1.24 Query: Valuation of inventories.
1.A Company manufacturing super phosphate and sulphuric acid, up to the year ended 31.3.1989, used to value its finished products at lower of cost or market value. During the year ended 31.3.1990, the company has changed the method of valuing finished stocks from lower of cost or market value, to cost, irrespective of the market value. The net realisable value is lower than the cost. The company contends that it is going to value at cost on consistent basis for all future years. This policy of valuing finished stocks at cost is explained by way of a note on accounts which reads as under:
“Note 9(b): There has been a change in the method of valuation of closing stock of finished goods which has been valued this year at ‘cost’, whereas in the previous period, the same had been valued at lower of cost and net realisable value. Had the company followed the method of valuation adopted in the previous period, the value of closing stock would have been lower by Rs. 14,28,503/- and the loss for the year higher by the amount”.
2. Further, the term ‘cost’ includes finance charges. This policy is explained by way of a note to the accounts as under:
“Note 9(a): The company follows the practice of valuing stock of finished products at cost. The term ‘cost’, however, includes finance charges which is considered fair and appropriate to the circumstances of the industry to which the company belongs. The quantum of finance charges is Rs. 29,41,122/- (Previous year Rs. 17,02,252) and, consequently, the value of socks will go down by similar amount, if the finance charges are excluded”.
3. In the opinion of the querist, the above policy is not in accordance with the normally accepted accounting principles, and, that the following qualifications should be included in the auditor’s report.
(a) In the main audit report:
“Subject to note 9(a) of schedule 17 regarding inclusion of finance charges of Rs.29, 41,122/- for the purpose of valuation of finished stocks contrary to the recommendation of the Institute of Chartered Accountants of India and the corresponding increase in the value of finished stock by Rs.29, 41,122/- and its resultant impact in reducing the net loss of the year by Rs.12, 38,870/- after adjustment of this effect on opening stock.
Note 9(b) of schedule 17 regarding the change in the method of valuation of closing stock of finished products to cost from lower of cost and net realisable value resulting in increasing the value of the finished stock by Rs.14, 28,503/-, its resultant impact in reducing the net loss of the year by Rs. 17,28,503/- and subject to __________”.
(b) In the report under Section 227(4A) paragraph (vi).
In our opinion and on the basis of examination, the valuation of stocks is fair and proper except that finance charges are considered as part of the finished stock, which is contrary to the recommendation of the Institute of Chartered Accountants of India. (Refer to note 9(a) on schedule 17). Further, there is a change in the method of valuation of finished stocks to cost as compared to the previous period wherein stocks were valued at cost or net realisable value whichever is lower, which is contrary to the normally accepted accounting principles. If the company had continued the same basis of valuation, the value of closing finished stock would be lower by a sum of Rs. 14,28,503/- (refer to note 9(b) of schedule 17).”
4. The company intends to continue the same basis of valuation during the current year also.
5. The querist has sought the opinion of the Expert Advisory Committee on the type of qualification to be made in the light of the above for the current year which will end on 31.3.1991, in both
(a) The main audit report, and
(b) The report under Section 227(4A), para (vi).
Opinion May 29, 1991
1. The Committee notes that para 24 of Accounting Standard (AS) 2 on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, inter alia, recommends as below:
“………….. inventories should be valued at lower of historical cost and net realisable value.”
2. The Committee further notes that para 16 of Accounting Standard (AS) 2 recommends as below:
“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.”
3.The Committee is accordingly of the view that the accounting policy regarding valuation of finished stock at cost and inclusion of finance charges in the cost of finished goods is not proper in the facts and circumstances of the case.
4. Regarding manner of the making a qualification in the main report of the auditors, the Committee notes that paras 3.7, 3.10 and 3.16 of the Statement on Qualifications in Auditor’s Report, issued by the Institute of Chartered Accountants of India, state as follows:
“3.7 In a majority of cases, items which are the subject matter of qualification are not so material as to affect the truth and fairness of the whole of the accounts but merely create uncertainty about a particular item. In such cases, it is possible for the auditors to report that in their opinion but subject to the specific qualifications mentioned, the accounts present a true and fair view. Sometimes, however, the items which are the subject matter of qualification are so material that it would be meaningless to state, that subject to the qualification, the accounts disclose a true and fair view. An extreme example would be where the auditors were not able to examine a substantial part of the books of account, e.g., they were in police custody. In such a case it would not be proper to express an opinion on the truth and fairness of the accounts after merely stating that the books of account were not examined. In such cases the auditors must report that either-
(i) They are unable to state whether the accounts present a true and fair view; or
(ii) Make a categorical statement that in their opinion the accounts do not present a true and fair view.
Which of the above two alternatives should be followed would depend upon the facts of each case. An example of a situation referred to in paragraph 3.7 (ii) is as follows:
(a) The company has adopted the method of taking entire profits on construction contracts to the Profit and Loss Account on entering into the contract. This has resulted in anticipating the profit in cases where contracts have not even been commenced or where only a very minor part of the expenditure on the contract has been incurred. We are of the opinion that this method of accounting is contrary to accounting principles and methods;
(b) In view of para (a) above, we are of the opinion that the said accounts do not give a true and fair view -
(i) In the case of the Balance Sheet, of the state of affairs of the company as at 31st March, 1980; and
(ii) In the case of the Profit and Loss Account, of the profit of this year ended on that date.
3.10 All qualifications should be contained in the auditor’s report. The notes to accounts normally represent explanatory statements given by the directors of the company and should not contain the opinion of the auditors. The practice has also grown recently of having a large number of notes to accounts, some of which are subject matter of qualification in the auditors’ report and some of which are merely clarificatory. It is necessary that the auditors should reproduce the notes of a qualificatory nature in their report to enable the reader to know the importance of these qualifications. It is also necessary that the auditors should quantify, wherever possible, the effect of these qualifications on the financial statements in clear and unambiguous manner if the same is material. In circumstances where it is not possible to quantify the effect of the qualifications accurately, the auditor may do so on the basis of estimates made by the management after carrying out such audit test as are possible and clearly indicate the fact that the figures are based on management estimates.
3.16 It is also not a good practice to qualify with reference to a report made in an earlier year because all the shareholders may not have access to such reports. The following type of statement should be avoided:
“The position of advance to ABC amounting to Rs……….remains the same as explained in our last report”
Each year’s accounts being independent, the essential facts relating a qualification made in an earlier year must be repeated where appropriate.”
5. The Committee notes that para 4(A) (vi) of MAOCARO, 1988, requires as follows:
“Whether the auditor, on the basis of his examination of stocks, is satisfied that such valuation is fair and proper in accordance with the normally accepted accounting principles? Is the basis of valuation of stocks same as in the preceding year? If there is any deviation in the basis of valuation, the effect of such deviation, if material, should be reported.”
6. With regard to auditor’s report under MAOCARO, 1988, the Committee notes that as per para 4(A)(vi) of the said Order, the auditor is required, inter alia, to affirm or dis-affirm whether valuation of stocks is fair and proper in accordance with the normally accepted accounting principles. Thus, where it is not so, the auditor should state that the valuation of stocks is not in accordance with the normally accepted accounting principles, indicating reasons therefor.
7. The opinion of the Committee, on the issues raised by the querist in para 5 of the query is as follows:
(a) In case the auditor feels that keeping in view the materiality of the amounts involved, the matter requires qualification and not expression of an adverse opinion, the main report for the year ended 31.3.1991, should be qualified and the qualification should contain the following points:
(i) That the company is valuing its stocks at ‘cost’ instead of “lower of cost and net realisable value”. Further, in valuing the closing stock at cost, the company has included finance charges in ‘cost’. This is not in accordance with principles of valuation of inventory as laid down in Accounting Standard (AS) 2 on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, which recommends, inter alia, that the inventories should be valued at “lower of cost and net realisable value” and that the finance charges should not normally be included in the cost.
(ii) As a consequence to this, the opening stock is overvalued by Rs… and the closing stock has been overvalued by Rs… resulting into increase/reduction of loss by Rs…
(b) Under the relevant clause [Para 4A(vi)] of MAOCARO, 1988, the report of the auditor should, inter alia, contain the following points:
(i) The valuation of finished stock is not fair and proper being not in accordance with normally accepted accounting principles as the finished stocks are valued at ‘cost’ instead of ‘lower of cost and net realisable value’, and the ‘cost’ includes finance charges.
(ii) This basis of valuation of finished stock is the same as that in the previous year. __________________________ |