Query No. 27

Subject:   

A.  Facts of the Case

1. A company is engaged in the manufacture of autocatalysts.  The raw materials used for production are precious metals and substrates.

2.  Metal market prices undergo continuous fluctuations.  The company hedges against these fluctuations by setting the metal prices in each specific sale to customers at the time of confirmation of the purchase order at exactly the purchased metal price.  This mechanism is contractually agreed with the customers.  The metal so bought against specific orders is termed as ‘hedged’ metal.  However, the company requires some base stock to ensure continuation of the production process.  The metal bought to form the base stock is termed as ‘unhedged’ metal since the fluctuation in such metals is not secured by way of an agreed selling price with the customer.

3. The physical metal stock is generally used on the FIFO basis.  However, for recording consumption for a specific order, the metal is taken, in the stock records, from the consignment of the hedged metal purchased for that specific order.  Accordingly, even if the unhedged metal might have been used in the production process (later to be replenished by the hedged metal), consumption is recorded from hedged metal.

4. The physical metal stock is not segregated on an individual consignment basis as the items of stocks are interchangeable.  The total stock does, however, agree with the books.  The books facilitate identification of the stock and purchase cost of the hedged and unhedged metal.  According to the querist, in this manner, the books follow the matching principle by matching purchase cost with sales revenue correctly.  However, in doing so, the company follows the FIFO basis in respect of customers instead of in relation to the items of inventory issued for production.

5. Since the company is recording consumption as per the specific consignment of the hedged metal purchased for the related order from the customer, at the year-end, metal consumed (from unhedged stock) for one specific order has been recorded at the prices at which the metal (hedged) has been purchased, but the metal purchased for that specific order was in transit at the year end.  In effect, consumption has been recorded from the goods in transit instead of the unhedged metal.

B. Query

6. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) Given the above circumstances, what is the appropriate method of valuation of inventories.

(b) Whether the method of valuation of stock followed by the company complies with Accounting Standard (AS) 2, ‘Valuation of Inventories’.

(c) Whether the accounting treatment followed as stated in paragraph 5 above is correct, or whether the consumption should be recorded from the unhedged stock.

C.  Points Considered by the Committee

7.  The Committee notes paragraphs 14 and 15 of AS 2 which state as below:

“14. The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by specific identification of their individual costs.

“15. Specific identification of cost means that specific costs are attributed to identified items of inventory. This is an appropriate treatment for items that are segregated for a specific project, regardless of whether they have been purchased or produced. However, when there are large numbers of items of inventory which are ordinarily interchangeable, specific identification of costs is inappropriate since, in such circumstances, an enterprise could obtain predetermined effects on the net profit or loss for the period by selecting a particular method of ascertaining the items that remain in inventories.”

8. From the above, the Committee is of the view that since the raw-material in the given case is interchangeable and is also actually used from the stock already lying with the company and not only out of the purchases made for the particular order, the specific identification method of valuation of inventories can not be adopted.

9.  The Committee also notes paragraph 16 of AS 2 which states as below:

“16. The cost of inventories, other than those dealt with in paragraph 14, should be assigned by using the first-in, first-out (FIFO), or weighted average cost formula. The formula used should reflect the fairest possible approximation to the cost incurred in bringing the items of inventory to their present location and condition.”

10. From the above, the Committee is of the view that under the circumstances explained in the query, for the purpose of inventory valuation, the FIFO method appears to be more appropriate irrespective of the manner of billing to the clients, since the manner of billing does not affect the cost incurred in the related production.  In appropriate circumstances, weighted average method can also be suitably used in terms of AS 2.

11. The Committee also observes that the raw-materials in transit can not be issued for consumption in the production process and, therefore, consumption can not be recorded out of such materials-in-transit.

D.  Opinion

12.  On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 6:

(a) Under the given circumstances, FIFO appears to be the more appropriate method of valuation of inventory.

(b) No.  The accounting treatment followed by the company in respect of valuation of inventory does not comply with AS 2.

(c) No.  The accounting treatment as stated in paragraph 5 above is not correct. FIFO basis appears to be more appropriate under the given circumstances.

1Opinion finalised by the Committee on 8.8.2000.