1.7 Query: Valuation of inventories.
1. An information technology company offers, both in India and abroad, a range of services and solutions in the area of information technology, comprising mainly of systems maintenance, systems design and development, systems engineering, consultancy, installation, training and total facilities management. The company maintains every size and make of computer system of over 40 international manufacturers such as IBM, HP, DEC, Control Data, Sun etc. It has been the experience of the company, as per the querist, that the original equipment manufacturers do not continue to provide spare part support in view of the continuous technological development/advancement taking place in the advanced nations of the world, resulting also in rapid obsolescence and discontinuance of manufacture of old models of machines and spare parts thereof. Thus, considering the unique nature of its business as a third-party maintenance company, the company has to keep stock of spares for the maintenance of computer systems under its maintenance all over India. This inventory of spares, as per the querist, is not held for resale.
2.The querist has stated that inventory is valued at historical cost on weighted average basis. This policy has been consistently followed and disclosed in the Annual Accounts. (The querist has submitted a copy of the Annual Report 1992-93 for the perusal of the Committee). Consumption of spares is also booked at weighted average cost. As the spares inventory comprises more then 60,000 spare parts of 70-80 different manufacturers, as per the querist, it is impractical to find out the realisable value of this holding at any given point of time.
3.The querist has further stated that every year obsolete and surplus inventory is identified and is stated at assessed realisable value that is usually taken at 1% of the cost. The identification of obsolete/surplus inventory is done by a standing Inventory Advisory Committee (IAC), that studies various factors that contribute to efficient maintenance support to the company’s customers, the most notable one being availability of spares for reducing machine downtime, and the consequent requirement of maintaining inventory of spares to reduce downtime to the minimum possible. As per the querist, even though the normal life of a computer system is six to seven years, the company is usually required to maintain machines beyond this period. Therefore, it is not possible to write-off all spares in the year of purchase or adopt the usual criteria of writing off depending on its age/movement.
As per the querist, every year, surplus/obsolete inventory is identified by the IAC according to the following norms for specific items of spares:
(i) Moved inventory – retain all.
(ii) Non-moved inventory
a. Non-moved in last four years, but moved in last seven years:
- If unit rate is less then Rs.501/-, retain all
- If unit rate is more then Rs.500/-, but less then Rs.5001/-, retain 50% quantity.
- If unit rate is more than Rs.5000/-, retain one unit and write off balance quantity.
b. Non-moved in last seven years, write-off total quantity.
(iii) Inventory of spares pertaining to machine types not under company’s maintenance as at year-end, write-off total quantity.
(‘Moved inventory’ is defined as that where minimum one issue and/or receipt has taken place during the last four years).
4. The statutory auditors of the company however have expressed the following view in this regard- “The basis of valuation of stocks is not fair and proper, in accordance with normally accepted accounting principles and is on the same basis as in the preceding year. The maintenance inventory is valued at cost. The company is in the business of maintenance of computers and keeping in view the fast changing technology in computers the inventory is becoming obsolete very fast. Moreover, as the realisable value of obsolete inventory is about 1% of cost, we are of the opinion that the same should be valued at cost or net realisable value whichever is lower.”
5. The querist has sought the opinion of the Expert Advisory Committee with regard to the following:
(a) Is the abovestated method of valuation of spares inventory fair and proper and in accordance with the generally accepted accounting principles?
(b) In view of the high rate of obsolescence in the ‘information technology’ industry, would either of the following two methods of writing down the value of inventory be fair and proper.
Method I
Inventory of spare parts which has not moved during the last three years, may henceforth be written down by 24.75% of the purchase price every year. That is, if a part remains unmoved beyond three years, it should be written off at the rate of 24.75% of the purchase price per year from the fourth year onwards, and it will thus be completely written off in the seventh year.
Method II
All items of spare parts inventory which are more than one year old as of 31st March of every year, shall be written down at the rate of 16.5% of the purchase price per annum, i.e., the spares remaining unmoved would be written off to the extent of 99% at the end of the seventh year.
However, all spare parts exclusively pertaining to a system which no longer fall under the company’s maintenance would be written off in the year the system goes out of the company’s maintenance.
In order to maintain a physical control on the written off spare parts till they are disposed off, they shall be retained at the notional value of 1% in the books of account.
(c) Should the said inventory of spares be valued at lower of historical cost or net realisable value in accordance with Accounting Standard (AS) 2 on ‘Valuation of Inventories’? If so, what could be the suggested methodology of having the spares valued considering the difficulty involved in having the very large number of spares procured from such a broad spectrum of manufacturers and also keeping in mind that the inventory is of a very specialised nature of which perhaps the company is the only stockiest in the whole country. Opinion May 17, 1994
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 that “Inventories should be valued at lower of historical cost and net realisable value.” The Committee further notes that the term ‘Net realisable value’ has been defined in para 6.9 of the said accounting standard as “ The actual/estimated selling price in the ordinary course of business, less cost of completion and cost necessarily to be incurred in order to make the sale.”
2. The Committee also notes para 19 of Accounting Standard (AS) 2, issued by the Institute of Chartered Accountants of India, which reads as follows:
“19. Normal quantity of materials and other supplies held for use in production are not written down below historical cost if the finished goods are expected to be sold at or above historical cost.”
3. The Committee notes from the facts of the query that the company normally holds inventory of spares for use in provision of services to its clients and not for re-sale in the market.
4. On the basis of the above, the Committee is of the following opinion in respect of the issues raised at para 5 of the query:
(a) The company may continue to value its normal inventory of spares which is held for, and expected to be ultimately used in, provision of services to its customers at historical cost, if the revenue from provision of such services is expected to cover the cost incurred, including the cost of such spares. The inventory which is determined as obsolete/surplus, i.e., which is not expected to be consumed in the normal course of business of the company (such as inventory of spares pertaining to machine types no longer under company’s maintenance) should be valued at lower of cost or net realisable value. With regard to the determination of the net realisably value of obsolete/surplus items of inventory at 1% of cost, the policy appears to be proper in the facts and circumstances of the case. Insofar as the method for ascertainment of obsolete/surplus inventory items is concerned, the Committee is of the opinion that it would depend on the facts and circumstances of each case.
(b) In view of (a) above, none of the methods suggested by querist in para 5 (b) of the query is correct.
(c) Refer to (a) above. _____________________________
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