Query No. 1

Subject:           

Treatment  of  interest  cost  for  the  period  inventories 

are held in stock in a seasonal business.1

A. Facts of the Case

1. A company manufactures sugar and its by-products. The company falls under the category of a seasonal industry.

2. The  crushing  season  starts  in  the  first  week  of  November  and continues upto the end of April or first week of May next year, depending on the availability of sugarcane in the area. The sugar stocks start building up from the start of crushing season and are normally at its peak at the end  of  the  crushing season.  The despatches  of  sugar  from the  mill  are controlled by the government. Monthly release quotas are fixed in respect of each sugar mill and despatches from mills are strictly based on these release quotas. Under normal circumstances, each sugar mill carries stock of sugar for at least one full season at any point of time.

3. At the end of each financial year/season, the sugar mill carries large stocks  of  sugar  relating  to  the  current  season,  which  get  depleted  to  a large extent before the start of the next season. Sometimes, the stocks are carried over beyond one season also.

4. As  per  the  querist,  sale  prices  remain  low  during  the  season  but increase  during  off-season  to  compensate  the  inventory  carrying  cost involved in carrying the inventory.

5. The working capital facilities from bankers are available against the sugar stocks. The company is of the view that since the interest paid on working capital facilities relates directly to the inventories of sugar held i n stock, this interest cost should be included as part of cost of inventories of sugar. The company is of the view that the interest component relating to  such  stocks  can  not  be  ignored  for  the  purpose  of  valuation  of inventories.

6. The company’s auditors do not agree with this view and have placed their reliance on the revised Accounting Standard (AS) 2, ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, and have qualified their report. They have drawn reference to paragraphs 11 and 12 of the Standard relating to ‘Other Costs’, which state as below:

“11. 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. For example, it may be appropriate to include overheads other than production overheads or the costs of designing products for specific customers in the cost of inventories.

12. Interest  and  other  borrowing  costs  are  usually  considered  as not relating to bringing the inventories to their present location and condition  and  are, therefore,  usually  not  included  in  the  cost  of inventories.”

7. The querist  has argued  that the sugar  producing companies  in the country are faced with a peculiar situation that almost the entire production of  sugar  remains  in  stock  at  the  end  of  a  financial  year.  As  per  the querist, the word ‘usually’ which has been used twice in paragraph 12 of AS  2  also  takes  cognisance  of  the  fact  that  there  may  be  exceptional/ unusual circumstances, like the one in the case of the company, where the interest cost may be considered for the purpose of valuation.

B. Queries

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

(a) Whether the interest paid on working capital facilities can be considered for the purpose of valuation of inventories of sugar particularly keeping in view that sale price at the time of sale of  sugar  in  off-season  generally  compensates  the  inventory carrying costs also.

 

(b) If  the  answer  to  (a)  above  is  in  the  negative,  whether  it  is justified to charge off the entire interest cost against the sales revenue from the goods which have not been generated out of those borrowings.

(c) Any  other  treatment  for  such  interest  costs  which  would reflect the correct state of affairs.  

C. Points considered by the Committee

9. The Committee notes that Accounting Standard (AS) 16, ‘Borrowing Costs’, which is a mandatory Accounting Standard, prescribes that only those  borrowing costs  should  be  included in  the  cost  of  the  qualifying asset as defined in the said Standard that are “directly attributable to the acquisition,  construction  or  production”  of  the  same.  Other  borrowing costs are required to be “recognised as an expense in the period in which they are incurred” (paragraph 6).

10. The  Committee  observes  that  the  interest  cost  referred  to  in  the query relates to the period during which sugar is held in stock after its production.  Thus,  the  Committee  is  of  the  view  that  such  interest  cost should be recognised as an expense in the period in which it is incurred.

11. The  Committee  further  notes  that  paragraph  6  of  AS  2,  which  is also a mandatory Accounting Standard, states as below:

“6. 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.”

The Committee notes that this paragraph also supports the Committee’s view  as  stated  in  paragraph  10  above.  The  cost  incurred  after  the inventories are brought to their present location and condition cannot be added  to  the  cost  of  inventories.  The  mere  fact  that  the  inventories  of sugar are to be carried over for long periods cannot be a justification for adding  the  interest  cost  pertaining  to  that  period  to  the  cost  of  such inventories.

12. The Committee observes that the word ‘usually’ in paragraph 12 of AS 2 signifies that though normally the interest cost is not considered as relating to bringing the inventories to their present location and condition, there may be certain exceptional circumstances where interest cost may relate to bringing the inventories to their present location and condition. For example, interest cost can be included in the valuation of inventories of wine for the period it is kept in store to enable it to mature so that it could be sold in that condition. From the facts of the case, the Committee notes that sugar is not held in stock by the company for such a purpose. Therefore, interest cost can not be added to the cost of inventories.

D.        Opinion

13. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 8:

(a) The interest paid on working capital facilities relating to sugar held in stock should not be included for the purpose of valuation of such inventories.

 

(b) The  interest  cost  relating  to  sugar  held  in  stock  should  be expensed in the period in which the same is incurred.

 

(c) The correct treatment of interest cost is as stated in (a) and (b) above. No other treatment is appropriate.

1  Opinion finalised by the Committee on 5.3.2001.