Query No. 30

Subject:           

Net realisable value of inventory1

A. Facts of the Case

1. A  public  sector  undertaking  is  engaged  in  the  business  of manufacture,  repair  and  overhaul  of  aircraft,  aero  engines,  helicopters, etc. The entire share capital of the company is held by the Government of India and the company is under the administrative control of Ministry of Defence.

2. The  company  has  followed  the  following  accounting  policy  for valuation of inventories prior to 1.4.2000:

(a)        Raw material, components, stores and spare parts are valued at cost.

 

(b)        work-in-progress/stock-in-trade  is  valued  at  lower  of  cost  or realisable value.

 Keeping in view the revised Accounting Standard (AS) 2, ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, which became mandatory, as per the querist, w.e.f. 1.4.2000, the company has  changed  the  above  policy  and  the  present  policy  being  followed w.e.f. 1.4.2000 is as below:  

“Inventories are valued at lower of cost and net realisable value”.

3. The querist has referred to the definition of the term ‘net realisable value’ which has been defined in AS 2 as “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”.

The querist has also referred to the following portion of paragraph 24 of AS 2:  

“..... 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.”

4. According to the querist, the company holds more than 10,000 items as inventory in its books of account. Due to such large number of items of inventory being carried by the company in its books, as per the querist, it is not practicable/feasible to work out the net realisable value of each item of inventory. However, in respect of these inventories, an analysis of  non-moving  and  slow  moving  items  is  carried  out  periodically  and wherever it is necessary, adequate provision is made for redundancy of such inventories pending transfer to salvage stores. In addition, provision for  redundancy is  also  maintained at  a  suitable percentage/level.  Thus, care  is  being  taken  by  the  company,  by analysing  the  non-moving  and slow moving inventories and creating necessary provisions for redundancy in respect of such inventories which, as per the querist, in effect, amounts to carrying the inventories at lower of cost and net realisable value. The above  practice  has  also  been disclosed  in  the  accounting policy  of  the company which is reproduced below:  

“Provision  for  redundancy  is  maintained  at  a  suitable  percentage/ level  of  the  value  of  closing  inventory  of  raw  materials  and components, stores and spare parts and construction materials less the value of inventory to be borne by the customer and the value of the  inventory  for  the  initial  phases  of  the  new  projects.  Besides, where necessary, adequate provision is made for redundancy of such materials in respect of completed/specific projects and other surplus/ redundant materials pending transfer to salvage stores.”

5. Inspite of the above facts, one of the branch auditors has commented in its report for the year 1999-2000 as follows:  

“The  company’s  policy  for  valuation  of  raw  materials  containing stores and spare parts was changed from ‘at cost’ to ‘lower of cost and net realisable value’. While the unit has followed the policy of valuation of stores and spare parts, the valuation of raw materials and components is made at cost since we are informed that the net realisable value of these items, which are directly used for production of finished goods, is more than the cost. We are unable to formulate an opinion as to whether the method followed is in consonance with the Accounting Standard.”

6. In order to avoid such adverse comments being made by the auditors, in cases where it is not practicable for the company to calculate realisable value  for  each  item  of  stock,  it  was  considered  necessary  that  the Accounting Standards Board of the Institute of Chartered Accountants of India, issues suitable modifications to AS 2. For this purpose, the matter was referred to the Accounting Standards Board suggesting the following addition as paragraph 25 to the existing AS 2:

“An assessment is made of the net realisable value at each balance sheet  date.  Where  it  is  not  practicable  to  ascertain  the  realisable value of each item, an assessment can be made for its usability in the  production  of  its  main  products  and  provisions  for  suitable redundancy may be created in respect of materials which are found to be redundant.”

7. The  Board,  however,  felt  that  there  was  no  need  to  make  any modification in AS 2 as it is a specific issue arising on application of an accounting standard. Hence, it suggested to refer the matter to the Expert Advisory Committee for its opinion.

8. According  to  the  querist,  the  query  is  required  to  be  addressed under the following circumstances:

(i)         Where  number  of  items  of  inventory  are  more,  and  it  is  not practicable/feasible  to  work  out  the  net  realisable  value  of each  item  of  inventory,  the  company  makes  an  analysis  of inventory of non-moving and slow moving items at periodical intervals  and  wherever  it  is  necessary,  adequate  provision  is made  for  redundancy  of  such  material  pending  transfer  to salvage stores.

 

(ii)        In addition, provision for redundancy is also maintained at a suitable  percentage/level  of  the  value  of  closing  inventory towards any such redundancy.

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

(a)        Whether  treatment  as  explained  above  is  sufficient  for compliance with AS 2 with regard to valuation of inventoriesat lower of cost and net realisable value.

 

(b)        In  case  the  above  treatment  is  considered  not  sufficient  to comply with the requirements of AS 2 with regard to valuation of  inventories  at  lower  of  cost  and  net  realisable  value,  the Committee is requested to advise the company regarding the action to be taken for compliance with the above requirements of   AS 2.

  C. Points considered by the Committee

10. The  Committee  notes  that  the  basic  issue  in  the  query  relates  to valuation  of  inventories  of  materials  with  particular  reference  to determination of  net realisable value  of materials. The  Committee has, therefore, considered only this issue.

11.   The Committee notes that AS 2 (revised) came into effect in respect of accounting periods commencing on or after 1.4.1999 and is mandatory in  nature  from  that  date.  Therefore,  it  is  not  correct,  as  stated  by  the querist  in  paragraph  2,  that  AS  2  (revised)  became  mandatory  w.e.f. 1.4.2000.

12.   The Committee 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.”  

13.   The  Committee  notes  from  the  above  that  cost  and  net  realisable value  of  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 product 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.

14.   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.”  

15.   On  the  basis  of  the  above,  the  Committee  is  of  the  view  that  the basic requirement of writing down inventories to net realisable value is on item-by-item basis. However, considering the practicability, AS 2, as an  exception  from  the  basic  requirement  of  item-by-item  comparison, allows grouping of similar or related items for the purpose of comparison of  costs  and  net  realisable  value. Accordingly,  in  the  given  case,  since item-by-item comparison of various items of inventories is not practicable/ feasible,  the  Committee  is  of  the  view  that  the  company  may  group similar or related items in accordance with the requirements of paragraph 21 of AS 2 for determining the net realisable values.

16. The  Committee  does  not  agree  with  the  view  of  the  querist  that provision  for  redundancy,  which  has  been  created  in  respect  of  non- moving, slow moving and other such items, would be adequate to write down  the  inventories  to  their  net  realisable  value  in  terms  of  the requirements of paragraph 24 of AS 2. This is because, it is possible that there are certain items of inventory which are not slow-moving or non- moving or otherwise redundant, but otherwise are required to be written down to their net realisable value in terms of the requirements of paragraph 24 of AS 2.

17. The  Committee  is  of  the  view  that  in  addition  to  valuation  of inventories  of  raw  materials  in  accordance  with  the  requirements  of paragraph  24  of  AS  2,  provision  for  redundancy  and  non-moving  and slow-moving items should be made, if necessary.  

D. Opinion

18. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 9 above:

(a)      No, the treatment explained by the querist is not sufficient for compliance with AS 2.

 

(b)        The  inventories  of raw  materials  should  be  valued at  cost  if the conditions stipulated in paragraph 24 of AS 2 are not met. In case the said conditions are met, the value of inventories of raw materials should be written down below cost, i.e., to its net realisable value. For writing down the value of inventories to their net realisable value, the cost and net realisable value (at replacement cost) could be compared by grouping of similar or  related  items  in  accordance  with  the  requirements  of paragraph 21 of AS 2.

1Opinion finalised by the Committee on 5.7.2001.