Query No. 29

Subject:           

Net  realisable  value  of  inventory  of  raw 

material  and intermediate products.1

A. Facts of the Case

1. A public sector company is engaged in refining, transportation and sale of petroleum products. The crude oil for the purpose of refining is acquired both indigenously and through imports. For valuation of crude oil inventory, the following elements are considered:

(a) Imported crude

l           FOB/C&F value

l           Marine freight

l           Marine insurance

l           Wharfage and port charges

l           Customs duty

(b) Indigenous crude (off shore and on shore)

l  Price  paid  to  suppliers  as  advised  by  Oil  Coordination Committee on a monthly basis.

2. According to the  querist,  the refining sector  has been  deregulated w.e.f. 1.4.1998. Under the phased deregulation of the oil sector approved by  the  Government  of  India,  the  oil  refineries  are  eligible  to  get  the product prices based on the import parity concept. Similarly, the cost of raw material to be borne by the refineries is also based on import parity concept.  Therefore, even  for  usage  of indigenous  crude,  the  cost to  be borne by the refineries is based on the import parity concept. The import parity  cost  for  this  purpose  is  taken  as  the  landed  cost  upto  the  port including notional customs duty. In case of imported crude, the cost will be at actuals.

3. As  per  the  querist,  presently  the  oil  industry  in  India  is  passing through a phase of deregulation. The refineries are out of the administered pricing mechanism w.e.f. 1st April, 1998. As per the Government’s agenda for  deregulation,  prices  of  oil  and  petroleum  products  will  get  totally deregulated by 1st  April, 2002. In the meanwhile, the consumer prices of LPG,  MS, HSD  and SKO  are still  administered by the Government  of  India. The rest of the products are free for trading at prices fixed by the individual oil companies.

4. As  per  the  querist,  the  company  is  entitled  to  the  import  parity prices for controlled products, even though the consumer prices thereof are administered. Similarly, the company has to bear the cost of crude oil at  import  parity prices  even  in  respect  of  domestically produced  crude oil. The cost of imported crude oil, in any case, will be at actual.

5. According  to  the  querist,  the  prices  paid  by  oil  companies  to indigenous crude suppliers are at a lower price though the costs of such crude are borne at import parity by the refineries. The difference between import parity price of indigenous crude oil and the actual price paid to the suppliers are adjusted in the prices of the controlled products through a mechanism of crude surcharge. The existence of such mechanism results in  lower  product  prices  as  compared  to  import  parity  and  also  lower crude  oil  cost  in  case  of  usage  of  indigenous  crude  oil.  However, theoretically, this will not have any effect on the profitability since both the cost of crude as well as product prices are understated. But since the mechanism  assumes  certain  parameters  of  crude  mix  (i.e.,  between indigenous  and  imported  crude)  and  also  of  product  dispatches  for notification  of  prices  in  advance  at  the  beginning of  the  month  by Oil Coordination Committee, the margin realisation can get vitiated by the actual performance during the month.

6. The company has followed the following accounting policy in respect of valuation of inventories of raw materials and intermediate products:

l           Crude oil is valued at cost on first-in, first-out basis. Base Oils and Additives are valued at weighted average cost.

 

l           Stock-in-process is valued at raw material cost plus conversion costs as applicable.

7. As  per  Accounting  Standard  (AS)  2,  ‘Valuation  of  Inventories’, issued  by  the  Institute  of  Chartered  Accountants  of  India,  inventories should  be  valued  at  the  lower  of  cost  and  net  realisable  value.  The company  has  complied  with  this  requirement  of  AS  2  in  respect  of valuation of finished products. However, valuation of raw materials and stock-in-process is at cost including conversion cost in respect of stock- in-process. In this connection, the querist has drawn reference to paragraph 24 of AS 2 which provides the following:

“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.”

8. As  per  the  querist,  in  order  to  elaborate  the  issues  further,  the following points, which take into account the entire supply chain from the receipt of crude oil at port to the making of finished product, are also required to be considered:

(a) Crude oil inventory consists of the following:  

Crude oil in transit: Since the company is the canalising agency, large quantities of stock-in-transit appears on its balance sheet date by virtue of being the Bill of Lading holder. The actual deliveries of some of these quantities may finally be made to other  oil  companies.  The  querist  has  stated  that  since  the product yield of the particular crude will vary from refinery to refinery  and  the  refinery  that  shall  finally  process  the  crude lying  in  transit  as  on  31March  is  not  ascertainable,  it  is practically  not  possible  to  assess  the  quantity/value  of  the products to be manufactured out of the crude lying in stock.

 

Crude oil in tank farms at port and in the pipeline system: The company’s four inland refineries are receiving imported crude/ offshore  indigenous  crude  through  feeder  pipelines  from the respective port locations. At any point of time, large quantities of  crude  oil  are  held  in  the  tanks  at  the  port  locations  and pipeline enroute..

 

Crude oil held in refinery tank farms for day to day processing: According  to  the  querist,  yield  pattern  of  the  crude  varies depending  upon  the  stages  of  secondary  processing.  Within the  technical  parameters  the  actual  yield  pattern  is decided based on the prices and demand of the various products.

 (b) Intermediate Process Stocks

Intermediate Process Stocks are the process streams in semi- finished condition in the refinery plants/refinery tanks which require  further  processing  to  make  finished  products.  Each such semi-finished stream can be converted to finished products having different realisable values.

9. According to the querist, for refineries processing multiple crude it is not possible to ascertain the actual yield pattern of the crude lying in stock as on a particular date even notionally on FIFO basis as the actual processing of various crude after the said date may not be in the same ratio as the ratio of these crudes in stock as on the said date.

B. Queries

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

(a)    Whether  the  existing  valuation  principles  adopted  by  the company are in line with the requirements of AS 2.

 

(b)    Whether the requirements of AS 2 are required to be followed even in situations wherein the net realisable value ascertainment can lead to subjectivity due to uncertain patterns of production, crude mix, time references for dispatch, etc., all having various price/cost implications.

 

(c)    Whether stocks of raw material and intermediate products can be valued at cost and the fact be disclosed in the accounting policy of the company, in view of the subjectivity involved in the  assessment  of  realisable  values  of  the  finished  products which will be produced in due course from the stock of crude oil and intermediate products.

C. Points considered by the Committee

11. The Committee notes that the basic issue in this query is the valuation of inventories of raw materials and intermediary products at the lower of cost and net realisable value and determination/estimation of net realisable value.  The  Committee,  therefore,  has  not  touched  upon  any  other accounting issues, e.g., charges to be included in cost of imported crude oil, cost of indigenous crude oil and selling prices of controlled products under the import parity concept.

12. The  Committee  notes  paragraph  24  of  AS  2  as  reproduced  in paragraph 7 above. The Committee notes from this paragraph that cost and net realisable value of raw materials is required to be compared 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  their  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.

13. The  Committee  also  notes  that  paragraph  22  of  AS  2  provides  as below:  

“22. Estimates of net realisable value are based on the most reliable evidence  available  at  the  time  the  estimates  are  made  as  to  the amount the inventories are expected to realise. These estimates take into consideration  fluctuations of  price or  cost directly relating to events occurring after the balance sheet date to the extent that such events confirm the conditions existing at the balance sheet date.”

14. On  the  basis  of  the  above,  the  Committee  is  of  the  view  that  the company  may  first  determine  whether  the  prices  of  the  raw  materials have declined. In case these prices have not declined, the company would not be required to write down the value of inventories of raw materials below cost, i.e., to their net realisable value as per paragraph 24 of AS 2. However, in case there has been a decline in the prices of raw materials, the company would be required to ascertain whether the cost of finished products to be manufactured using the raw materials would exceed their net realisable value. For this purpose, net realisable value of the finished products to be manufactured using the raw materials may be estimated based  on  relevant  factors  such  as  past  experience  of  the  patterns  of production, crude mix, time references for  dispatch, prices, etc. In this regard,  events  occurring  after  the  balance  sheet  date  may  also  be considered as per the requirements of paragraph 22 of AS 2.

15. The  Committee  notes  that  paragraph  24  of  AS  2  relates  only  to valuation of materials and other supplies held for use in the production

of inventories. Therefore, inventories of intermediate products should be valued at the lower of cost and net realisable value as per paragraph 5 of AS 2 which states that “inventories should be valued at the lower of cost and  net  realisable  value”.  The  Committee  notes  that  the  term  ‘Net realisable value’ has been defined in AS 2 as follows:  

“Net  realisable  value  is  the  estimated  selling  price  in  the ordinary  course  of  business  less  the  estimated  costs  of completion and the estimated costs necessary to make the sale.”

16. The  Committee  notes  from  the  above  that  net  realisable  value  of intermediate  products  is  the  price  expected  to  be  realised  from sale  of finished  products  in  the  ordinary course  of  business  less  the  estimated costs of completion and the estimated costs necessary to make the sale and  is  of  the  view  that  net  realisable  value  can  be  estimated  on  an appropriate basis as per the requirements of paragraph 22 of AS 2.

D. Opinion

17. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 10 above:

(a)     No, the existingvaluation principles adopted by the company are not in line with the requirements of AS 2.

 

(b)   The  requirements  of  AS  2  are  to  be  followed  by  making reasonable estimate of the net realisable value based on relevant factors such as past experience of the patterns of production, crude  mix,  time  references  for  dispatch,  prices,  etc.  In  this regard, events occurring after the balance sheet date may also be considered.

 

(c)    The  accounting  policy  for  valuation  of  inventories  of  raw materials and intermediate products should also be the lower of cost and net realisable value. The inventories of raw materials can be valued at cost if either the prices of raw materials have not declined or the net realisable value of the finished products is estimated to exceed the costs thereof. In case there has been a decline in the price of raw materials and it is estimated that the  cost  of finished  products  will  exceed their  net  realisable value, the value of inventories of raw materials is required to be written down below cost, i.e., to their net realisable value (at replacement cost). The inventories of intermediate products can not be valued at cost ignoring their net realisable value. If the inventories of raw materials and intermediate products are valued at cost ignoring the requirements of AS 2, disclosure of this  fact  would  not  remedy  the  incorrect  accounting  policy adopted by the company.

1Opinion finalised by the Committee on 5.7.2001.