Query No. 12 Subject: A. Facts of the Case
1. A company is engaged in transmission, processing and marketing of natural gas. Besides sale to different customers, natural gas is also used internally by the company as a major raw material for the manufacture of LPG, polymers and other value added products and as a fuel. For the transmission of natural gas, the company has laid various pipelines and created other related infrastructure. The company purchases natural gas and transmits it through the pipeline for the purpose of sale to various customers along the pipeline system and for internal consumption.
2. The company earns a marketing margin which is based on the quantity of gas sold and/or is fixed on monthly basis. According to the querist, the marketing margin is meant to reimburse the cost incurred by the company on transmission of gas sold and to provide it a profit margin. According to the querist, it is not possible to segregate the marketing margin between the elements of cost and profit.
3. At the year end, some natural gas is there in the pipelines. The company considers only the cost of purchase for the purpose of computing the cost of the inventory.
B. Queries
4. The querist has sought the opinion of the Expert Advisory Committee on the following issues:
(a) For the purpose of computing the cost of inventory of natural gas in the pipelines, whether the entire amount of the marketing margin in addition to the purchase cost to the company should be considered or whether the cost of the inventory should be computed on the basis of the purchase cost of natural gas only. In case the answer to both is in the negative, how should the cost of inventory of natural gas be computed?
(b) Whether the cost of natural gas used or to be used for the manufacture of LPG, polymers and other value added products should be computed based on the purchase cost of natural gas to the company or whether the entire amount of the marketing margin should also be considered in addition to the purchase cost. In case the answer to both is in the negative, how should the cost of raw material (i.e., natural gas) be computed?
C. Points Considered by the Committee
5. Accounting Standard (AS) 2, ‘Valuation of Inventories’, requires (paragraph 5) that “inventories should be valued at the lower of cost and net realisable value”.
6. Paragraph 6 of AS 2 requires that “the cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition”. Paragraph 8 of AS 2 recognises that the costs of conversion of inventories include costs directly related to the units of production as also a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. AS 2 further recognises that other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition (paragraph 11). AS 2 also states that in determining the cost of inventories, it is appropriate to exclude certain costs such as selling and distribution costs (paragraph 13).
7. The Committee is of the view that the determination of cost of inventories should be in accordance with paragraph 6 of AS 2. Thus, apart from cost of purchase of natural gas, the cost of inventory should also include other costs incurred in bringing the inventory to its present location and condition.
8. As far as gas meant for supply to customers is concerned, the Committee is of the view that the costs incurred in transportation of gas through the pipelines represent distribution costs and should not therefore be included in valuing year-end inventory of gas meant for sale to various customers.
9. As far as gas meant for internal use by the company is concerned, the Committee is of the view that the costs incurred in transportation of the gas to different locations (e.g., repairs and maintenance costs and depreciation of pipelines) are in the nature of freight costs in respect of raw materials/fuel should be added to the purchase price of gas for purposes of inventory valuation. In this regard, the Committee takes note of the observation made by the querist that it is not possible to segregate the transmission costs incurred by the company. The Committee is of the view that for proper valuation of inventories, it would be necessary to make a reasonable estimate of such costs (unless they can be considered to be immaterial under the facts and circumstances of the case). For example, repairs and maintenance costs and depreciation of a pipeline system can be allocated to gas transmitted for sale and gas transmitted for internal use on the basis of the respective quantities.
10. The Committee is of the view that as the marketing margin includes an element of profit, its inclusion in determining the cost of inventory would not be in consonance with AS 2. The cost of inventory should be arrived at in the manner specified in paragraphs 8 and 9 above.
D. Opinion
11. Based on the above, the Committee is of the following opinion on the issues raised in paragraph 4:
(a) In respect of gas in pipelines at the year end which is meant for supply to customers, the costs of transportation of gas to the locations of customers represent distribution costs and should not, therefore, be included in valuing the year-end inventory. The valuation should be with reference to the cost of purchase of gas.
(b) The cost of year-end inventory of gas meant for internal use should be determined by adding to the cost of purchase those costs that are incurred for bringing the gas to its present location and condition. Thus, costs of transmission should be included in the cost of year-end inventory (besides any other costs incurred for bringing the gas meant for internal use to its year-end location and condition).
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