Query No. 4

Subject:           

Inclusion of excise duty in inventory valuation.1

A. Facts of the Case

1. A private limited company has been valuing its inventories of finished goods  by  not  considering  excise  duty  payable  on  manufactured  goods lying  in  bonded  warehouse  as  an  element  of  cost.  The  company  has valued its closing inventories as on 31.3.2000 also by not considering the excise duty payable on manufactured goods lying in bonded warehouse as an element of cost.

2. The querist has stated that Accounting Standard (AS) 2 (revised), ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, provides the following in paragraph 7:  

“7. The costs of purchase consist of the purchase price including duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities) ….”

3.  The auditors qualified their report stating that valuation of inventories was  not  in  consonance  with AS  2.  For  quantification  of  the  effect  of qualification  on  profit  or  loss,  opening  inventories  were  valued  by not considering excise duty as an element of cost whereas closing inventories were valued by considering excise duty as an element of cost. The auditors did  not  adjust  the  valuation  of  both  the  opening  as  well  as  closing inventories as per AS 2 (revised) for calculating the difference.

4.  The  company  is  of  the  view  that  opening  inventories  should  be valued  on  the  same  basis  as  closing  inventories  to  bring  parity  and  to calculate  actual  impact  on  the  profit  and  loss  account.  Such  an  item, therefore, will be of the nature of a prior period item and would amount to change in accounting policy as per AS 5.

B.  Queries

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

(a) Whether  opening  inventories  and  closing  inventories  should be valued on the same basis so as to quantify the actual impact on the profit and loss account for the year and, if so, whether the change in value of opening inventories should be shown as a prior period item or as a change in accounting policy as per AS 5.

 

  (b)  Whether it was not sufficient for the auditor to have qualified his report by stating that the accounting policy of the company is not as per AS 2 rather than quantifying it by revaluing only the closing stock.

C.  Points considered by the Committee

6.  The Committee notes that paragraph 6 of Accounting Standard (AS) 2 (revised), ‘Valuation of Inventories’, provides 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.”

7.  The  Committee  notes  that  the  ‘Guidance  Note  on  Accounting Treatment for Excise Duty’ (revised), issued by the Institute of Chartered Accountants of India, deals with the applicability of the provisions of AS 2  in  the  specific  case  of  excise  duty. According  to  the  said  Guidance Note  which  is  applicable  for  accounting  periods  beginning  on  or  after 1.4.1999,  the  excise  duty is  a  cost  incurred  to  bring  the  inventories  to their present location and condition and, accordingly, it is required to be considered as an element of cost for inventory valuation. The Guidance Note also requires that the auditor should qualify his report, if the method of  accounting  for  excise  duty  is  not  in  accordance  with  the  principles explained in the Guidance Note.

8.  The  Committee  notes  that  ‘prior  period  items’  are  defined  by Accounting  Standard  (AS)  5,  ‘Net  Profit  or  Loss  for  the  Period,  Prior Period Items and Changes in Accounting Policies’, 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.”

9. The  Committee  also  notes  that  as  per  the  pre-revised  ‘Guidance Note  on Accounting Treatment  for  Excise  Duty’ (applicable  as  on  31st March, 1999), the company had the option of not considering the excise duty  as  an  element  of  cost  for  the  purpose  of  inventory  valuation. Accordingly,  the  Committee  is  of  the  view  that  there  was  no  error  in valuation of inventories as on 31st  March, 1999, with regard to the non- inclusion of excise duty and, therefore, excise duty payable on opening inventory  not  included  in  the  valuation  thereof  cannot  be  termed  as  a prior period item.

10. The Committee notes that the company has not so far changed its method  of  valuation  of  inventories  with  regard  to  excise  duty.  If  the method is changed, it would amount to a change in the accounting policy and the impact of change, if material, should be shown in the financial statements for the period as per the requirements of AS 5.

11. The Committee notes that under section 227(3)(d) of the Companies Act, 1956, the auditors are required to state in their report that whether,in  their  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 accounting recommended by the Institute of Chartered Accountants of India.

12. 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.”

13.  The Committee is of the view that with regard to the matter covered under  this  query,  the  auditor  should  state  under  clause  (d)  of  Section 227(3)  of  the  Companies  Act,  1956,  that  balance  sheet  and  profit  and loss account of the company do not comply with AS 2 (revised).

14. With  regard  to  reporting  under  section  227(2)  of  the  Companies Act, 1956, the Committee is of the view that the amount of excise duty not included in the opening inventories is not required to be taken into account in this case since non-inclusion of excise duty in the valuation of inventories  was  permissible  at  that  time.  However,  the  auditors  should consider the amount of excise duty not included in the value of closing inventories. The Committee, however, notes that non-inclusion of excise duty in the value of closing inventories will not have any impact on the profit/loss for the year, but will have impact on the ‘current assets’ and ‘current liabilities and provisions’ in the balance sheet as these will be understated  by  the  amount  of  the  excise  duty  not  provided  for.  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.

D. Opinion

15. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 5:

(a) Under the facts and circumstances of the query, the value of the opening inventories is not required to be changed. However, since the value of closing inventories should include the amount of provision for excise duty, the opening and closing inventories would  not  be  valued  on  the  same  basis  for  the  purpose  of quantifying the impact on the profit/loss for the year. Since the value of the opening inventories is not required to be changed, the question of disclosure as a prior period item or change in accounting  policy  with  regard  to  such  inventories  does  not arise.

 

(b) It would not have been sufficient for the auditors to have only stated in their report that the accounting policy is not as per AS  2  without  quantifying  its  effect  by  revaluing  the  closing stock.

1  Opinion finalised by the Committee on 5.3.2001.