The Institute of Chartered Accountants of India (ICAI) has created standards for India to improve consistency, openness, and reliability in financial statement presentation and preparation. They enable uniformity across several businesses by defining how accounting events and transactions are to be acknowledged, measured, and disclosed.
Accounting Standards’ main aim is to improve the reliability and comparability of financial data such that investors, regulators, and other stakeholders may make wise judgments. Their aim is to minimise discrepancies in accounting systems and guarantee that an organisation’s performance and financial condition are accurately reflected in financial statements.
Depending on their size, nature, and listing status, businesses in India must follow either Accounting Standards (AS) or Indian Accounting Standards (Ind AS), therefore bringing Indian financial reporting equivalent to global accounting standards.
What is Accounting Standard 2 (AS-2)?
The Institute of Chartered Accountants of India (ICAI) has prepared Accounting Standard (AS) 2 – Valuation of Inventories, which specifies the practice of valuing inventories in financial reports. The main aim of AS-2 is to ensure that inventories are accounted for and disclosed at a value that is reflective of their real worth, thus presenting a fair and consistent basis for determining profit and evaluating financial position.
AS-2 requires that the inventory is to be valued at the lower of the cost and net realisable value (NRV). “Cost” includes all the expenses of bringing the inventory to its present location and condition, which include the purchase price, conversion costs, and other directly related costs. Net realisable value is an estimated selling price in the normal course of business, minus the estimated cost of completion and selling.
This standard can be applied to the majority of inventories, including finished goods, work-in-progress, as well as raw materials, with the exception of work-in-progress under construction contracts and financial instruments.
AS-2 ensures consistency, reliability, and prudence in financial reporting by avoiding overstatements in profits or assets. It is important for the provision of transparency and comparability among different enterprises.
Valuation of Inventories
Accounting Standard (AS) 2 values inventory on the basis of “lower cost and net realisable value (NRV)”. By cost, we mean all the expenses incurred in order to bring the inventory to its current location and condition. It includes the following factors:
- Cost of purchase, including the cost of purchase, duties on importation, freight cost, and other directly connected costs. Trade discounts, rebates, and the like do not come under this category.
- Conversion Cost – It consists of the cost of production, like labour, fuel, and fixed and variable overheads incurred in converting raw material into finished goods.
- Other Costs – Costs of inventory preparation, such as design or product development, can also be included.
- Excluded Costs – The AS-2 directly excludes abnormal waste, storage expenses (unless necessary for production), administrative overhead, selling and distribution expenses, as well as interest or borrowing charges.
Therefore, the cost terminology adopted in inventory valuation ensures that only those costs bearing a direct relationship with the manufacturing or acquisition of inventory are taken into account.
Methods of Valuation of Inventories
Inventories account for a significant percentage of the current assets of a company and have a direct impact on the cost of goods sold, gross profit, and net income. As such, the method of inventory valuation used is critical in ensuring that the financial reports are truly reflective of the company’s financial performance and position.
AS-2 requires inventories to be carried at lower cost or net realisable value (NRV). “Cost” includes all costs borne in bringing the inventory to its current location and condition, whereas “NRV” represents the estimated selling price in the ordinary course of business, less the estimated costs of completion and the expected costs necessary to complete the sale.
But the expense depends on the method of inventory valuation followed by the company. AS-2 identifies various methods of approximation of inventory costs, differing according to the kind of business, type of inventory, and compliance with accounting principles.
1. Specific Identification Method
The specific identification method is used when every item in the inventory can be clearly identified and its cost directly assigned to it. This technique is specifically useful for non-interchangeable items or projects custom-made for a single customer.
Under this approach, the real cost of the individual item is assigned to the item when it is sold or in stock. Although it provides a very high level of precision, it is not practical for companies dealing with huge volumes of similar or substitute products. Moreover, scope for fraud in deciding which items are considered sold (particularly in changing price conditions) can lead to inaccurate reporting of profit.
2. First-In, First-Out (FIFO) Method
The FIFO method works based on the assumption that the products bought or produced first are sold or distributed first, while the most recent purchases form the ending inventory. The ending inventory is thus valued at the latest or current market prices, whereas the cost of goods sold is a representation of the costs incurred on the older layers of inventory.
FIFO is a long-standing technique that is consistent with the physical flow of goods in most companies (like perishables and consumables). In periods of rising prices, FIFO gives a lower cost of goods sold and a higher valuation of closing stock, thus improving reported profits. In a situation of falling prices, profits are negatively impacted.
AS-2 recognises FIFO as a reliable and systematic approach to inventory valuation since it reflects an orderly pattern of movement of goods and provides a fair estimate of closing stock.
3. Weighted Average Cost Method
The weighted average cost method calculates costs of sales and inventories by averaging all similar items available within a given time. In order to arrive at the average, one should divide the total cost available for sale by the total units available for sale.
This approach reduces the effect of price changes over time by including current and historical purchase prices within the average. It is most appropriate for bulk commodities and homogeneous goods, including chemicals, cereals, or petroleum, in which individual items are not distinguishable.
AS-2 approves of this approach in industries where it is not practicable to trace individual costs and where stability of prices is desirable in the process of valuation.
4. Standard Cost Method
The standard cost method evaluates inventories at a fixed cost based on average levels of materials, labour, efficiency, and capacity utilisation. This standard cost is periodically reviewed and corrected to reflect existing market conditions.
Although this system simplifies cost control and record-keeping, AS-2 does necessitate that any difference between the actual cost and the standard cost be regularly examined and revised so that the cost of inventory reported closely equals the actual cost.
This method is appropriate in mass production industries with repetitive operations which already apply conventional costing techniques to performance evaluation and cost control.
5. Retail Method
The retail method is widely applied in the retail sector, where large amounts of frequently changing products are merchandised, and hence it is not easy to track the cost of every item separately. Under this method, the inventory cost is calculated by dividing the sales value by the relevant gross margin percentage.
This approach gives a rapid approximation but is not as precise as FIFO or weighted average techniques. Therefore, AS-2 recommends its adoption only when other methods are not practicable, on condition that the markup percentages are consistent and actually represent the true margins.
Important factors under AS-2
- Select a process that is systematic and consistent. Variations in technique should be avoided unless required due to a change in circumstances.
- Make visible the process and its impact on financial performance in the financial statements.
- Value inventories at cost or net realisable value to avoid overstatement.
AS-2 gives detailed instructions regarding the acceptable methods of inventory valuation to create consistency and transparency in financial statements. The method adopted depends upon the nature of the firm and the nature of the inventory held. All have their own strengths and weaknesses, but serve to determine the most precise cost estimate with care through their comparison with net realisable value. Using an even-handed and logical inventory valuation technique strengthens financial statements’ credibility as well as facilitates informed decision-making for the firm.
Conclusion
Accounting Standard (AS) 2 – Valuation of Inventories is critical in making sure that inventories are correctly valued and properly reflected in financial reports.
AS-2 promotes prudence and consistency in accounting practice by requiring that inventory be accounted for at the lower of cost and net realisable value (NRV).
This standard helps to prevent overstatement of profits and assets by highlighting possible losses in inventory at an early point in time, as well as promoting consistency in valuation across various organisations.
The standard is very explicit with regard to what should be considered as the cost of inventory, appropriate methods for ascertaining costs, and excluded items.
Compliance with AS-2 increases the reliability, comparability, and transparency of financial statements, thus increasing stakeholders’ confidence and enabling informed decision-making.
Overall, AS-2 provides for inventory valuation to be consistent with accepted accounting principles and aids in the accurate reflection of the financial status of a company.
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