Query No. 8

Subject:           

Treatment  of  interest  cost  for  the  period  inventories

are held in stock in a seasonal busines¹

A. Facts of the Case

1. The  Institute  of  Chartered  Accountants  of  India  has  issued Accounting  Standard  (AS)  2,  ‘Valuation  of  Inventories’,  which  is mandatory for accounting periods beginning on or after 1st  April, 1999. According  to  AS  2,  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.

2. Sugar industry is a seasonal industry where production is limited to a part of the year, say 5-6 months but sales are distributed over the year. As per the policy of the Central Government, sale of sugar is regulated on  the  basis  of  release  orders  issued  by  the  Central  Government  and quantity to be sold is also notified by the Central Government on monthly basis.  As  such,  the  sugar  mills  cannot  sell  sugar  on  their  own  and  are required to hold the stock till released by the government.

3. According  to  the  querist,  sugar  mills  usually  value  their  stock  of sugar ‘at  the lower of  cost or net realisable  value’. For the  purpose of determination of cost, certain sugar mills consider interest as a part of the cost. This method of valuation is being followed by them consistently for the past few years.

4. As per the querist, in terms of AS 2, if interest, which is the second highest component of cost, is not considered as part of cost, profit shown for  the  year  may  result  into  losses,  and,  accordingly,  sugar  companies may not be in a position to declare dividends. The auditors of the company have  qualified  their  report  for  non-compliance  of  AS  2  and  have  also given a qualification that the profit and loss account does not give a true and fair view to the extent of inclusion of interest as a part of cost for the valuation of stocks of sugar since the impact of inclusion of interest has resulted into conversion of loss into profit.

5. The querist has submitted that:

(a) Holding  large  stocks  of  sugar  forms  an  integral  part  of  the sugar industry in India due to its seasonal nature where though production is limited to a part of the year, sales are distributed over  more  than  a  year  and  are  controlled  by  the  Central Government.  The  sugar  industry  is  compelled  to  hold  stock due to the terms of the government order and any violation of the  same  will  attract  penal  action  against  the  defaulting company under the Essential Commodities Act.

(b) A sugar company can sell sugar only on the basis of release mechanism of the Central Government on monthly basis and not at its own will as in the ordinary course of business.

 

(c) Due  to  mismatch  between  production  and  monthly  releases made by the government, the average holding period of sugar stock is generally 12-15 months.

 

(d) The  sugar  mills  have  to  borrow  huge  funds  to  meet  their working capital requirements and to hold the stock for a longer period. Further, they have to borrow funds for the purpose of making payments for sugarcane to the growers within 14 days from the date of purchase of sugarcane, which is a statutory obligation.

 

(e) After the cost of raw materials, interest is the second highest component of the cost of sugar.

 

(f) In the years when there is surplus stock of sugar, the government creates a buffer stock and reimburses the carrying charges to the sugar mills for the inventory to be carried by them, which includes interest.

6. The  querist  has  contended  that  under  the  above  circumstances, interest must be considered as a component of cost for the valuation of closing stock. AS 2 also states in paragraph 12 that “interest and other borrowing  costs  are  usually  considered  as  not  relating  to  bringing  the inventories to their present location and condition”, which, according to the querist, implies that there may be circumstances where interest can form part of the cost for valuation of inventory.

7. The querist has stated that paragraph 12 of AS 2 is not applicable to the industries like wine and timber and accordingly, the sugar industry should also be exempted from such compliance so as to avoid hardship to the sugar companies and their shareholders.

B. Queries

8. The querist has sought the opinion of the Expert Advisory Committee as to:

(i) whether interest can be considered as a component of the cost for valuation of stocks of sugar, and, accordingly,

 

(ii)  whether the company can declare dividend.

C.  Points considered by the Committee

9. The Committee notes that paragraph 6 of AS 2, which is 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  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.

10. 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.

11. The  Committee  further  notes  that  Accounting  Standard  (AS)  16,‘Borrowing  Costs’,  which  is  also  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).

12. 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.

D. Opinion

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

(i)  The interest paid on working capital facilities relating to sugar held in stock should not be included in cost for the purpose of valuation of such inventories. The interest cost related to sugar held in stock should be expensed in the period in which the same is incurred.

 

(ii)  It  would  be  improper  to  declare  dividends  out  of  the  profits arrived  at  by  not  charging  the  interest  cost  in  the  profit  and loss account of the relevant period.

1Opinion finalised by the Committee on 5.3.2001.