1.32 Query Valuation of inventories.
1.A company in engineering industry is engaged in the manufacture of machines, machine tool accessories, industrial forgings and castings. In the recent past, the company has taken up manufacture of CNC machining centres in collaboration with a world renowned company of Japan, involving an investment of around Rs. 10 crores. This machine is highly sophisticated with high precision and numerically computer controlled features. On account of addition of this product to the existing range of manufacture, the company can be classified as a heavy engineering unit.
2.The above manufacturing activities are carried out in three different divisions, viz., Machine Tool Division, CNC Division and Forge & Foundry Division. The Machine Tool Division is basically engaged in the manufacture of standard machines like cutter and tool grinder, surface grinder milling machine, thread rolling machine, GF copy lathe, etc. The CNC Division provides facilities for manufacture of CNC machining centres, CNC lathes, etc. The Forge & Foundry Division manufactures industrial forgings and casting.
3. The manufacturing cycle in the case of standard machines ranges from 2 to 3 months, whereas in the case of CNC, it is about 8 to 10 months. The production of CNC machining centres involves manufacture and assembly of a side rage of components from 1,500 to 3,500. Some of the components are bought-out items which require a lead time of 4/5 months. Since the optional facilities provided on these machines vary from customer to customer, it is not possible to standardise these components.
4.The components required for the above machines are basically of two types, viz., mechanical components and CNC systems. The CNC systems are imported from Japan alongwith a few mechanical components. The supply of systems takes longer time as these are to be designed and manufactured separately as per optional features required by the customer. Therefore, the lead time for its importation is in the range of 8 to 10 months. Further, the supplies are normally delayed on account of import formalities and certain restrictions imposed by Government of Japan. On account of these peculiar circumstances, the semi-finished machines in the form of work-in-progress remain on shop floor blocking the working capital for a considerably long time. The completion of the machines is ultimately linked with the receipt of CNC systems. In view of Hi-tech/Multi-product nature of the company it is necessary to have high holding of inventory of indigenous and imported components for ensuring the regular production process.
5.Keeping in view the circumstances and nature of the company’s manufacturing cycle, it is felt by the querist that it is appropriate to include financing charges for the valuation of inventory as these charges clearly relate to bringing the inventories to their present position and location (Emphasis supplied by the querist). As per the present accounting policy followed by the company, for the purpose of computing the cost of each product manufactured, overhead expenses in respect of all the basic production units are calculated and are absorbed in the cost as a percentage on direct labour cost. While calculating the overhead percentage, the following expenses are also included in overheads:
1) Financing charges representing the interest on loans from Government of India basically for capital expenditure, interest on foreign currency loans/ deferred credit loans, interest on cash credit/ export packing credit and interest on working capital loans.
2) Expenses on centralised service departments like Finance & Accounts, Purchase, Personnel, Stores, etc.
3) Prior period expenses.
The above expenses are included in overheads and overhead percentage so computed has been adopted for valuing inventories of work-in-process and finished goods. This method is being consistently followed by the company for the past several years. The above expenses, specially the financing charges, are considered high due to longer manufacturing cycle of the products manufactured by the company and hence it is appropriate, as per the querist, to treat them as manufacturing expenses and include the same in overhead expenses. The company is of the view that the exclusion of these expenses from overheads is not proper in view of their quantum as well as the nature and circumstances of the business. Exclusion of these expenses will only result in under-valuation of inventories. Consequently, the profit will also be understated.
6.While auditing the accounts of the company for the year ended 31st March, 1989, the Government Auditors objected to the inclusion of financing charges in computation of overhead expenses on the plea that the procedure followed is not in consonance with the Accounting Standard (AS) 2, issued by the Institute of Chartered Accountants of India, on ‘Valuation of Inventories’. The company has expressed the view that the Accounting Standard issued by the Institute is not to be applied to all types of organisations uniformly as the nature of the business and circumstances will differ from company to company. The details of the comments of the C. & A.G. and company’s replies thereto have been supplied by the querist.
7.The querist has sought the opinion of the Expert Advisory Committee on the following issues:
(a) Considering the nature of the business of the company, it may be clarified whether the procedure followed by the company is proper.
(b) Whether the guidelines indicated in the Accounting Standard (AS) 2 issued by the Institute are to be followed by all the companies irrespective of the nature of the business.
(c) In case the financing charges are to be excluded, it may be clarified whether financing charges incurred on long term loans for capital expenditure are also to be excluded.
(d) Whether administrative overheads and share of head office expenses are also to be excluded from overheads for the purpose of valuation of inventories.
Opinion August 3, 1990
1.The Committee notes paragraphs 5, 6.2, 6.4, 16 and 28 of Accounting Standard (AS) 2 on “Valuation of Inventories”, issued by the Institute of Chartered Accountants of India, which recommend, as below: “5. This statements applies to valuation of all inventories except inventories of the following to which special considerations apply:
(i) Plantations, forestry, agricultural commodities and live stock;
(ii) Extractive industries such as mining, quarrying etc;
(iii) Work-in-progress under long-term contracts, such as engineering, real estate development and construction projects;
(iv) Shares, debentures and other securities held as stock-in-trade;
(v) Immovable properties;
(vi) Loose tools.
6.2 ‘Historical Cost’ represents an appropriate combination of the
a) cost of purchase;
b) cost of conversion; and
c) other costs incurred in the normal course of business in bringing the inventories up to their present location and condition.
6.4 ‘Cost of Conversion’ consists of
i) costs which are specifically attributable to units of production, i.e., direct labour, direct expenses and sub-contracted work; and
ii) production overheads, ascertained in accordance with either the direct costing or absorption costing method.
Production overheads exclude expenses which relate to general administration, finance, selling and distribution.
16. Costs other than production overheads are sometimes incurred in bringing inventories to their present location and condition, for example, expenditure incurred in designing products for specific customers. On the other hand, selling and distribution expenses, general administration overheads, research and development costs and interest are usually considered not to relate to putting the inventories in their present location and condition. They are, therefore, excluded from determining the valuation of inventories.
28. Overheads other than production overheads should be included as part of the inventory cost only to the extent that they clearly relate to putting the inventories in their present location and condition.”
2.The Committee is of the view that Accounting Standard (AS) 2 is applicable to the company referred to in this query.
3.The Committee is of the view that although finance charges, expenses on centralised service departments, head office expenses, research and development costs and prior period expenses are incurred for the purposes of business, yet these costs are not directly related in effecting change in the present location and condition of inventory items. Only in exceptional cases the said costs can be considered to be directly related in putting certain inventories in their present location and condition. For instance, interest cost, which is a period related cost, can be included in the valuation of inventories of timber for the period it is kept in store to enable it to mature so that it could be sold in that condition; in this case there is a clear change in the condition of inventory during the period it was lying in store. However, in the facts and circumstances of the query, no direct nexus can be established in the incurrence of finance charges, expenses on centralised service departments, head office expenses, research and development costs, prior period expenses, etc., and the change in the present location and condition of the inventories. The quantum of the interest expense and the length of the production period cannot in themselves be considered as the justifications for the inclusion of interest in the cost of inventories.
4.The Committee is of the following opinion in respect of the issues raised in para 4 of the query:
(a) The procedure followed by the company for valuation of inventories is not correct.
(b) The recommendations contained in Accounting Standard (AS) 2 are expected to be followed in all cases, except in respect of the inventories mentioned in para 5 of the Accounting Standard reproduced above.
(c) The financing charges, including the financing charges on long term loans for capital expenditure, are not to be taken into account for the valuation of inventories.
(d) Administrative overheads and share of head office expenses, (presumably the administrative expenses), should not be included in the overheads for the purpose of valuation of inventories.
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