Query No. 34 Subject: Inclusion of interest in valuation of inventories.[1] A. Facts of the Case 1. A public sector company manufacturing fertilizer has been consistently including interest on short term loans in valuing its finished stock.
2. The CAG has been commenting on the above inventory valuation practice since the year 1992-93. The comments on the accounts for the year 1997-98 are stated below:
“Schedule 6 – Inventories Rs. 236.73 crore
This includes Rs. 6.11 crore being the interest on short term loans which should be excluded for the purpose of valuation of inventories as per Accounting Standard (AS) 2, ‘Valuation of Inventories’. The company continues to include interest on short term loans for valuation of inventories despite comments in earlier years. The inclusion of interest has resulted in overvaluation of inventories by Rs. 6.11 crore.”
3. The company, in its reply to the above comment, stated as below:
“In fertiliser industry, the sales are seasonally spread over a maximum period of 6 to 7 months, that is, from July thru September in the Kharif season and October thru January in the Rabi season. The entire sale in the year is made during these seven months but the production has to be continuous in view of the very nature of a process industry. Fixed costs are high in fertilizer companies and the plants have to be operated at high capacity utilisation on a uniform basis to achieve optimal contribution towards recovery of fixed costs. The seasonality of sales coupled with the necessity to maintain production uniformly and at high levels throughout the year, after providing for maintenance shutdowns, involves tie up of a substantial amount of working capital by way of cash credits (short term loans) from company’s bankers for manufacturing and positioning the inventories in the location for meeting sales demand. The interest on short-term borrowings, therefore, forms a major item of expenditure directly linked to manufacture and exclusion of the same in inventory valuation will not reflect the correct value of the inventories. The ultimate realisation by sale of these inventories is much more than the cost at which these inventories have been valued.
Therefore, inventory valuation has to be, as far as possible, practicable and consistent with normally accepted accounting principles. The corporates are free to value inventory on the basis of any method as long as it is fair and proper. AS 2 seeks only to narrow down the differences in the current practice of inventory valuation by corporates.
Inasmuch as the company is consistent in including interest on short term loans and consistency in valuation is maintained as per the requirement of AS 2, inclusion of interest on short term loans amounting to Rs. 6.11 crore is fair and as per accepted practice, especially in view of the fact that fertilizer is a seasonal product.”
4. According to the querist, the company had taken the above stand on the basis that Accounting Standard (AS) 2, ‘Valuation of Inventories’ was not mandatory (in respect of the accounts for the year 1997-98). As per the querist, the company had also intended to follow AS 2 once it became mandatory.
5. The company is in the process of financial restructuring and consequently, the accounting period that commenced on 1.4.1998 has been extended to 30.9.1999.
6. The revised Accounting Standard (AS) 2, ‘Valuation of Inventories’, comes into effect in respect of accounting periods commencing on or after 1.4.1999 and is mandatory in nature.
B. Query
7. The opinion of the Expert Advisory Committee has been sought on the issue whether the company can follow its earlier practice of inclusion of interest for valuation of inventories for the period ending 30.9.1999, on the ground that revised AS 2 is not mandatorily applicable to the company since the company’s accounting period commenced prior to 1.4.1999.
C. Points considered by the committee
8. The Committee notes that the revised AS 2 is mandatory in respect of accounting periods commencing on or after 1.4.1999. As such, the revised standard is not mandatory for the accounting period which commenced in April, 1998, notwithstanding that it has been extended to 30.9.1999.
9. The Committee notes paragraphs 6.2, 16 and 28 of the erstwhile AS 2 which state as below:
“6.2 Historical Cost represents an appropriate combination of the
“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.”
10. Based on paragraphs 6.2, 16 and 28 of erstwhile AS 2 reproduced above, the Committee is of the view that the sole criterion for determining whether interest should be included in valuing inventories or not is whether it relates to putting the inventories in their present location and condition. According to the Committee, the magnitude of interest and seasonal nature of sale of an item are not the determining factors for inclusion of interest in valuing inventories.
11. The Committee also notes that the aforesaid standard recognises that interest does not usually relate to putting the inventories in their present location and condition. Thus, it is only in exceptional circumstances that interest can be considered to be related to putting the inventories in their present location and condition. Two common examples are timber and liquor whose physical condition undergoes a change during the period they are stored for seasoning/maturing. However, in the case of fertilizer, no such change occurs during the period it is held in store pending sale. Accordingly, the Committee is of the view that inclusion of interest in valuation of inventory of fertilizer is not proper. This treatment cannot be considered acceptable even in respect of an accounting period that commenced before the date on which the revised AS 2 came into effect as a mandatory accounting standard. The Committee is further of the view that consistency cannot be a justification for continuing to adopt an inappropriate accounting treatment.
D. Opinion
12. On the basis of the above, the Committee is of the opinion that under the facts and circumstances of the case, interest cannot be included in valuing inventories.
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[1] Opinion
finalised by the Committee on 14.1.2000.
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