Query No. 22

 

Subject:          

Inclusion of borrowing costs in the valuation of inventories.1  

 

A. Facts of the Case

 

1. A  private  limited  company  has  been  consistently  valuing  its inventories of finished goods by considering interest and administrative overheads as an element of cost.

 

2. Accounting  Standard  (AS)  2  (revised),  ‘Valuation  of  Inventories’, issued by the Institute of Chartered  Accountants of India,  provides the following in paragraph 12:  

“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.”

 

3. As  per  its  practice,  the  company  valued  its  inventories  as  on 31.3.2000  by  considering  interest  and  administrative  overheads  as  an element of cost, since it is of the view that interest paid on cash credit and  overdraft,  which  are  used  for  purchase  of  inventories  or  for  the purpose of bringing the inventories to their present location and condition, should be considered as an element of cost for the purpose of valuation of inventories.

 

4. The auditors qualified their report stating that valuation of inventories was not in consonance with AS 2 and quantified the difference by revising the  valuation  of  closing  inventories  only,  whereas  cost  of  opening inventories  also  included  interest  and  administrative  overheads.  The auditors did not adjust the valuation of opening inventories but adjusted the valuation of closing inventories as per AS 2 for calculating the said difference.

 

5. The company is of the view that opening inventories should also be valued  on  the  same  basis  as  closing  inventories  to  bring  parity  and  to calculate  actual  impact  on  the  statement  of  profit  and  loss.  As  per  the querist, this item, therefore, will be in the nature of a prior period item and  would  amount  to  change  in  accounting  policy  as  per  Accounting Standard (AS) 5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’.

 

B. Queries

 

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

 

(a)        Whether the interest and other borrowing costs on cash credit and overdraft used for these inventories can be included in the cost of inventories.

 

(b)        Whether the opening and closing inventories should be valued on the same basis so as to quantify actual impact on the profit and loss account for the year.

 

(c)        Whether it was  mandatory for the auditors  to have qualified their  report stating that the  valuation was  not in  consonance with  AS  2  and  to  have  quantified  the  difference  between opening and the revalued closing stock, rather than qualifying their report by simply drawing attention to the accounting policy of the company not conforming to AS 2.

  C. Points considered by the Committee

 

7. The Committee notes that the query basically relates to inclusion of borrowing  costs  on  cash  credits  and  overdrafts  in  the  valuation  of inventories  for  the  period  for  which  inventory  is  held  in  stock.  The Committee  has,  therefore,  not  considered  the  other  aspects  of  the accounting policy pertaining to valuation of inventories.

 

8. The Committee notes that paragraphs 11 and 12 of AS 2 (revised), which  is  applicable  for  accounting  periods  commencing  on  or  after 1.4.1999, provide 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.”

 

9. The  Committee  is  of  the  view  that  although  finance  charges  are incurred for the purposes of business and may be inevitable, yet, these costs are not directly related in effecting change in the present location and condition of inventory items. Only in exceptional cases, these costs can be considered to be directly related to bringing certain inventories to their present location and condition. For instance, interest cost, which is a period related cost, can be included in 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. In this case, there is a clear change in the condition of  inventory  during  the  period  it  was  lying  in  store.  However,  in  the absence of the relevant facts and circumstances of the query, it cannot be established that there is a nexus between the incurrance of finance charges and the change in present location and condition of inventories. The use of borrowings by way of cash credits and overdrafts for these inventories cannot, by itself, be considered a justification for inclusion of interest in cost of inventories.

 

10. The Committee notes that the term ‘prior period items’ is defined in AS 5 as below:  

“Prior period items are income or expenses which arise in the current period  as  a  result  of  errors or  omissions  in  the  preparation  of  the financial statements of one or more prior periods.”  

11. The  Committee  also  notes  that  paragraph  16  of  pre-revised Accounting  Standard  (AS)  2,  ‘Valuation  of  Inventories’,  which  was relevant as on 31st  March, 1999, provided as below:

“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  administrative  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.”

12. From the above, the Committee is of the view that it was an error on the part of the company to include the interest and other borrowing costs on  cash  credit  and  overdraft  in  the  valuation  of  inventories  as  on  31st March, 1999. Accordingly, interest and other borrowing costs included in the  valuation  of  opening  inventories  is  of  the  nature  of  a  prior  period item in the year 1999-2000.

13. The Committee is of the view that the nature and amount of interest and other borrowing costs forming part of the opening inventories should be separately disclosed in the statement of profit and loss as per paragraph 15 of AS 5 in a manner that its impact on the current profit or loss can be perceived.

 

14. The Committee notes that under section 227(3)(d) of the Companies Act, 1956, the auditor is required to state in his report as to whether, in his opinion, the profit and loss account and balance sheet comply with the accounting standards referred to in sub-section (3C) of section 211. As per section 211(3C), the expression ‘accounting standards’ means the standards  of  accountingrecommendedbythe Chartered Accountants of India.

15.  The  Committee  also  notes  that  section  227(2)  of  the  Companies Act, 1956, provides the following:

 

“(2)   The auditor shall make a report to the members of the company on the accounts examined by him, and on every balance sheet and  profit  and  loss  account  and  on  every  other  document declared by this Act to be part of or annexed to the balance sheet  or  profit  and  loss  account,  which  are  laid  before  the company in general meeting during his tenure of office, and the report shall state whether, in his opinion and to the best of his  information  and  according  to  the  explanations  given  to him,  the  said  accounts  give  the  information  required  by this Act in the manner so required and give a true and fair view –

 

(i)         in  the  case  of  the  balance  sheet,  of  the  state  of  the company’s affairs as at the end of its financial year; and

 

(ii)        in the case of the profit and loss account, of the profit or loss for its financial year.” 16.   The Committee is of the view that under clause (d) of section 227(3) of the Companies Act, 1956, the auditor should, with regard to matters covered  under  this  query,  state  that  balance  sheet  and  profit  and  loss account of the company do not comply with AS 2 (revised) and AS 5 (if separate disclosure of prior period item has not been made).

 

17.   For the purpose of reporting under section 227(2) of the Companies Act, 1956, the Committee is of the view that the auditor should consider the amount of interest and other borrowing costs included in the value of closing  inventories.  The  amount  of  interest  and  other  borrowing  costs included in opening inventory would be charged to profit and loss account as  a  prior  period  item either  as  a  part  of  value  of  opening  inventories with a separate disclosure or separately after reducing it from the value of opening inventory as per AS 5. Thus, the amount of interest and other borrowing costs related to opening inventories will, in any case, be debited to the profit and loss account. Therefore, the overall impact on the profit/ loss of the company would only be with respect to the amount of interest and other borrowing costs included in closing inventories. The auditors should  accordingly,  qualify  their  report  in  the  manner  required  in  the Statement on Qualifications in Auditor’s Report issued by the Institute of Chartered Accountants of India. Similarly, if interest and borrowing costs included  in  opening  inventories  have  not  been  disclosed  separately  in accordance with AS 5, the auditors should also qualify their report in this regard.

 

D. Opinion

 

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

 

(a)        Interest and other borrowing costs on cash credit and overdraft used  for  inventories  should  not  be  included  in  cost  for  the purpose of valuation of inventories.

(b)        In  the  facts  and  circumstances  of  the  case,  even  though  the basis of valuation of opening and closing inventories should be the same, the amount of interest and other borrowing costs related  to  opening  inventories  will  not  have  any  impact  on profit/loss for the period since the said amount would have to be included as a prior period item by way of a charge in the statement  of  profit  and  loss  either  as  a  part  of  opening inventories  with  a  separate  disclosure  or  separately  after reducing  from  the  value  of  opening  inventories.  Thus,  the amount of interest and other borrowing costs included in value of closing inventories should be considered for the purpose of quantifying the qualification in this regard by the auditors.

 

(c)        It  would  not  have  been  sufficient  for  the  auditors  to  simply draw  attention  to  the  accounting  policy  of  the  company  not conforming to AS 2. It was mandatory for the auditors to have qualified  their  report  stating  that  the  valuation  was  not  in consonance  with  AS  2  and  to  have  quantified  the  impact  of qualification  with  reference  to  only  the  closing  stock  in  the facts and circumstances of the case in view of (b) above.

1Opinion finalised by the Committee on 5.7.2001.