Know All about Accounting Standards IND AS 2 Inventory

The objective of this Standard is for prescribing the accounting treatment for inventories. This Standard guides determining the cost of inventories and subsequent recognition as an expense, including any write-down to net realizable value.

It guides the techniques for measuring costs, such as the method of standard price or retail method. It also helps to outlines acceptable procedures of determining cost, including specific identification, first-in-first-out, and weighted average cost method.

SCOPE  Accounting Standards IND AS 2 Inventory

This Standard is also applied to all inventories, except:

a) Financial instruments can be accounted under Ind AS 32, Financial Instruments: Ind AS 109, and Presentation, Financial Instruments.

b) Biological assets like living animals or plants, which are related to various agricultural activity and various products which are related to agriculture at the point of harvest, which can be accounted under Ind AS 41, Agriculture.

This Standard doesn’t apply for the measurement of inventories which are held by:

Production of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at the net realizable value following the well-established practices in those industries.

When such inventories have been measured at net realizable value, changes in that value can be recognized in profit or loss in the time of the change.
Commodity broker-traders who are measuring their inventories at fair value fewer costs to selling.

When such inventories have been measured at net realizable value / fair value, fewer costs to sell, changes in those values are to be recognized in profit or loss in the period of the change.

Broker traders are those people who are buying or selling commodities for others or on their accounts. They acquire inventories principally to sell shortly and profit from fluctuations in price or broker trader’s margin. When these inventories have been measured at fair value with fewer costs for selling, they can be excluded from only the measurement requirements of this Standard.

RELEVANT DEFINITIONS Accounting Standards IND AS 2 Inventory

The following are the key terms used in this standard:

1) Inventories can be assets:

a) Hold for sale in the ordinary course of business. (Finished Goods)
b) In the operation of production for such sale. (Work in progress)
c) In the structure of materials or supplies which can be consumed in the production process or the rendering of services. (Raw material)

2) Inventories encompass:

a) Goods which are have been purchased and held for reselling (e.g., merchandise which might be having purchased by a retailer or held for reselling, or land and other property that are held for reselling).
b) Finished goods are those products or work in progress which are being produced by the entity.
c) Materials and supplies can be awaited use in the production process.

Costs incurred to fulfill a contract with a customer that does not give rise to inventories are accounted as per Ind AS 115.

3) Net realizable value can be estimated as the selling price in the ordinary course of business which are less than the estimated costs of completion and the estimated costs necessary to make the sale.

Value Net realizable can be referred to the net amount that an entity is expecting for realizing the sale of inventory in the ordinary time of business.

Fair value can reflects the price at which an orderly transaction is for selling the same inventory in the principal, or most beneficial can be that market for that inventory would be taking places between market participants at the measurement date.

The previous is an entity-specific amount the latter is not. Net realizable value for inventories might not be equal to fair value fewer costs for selling.

4) Fair value is the price that can be received by selling an asset or paid for transferring a liability in an orderly transaction between market participants at the measurement date. (Ind AS 113, Fair Value Measurement.)

MEASUREMENT OF Accounting Standards IND AS 2 Inventory

Inventories shall be measured at a lower cost and net realizable value.

1) Cost of Inventories

Cost of Inventories comprises:
a) Purchase cost for all.
b) Costs of conversion.
c) Other costs can also be incurred by bringing the inventories to their present location and condition.

2) Cost of purchase

The costs of purchase of inventories include:
a) Purchase price.
b) Import duties and several other taxes (other than those subsequently recoverable by the entity from the taxing authorities).
c) Transport, handling.
d) Other costs that can be directly attributable to the acquisition of finished goods, materials, and various services.
Rebates, various trade discounts, and other similar items are deducted in determining the inventory purchase costs.

3) Conversion cost.

The costs of conversion of inventories can include costs directly which can be related to the units of production, such as:
a) Direct material, direct labor, and other direct costs.
b) A structured allocation of fixed and variable production overheads incurred in converting materials into finished goods.
Indirect costs of production like fixed production overheads relatively remain constant regardless of the production volume, such as depreciation and maintaining of factory buildings, equipments, and right of using assets which are used in the process of production, and equipment, and the cost of factory management and administration.

Allocating fixed production overheads for the conversion costs is based on the average capacity of the production facilities. Standard capacity is the production expected to be achieved on average over several periods or seasons under normal circumstances, considering the losing the capacity which can result from the maintenance which have been planned. The actual level of production can be used if it approximates average capacity.

When production levels are abnormally low and can be unallocated, overheads can be recognized as an expense in the period in which they have been incurred. During the time of abnormally high production, the amount of fixed overhead allocated to each production unit is which can be reduced so that inventories can’t be measured with the above cost.

Indirect costs of production like variable production overheads can vary directly, or nearly directly, with the production volume, such as indirect materials and indirect labor. Variable production overheads are allocated to each production unit based on the actual use of the production facilities.

4) Other costs

Other costs are included in inventories only for the extent that they can be incurred for bringing the stocks to their present condition and present location.
Cost can be excluded from the cost of inventories and can be recognized as expenses in the period in which they might be incurred:

a) Abnormal value of wasted materials, labor, or other cost of production.

b) Costs of storage, unless those costs are necessary for the production process before or further the stage of production.

c) Administrative overheads that are not contribute to bringing inventories to their present location and condition.

d) Selling costs.

The extent to which borrowing cost is included in the cost of inventories is determined based on the requirement of

Ind AS 23 Borrowing Costs.

Ind AS 23 “requires that the borrowing costs shall be capitalized on qualifying assets but scopes out inventories that are manufactured in large quantities on a repetitive basis. It also clarifies that inventories manufactured over a short period are not qualifying assets. However, any manufacturer producing small quantities over a long period has to capitalize borrowing costs into the cost of inventories.

An entity may need to acquire inventories on terms of the deferred settlement. When the arrangement are effectively containing a financing element, such as a difference between the purchase prices for regular credit terms and the amount paid, it is recognized as an interest expense throughout the financing.

5) Allocation of cost to joint products and by-products

A production process may be resulting in more than one product being produced simultaneously. It is the case, for example, when joint products are produced or when there is the main product and a by-product.

When each product’s conversion costs are not separately identifiable, then they are allocated between the products on a consistent and rational basis. The allocation can be based on the sales value, which is relative of each product either at the stage of the production process when the products become separately identifiable or after production.

Most of the products, by their nature, can be immaterial. While in this case, they are often measured at net realizable value, which can be deducted from the main product’s cost. As according to this, the carrying value of the main product can not be materially different from its cost.

6) Cost of agricultural products which have been harvested from biological assets.

By following the Ind AS 41, Agriculture, inventories can be comprised of agricultural produce that an entity have been harvested from its biological assets, which are measured on initial recognition at their fair value fewer costs to selling at the point of harvest. It is the cost of the inventories at that date for application of this Standard.

7) Techniques for the measurement of cost

Techniques for the measuring the cost of inventories, such as the method of standard cost or the retail method which may be used for convenience if the results approximate to actual cost.

Standard Cost Method: Cost is based on average materials and supplies, labor efficiency, and capacity utilization. They can be regularly reviewed and revised wherever it is necessary.

Retail Method: Cost can be determined by the reduction of the sales amount of the inventory by the gross margin’s appropriate percentage. The percentage that are used for taking into consideration inventory that have been marked down under its original selling price.

This method can be often used as the retail industry to measure inventories of rapidly changing items with similar margins.
The percentage that can be taken into consideration and inventory that have been marked down to below its actual selling price. An average percentage for each retail department can be used often.

The percentage has to be carefully determined to ensure that it considers the circumstances in which inventory has been marked down to below its original selling price.

Adjustments have to be made to eliminate the effect of these markdowns to prevent any inventories item from being valued at less than its cost and net realizable value. An average percentage for every retail department is used often. Judgment is applied in the retail method in determining the margin to be removed from the selling price of inventory to convert it back to cost.

8) Various cost formulas-

An entity should be using the same formula of cost for all inventories which are having a similar nature and can be useful for an entity. For inventories which are having different nature or different use, different cost formulas may be justified.

For example, those inventories which are used in one operating segment may be used for the various entity from the same type of inventories which is used in another. However, a difference in the environmental location of inventories or according to the respective tax rules, by itself, is not sufficient enough for justifying the use of different cost formulas.

9) Inventory not ordinarily interchangeable

The inventories cost of items that are interchangeable but not in an ordinary manner and goods or services which are produced and segregated for specific projects shall be assigned by using clear identification of their costs. Particular identification of charge can be done in a manner that typical costs are attributed to identify items of inventory.

10) Inventory ordinarily interchangeable

The costs of inventories, other than that, are not interchangeabily ordinary, and goods or services which are produced and segregated for specific projects shall be assigned by using the first-in, first-out (FIFO) or weighted average cost formula.

First-in, First-out Cost Formula (FIFO) assumes that the items of inventory purchased or produced first are sold first.

Hence in such a case, the items remaining in inventory at the end of the period are most recently purchased or produced.

For example, in the case of a perishable goods business, i.e., food retailers will first sell the goods they had purchased at the earliest.
The FIFO method, by allocating the earliest costs incurred against revenue, matches actual price flows with the physical flow of goods reasonably accurately. In the case of other businesses that do not deal in perishable goods, this would reflect what would probably be a sound management policy. In practice, the FIFO method is generally used where it is impossible to value inventory on an actual cost basis.

Weighted Average Cost Formula is suitable where inventory units are identical or nearly identical. It involves computing an average unit cost by dividing the total units by the number of units. The average unit cost has to be revised with every inventory receipt or at the end of predetermined periods.

In practice, weighted intermediate systems are widely used in packaged inventory systems that are computer-controlled. However, its results are not very different from FIFO in times of relatively low inflation or where inventory turnover is relatively fast.

As its name suggests, LIFO (last-in, first-out) is the opposite of FIFO and assumes that the most recent purchases or products are used first. In some instances, this could represent the physical inventory flow (e.g., if a store is filled and emptied from the top). However, it is not an acceptable cost formula under Ind AS 2.

LIFO is an attempt to match current costs with current revenues so that profit or loss excludes the effects of holding gains or losses. Therefore, LIFO is an attempt to achieve something closer to replacement cost accounting for the statement of profit or loss while disregarding the statement of financial position.

The period-end balance of inventory on hand represents the earliest purchases of the item, resulting in stocks being stated in the statement of financial position at amounts that may bear little relationship to current cost levels.

An entity should be using the same formula of cost for all inventories which are having a similar nature and can be useful for an entity. For inventories with a different use or nature, different cost formulas may be justified.

By FIFO formula, it can be assumed that the items of inventory that were purchased or produced first are sold first. Consequently, those items which are remaining in stock at the end of the period are those which are most recently produced or purchased.

Under the formula of weighted average cost, the cost of every item that can be set on from the weighted average of the cost of the same items at the start of a period and similar items cost that can be purchased or even produced during the period. The average might be calculated periodically or as each additional shipment is received, depending upon the entity’s circumstances.

11) Net realizable value

Measurement of net realizable value in Accounting Standards IND AS 2 Inventory is basically a Net realizable value can be estimated by the selling price of the ordinary course of business which is less than the estimated costs of completion and the estimated costs necessary to make the sale. The cost of inventories might not be recoverable if they have been damaged, if they have become partially or wholly obsolete, or if their selling prices have declined.

Estimation of net realizable value can be based on the most reliable evidence available when it is estimating the amount the inventories are expected to realize. These estimates can be considered as the fluctuation of price or cost, which is directly related to those events which are occurring after the end of the period to the extent that such events can confirm those conditions which exists at the end of the period.