland freight charges . If both indigenous and imported materials are
consumed, records showing details of percentage mix of the same have to be maintained for each item.
Materials processed through outside parties shall be recorded separately.
(2) In case of major components manufactured by the company itself, separate records shall be maintained
for the quantity manufactured/produced and the cost of manufacture/production of such components.
(3) Proper records shall be maintained to show the receipts, issues and balances, both in quantities and cost
of each item of consumable stores, tools and machinery spares etc. The cost shall include all direct charges upto
works.
(4) In the case of consumable stores and small tools the cost of which are insignificant, the company may,
if it so desires, maintain such records for the group of such consumable stores and tools.
(5) The cost of consumption of consumable stores, small tools and machinery spares shall be charged to
the relevant cost centre/department on the basis of actual issues.
(6) Proper records shall be maintained showing the quantity and value of wastage, spoilage, rejections and
losses of raw materials, whether in transit, storage, manufacture or at any other stage. The method followed for
adjusting the above losses as well as the income derived from the disposal of rejected and waste materials
including spoilage, if any, in determining the cost of product shall be indicated in the cost records. Any
abnormal wastage or spoilage or rejection shall be indicated distinctly and separately along with reasons thereof.
The records shall also be maintained to indicate the value of raw materials and components, finished & semi
finished which have not moved for more than twelve months.
(7) Where any credit under Modified Value Added Tax (MODVAT) or any other benefit under the Central
Excise Act, 1944 (1of 1944) are available on any item of material, the cost of such material should be shown
after adjusting such credit or benefits.
Thus it is clear though financial accounts require valuation of closing stock for the purpose pegging the profit of an accounting period, it is the cost accounting system that can give this information to the financial accountant, having an accounting standard inplace do not in itself reveal that valuation of inventory and that makes it over-simplistic and unreliable,it is process accounting Vs transaction accounting where the process accounting wins.
Unfortunately we do not often recognize merits by merits alone and that is why the things are at a place where it has not to be.
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