A. Facts of the Case

1. A government company refines crude oil and manufactures a wide range of petroleum and petrochemical products.  The company has a refining capacity of 7.5 million metric tonnes of crude oil per annum.  The plant of the company is capable of processing indigenous crude as well as imported crude.

2. The company normally processes equal quantities of imported and indigenous crude in an year.  However, the ratio of crude processed may change from time to time depending on their respective availability.  Switch–over between imported and indigenous crude is done regularly in a span of four or five days normally and the change over can be made without any additional modification in the process.  Both types of crude oil yield same petroleum products.  However, the yield pattern in the two cases varies which is dependent on the precise chemical character of the crude oil.  In other words, both the types of crude oil are raw-materials of the same nature which get refined in the distillation column of the refinery for the extraction of various petroleum products.

3. The company, at the close of the year ended 31^st March 2000, had a total stock of 3,00,664 MT of indigenous and imported crude and valued both the types of crude as below:

The stock of the crude oil of 3,00,664 metric tonnes as on 31^st March, 2000, was valued at landed cost since the net realisable value of the total quantity was Rs. 32,703 lakh, calculated on replacement cost basis, which was higher than the cost of Rs. 29,593.29 lakh. As per the querist, the above method of valuation was in line with Accounting Standard (AS) 2 (Revised), ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India.  The company’s accounting policy in this respect reads as under:

“Raw Material:

Stocks in refinery tanks and pipelines are valued at cost on first-in-first-out basis computed separately for imported and indigenous crude oil, and those in transit at C&I cost, or net realisable value, whichever is lower.”

4. Considering the nature of the two types of crude oil as explained in paragraph 2 above, the company had grouped both indigenous and imported crudes together and arrived at the net realisable value and compared it with the total landed cost of the same for the purpose of valuation, which, as per the querist, was in accordance with the provisions of AS 2.

5. The method of valuation adopted by the company was objected to by the government auditors.  They insisted on finding out the net realisable values for imported and indigenous crudes separately for comparing the same with cost of each type of crude.  However, the objection was dropped by them on a reference to paragraph 21 of AS 2.

B. Query

6. The querist has sought the opinion of the Expert Advisory Committee as to whether the company is justified in grouping imported and indigenous crude oil together for calculating net realisable value and comparing the same with the cost for finding the lower of the two.

C. Points Considered by the Committee

7. The Committee notes that the basic issue in the query relates to determination of net realisable value for materials.  The Committee has, therefore, not touched upon other accounting issues such as the method of valuation, i.e., FIFO or weightage average method.

8. The Committee notes that the chemical contents of the two types of crude oil are different and consequently their respective yield is also different.  Therefore, the Committee is of the view that these can not be termed as ‘interchangeable’ items and should be valued separately.

9. The Committee also notes that paragraph 24 of AS 2 provides as below:

“24. Materials and other supplies held for use in the production of inventories are not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost.  However, when there has been a decline in the price of materials and it is estimated that the cost of the finished products will exceed net realisable value, the materials are written down to net realisable value.  In such circumstances, the replacement cost of the materials may be the best available measure of their net realisable value.”

10. The Committee notes from the above that in respect of materials, the question of comparison of cost and net realisable value arises only when (i) there has been a decline in the price of materials, and (ii) it is estimated that the cost of the finished products will exceed its net realisable value.  In such circumstances, the net realisable value of the materials may be determined on the basis of the replacement cost of the materials.

11. The Committee further notes paragraph 21 of AS 2, which states as below:

“21. Inventories are usually written down to net realisable value on an item-by-item basis.  In some circumstances, however, it may be appropriate to group similar or related items.  This may be the case with items of inventory relating to the same product line that have similar purposes or end uses and are produced and marketed in the same geographical area and cannot be practicably evaluated separately from other items in that product line.  It is not appropriate to write down inventories based on a classification of inventory, for example, finished goods, or all the inventories in a particular business segment.”

12.  From the above, the Committee is of the view that the underlying principle of writing down inventories to net realisable value is on an item-by-item basis.  An item-by-item comparison of cost and net realisable value is based on the concept of prudence which has been described in the Framework for the Preparation and Presentation of Financial Statements issued by the Institute of Chartered Accountants of India as “the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated” (paragraph 37). However, considering the practicability, AS 2, as an exception from the underlying principle of item-by-item comparison, allows grouping of similar or related items for the purpose of comparison of costs and net realisable value.  This method of grouping should be adopted only when the results would not be materially different from those obtained by an item-by-item comparison.  The grouping of similar or related items may be done in case separate evaluation is not practicable.

13. The Committee is of the view that in the given case separate evaluation for the two types of crude oil, viz., indigenous and imported crude, is practicable. It appears from the facts of the query that separate records are being kept by the company for the two types of crude and the company has arrived at the net realisable value (at replacement cost) separately for the two and then added the two to arrive at a total figure.

14. From the above, the Committee is of the view that the two types of crude should be valued at cost unless the conditions stipulated in paragraph 24 of AS 2 are satisfied.  In case the said conditions are satisfied, the comparison of cost and net realisable value (at replacement cost) should be done for the two types of crude separately.

D. Opinion

15. On the basis of the above, the Committee is of the opinion that the company is not justified in grouping imported and indigenous crude oil for the purpose of comparison of their cost with their net realisable value for the purpose of valuation of inventories.  The inventories of the two types of crude should be valued as explained in paragraph 14 above.

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1Opinion finalised by the Committee on 17.1.2001