1. A public sector company is engaged in the manufacture and sale of iron and steel products. The company’s plant is located at Visakhapatnam, Andhra Pradesh, with over 25 outstation branch sales offices/marketing outlets situated at different locations of the country. The company has its own stockyards at Chennai, Mumbai and Hyderabad. In other places, the stockyards are operated through consignment agents.

2. The querist has informed that for the company owned stockyards, handling agents are appointed to handle stockyard operations and for other marketing outlets, consignment agents are appointed to provide storage and handling facility by maintaining a stockyard exclusively for storage of the materials. The materials manufactured by the company are despatched both by road and rail from headquarters under Form-‘F’ evidencing transfer of the material from the plant to the branch stockyards. Since the materials are sent to different locations on stock transfer basis, sales tax is not applicable for such stock transfers. The scope of the consignment agents/handling agents includes taking delivery of the materials from railway sidings, transporting the same to stockyards and stacking them in proper place, etc. According to the querist, the company classifies the expenditure incurred on transportation of these materials as freight outwards and the handling expenditure paid to the handling/consignment agents is classified as selling expenditure by the company.

3. The querist has further informed that the company has been valuing inventories of finished goods lying unsold at stockyards at cost of production plus the cost of transportation of material from plant to stockyards and the handling expenditure such as unloading materials from trucks/wagons, weighing the unloaded material, bringing from railway siding to stockyards wherever applicable, stacking, etc., incurred before sale.

4. The querist has forwarded the following comments of government auditors and the company’s reply to the same:

                                    Auditors’ comments

Government Auditors, during their audit of accounts of the company for the year 2002-03, observed that the company valued its closing stock including the handling charges and the freight component incurred by the company towards transfer of material from headquarters to different marketing stockyards which is not in line with paragraph 13 of the Accounting Standard (AS) 2, ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, according to which the selling and distribution costs are to be excluded. The observation of the Government Auditors has been reproduced hereunder:

"PROFIT AND LOSS ACCOUNT

 

Income

 

Accretion (Depletion) to Stock of Semi-finished/Finished Goods (Schedule-17)

 

Closing Stock – Rs. 25336.44 lakh Paragraph 13 of Accounting Standard (AS) 2 provides that while determining the cost of inventories in accordance with paragraph 6 of the Accounting Standard, the selling and distribution costs, inter-alia, are to be excluded and the same are to be recognised as expenses in the period in which they are incurred. The accounting policy no. 4(a)(i) also states that the cost for this purpose is determined on the basis of average cost of production of the last six months. However, while valuing the closing stock (lying at branch sales offices) at cost (being lower than its realisable price), handling charges (Rs. 67.32 lakh), which are classified by the company itself as selling expenses and freight outwards (Rs. 881.39 lakh), which are distribution costs are also considered as a part of cost of production, which is in contravention to the Accounting Standard as well as the accounting policy. This has resulted in overstatement of closing stock, inventory and profit for the year by Rs. 948.71 lakh."

 

Company’s reply

The company explained to the Government Auditors that the method of valuation of inventories followed by the company is in line with AS 2 since paragraph 11 states that the cost of inventories should comprise all costs of purchase, costs of conversion and other costs in bringing the inventories to their present location and condition.

The company’s reply to the observation of Government Auditor is given hereunder:

"As per AS 2, 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 which is stated at paragraph 6. The Standard speaks of the exclusions in paragraph 13 which inter-alia include selling and distribution costs. Paragraph 11 of the Standard states that other costs to the extent they are incurred in bringing the inventories to their present location and condition are to be included in the cost of inventories. Paragraph 17 also states that the formula used in determining the cost of an item of inventory needs to be selected with a view to providing the fairest possible approximation to the cost incurred in bringing the item to its present location and condition. The freight and handling costs are necessarily incurred for bringing the material to the relevant location without which the material would not have reached that location and condition. Further, it is pertinent to note that even the excise duty liability depends on the place of sale. The accounting policy of the company referred to by the auditors reads as follows: ‘Cost is determined on the basis of average cost of production of the last six months during the year considering normal capacity.’ This clearly brings out the basis for arriving at the cost of production. The railway freight and handling charges incurred for transporting the material to the stockyards of the company are necessarily to be incurred up to the point of sale and cannot be termed as distribution costs. The sale price is also determined based on the point of sale and hence the costs incurred up to this point are to be considered in valuing the inventory.In view of the above, audit is requested to drop the comment".(Emphasis supplied by the querist.)

                                         Views of the Government Auditors

The argument of the Government Auditors is based on paragraph 13(d) of AS 2 according to which selling and distribution costs are to be excluded from the cost of inventories and since the company has classified handling charges incurred at stockyards as selling expenditure and the freight incurred in transfer of materials from plant to different marketing offices as freight outwards, these would take the nature of distribution cost.

Views of the company

Selling and distribution costs as mentioned in AS 2 clearly refer to the costs incurred after the sale is effected and all the costs incurred up to the point of making the product available for sale are not to be considered as selling and distribution expenses. The costs incurred by the company for transfer of material from plant to marketing stockyards represent other costs as cited at paragraph 11 of AS 2 which states that the cost incurred for bringing the inventories to their present location and condition are rightly to be included in the cost of inventories. (Emphasis supplied by the querist.) The company’s accounting policy on valuation of inventories is reproduced hereunder:

 

"Finished/semi-finished goods are valued at lower of cost (excluding interest and administrative expenses) and net realisable value. Cost is determined on the basis of average cost of production of the last six months during the year considering normal capacity. Normal capacity is based on the average production of the preceding three years of main production units, excluding abnormal years. Abnormal year is the year in which the actual production is less than 40% of the installed capacity. Coke and other by-products are valued at net realisable value wherever cost is not determined except in the case of stock of BF granulated slag at dump yard for which no value is assigned. Products in respect of which there is no sale, are valued at cost. No credit is taken for the value of material in process except those lying at mills".

 

5. The querist has referred to the opinions given by the Expert Advisory Committee published in Volume IX of the Compendium of Opinions, vide Queries No. 1.16 and 1.25 wherein it was opined by the Committee that costs that are incurred and related to in effecting the change in location and condition of inventory items are to be included in the cost for the purpose of valuation of inventories. The querist has also referred to another opinion published in Volume XX of the Compendium of Opinions (Query No. 8), wherein the Committee has stated that the test for determining whether or not the cost of carrying out a particular activity should be included in the cost of inventories is whether the activity contributes to the present location and condition of the inventory. The ‘nomenclature’ of the activity or the place where the activity is carried out is not relevant. In view of the above opinion, it is felt that the transportation charges incurred in moving the inventories from the manufacturing point (where the company’s plant is located) to its stockyards, termed as freight outwards and the handling charges incurred towards unloading the goods transported, stacking them, etc., at the stockyards, before sale, termed as selling expenses, need to be included necessarily in the cost of inventories as per AS 2, since mere expressions freight outwards, and selling expenses do not, per se, qualify them as distribution cost and selling expenses resulting in exclusion of these expenses from the cost of inventories (paragraph 13(d) of AS 2).

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

(a) Whether the freight incurred for transfer of materials from plant to different marketing locations of the company and the handling expenditure towards unloading of the material, stacking and segregating at the stockyard before sale are to be considered as selling and distribution costs and not to be included in the valuation of inventories.

(b) Whether the accounting policy of the company on valuation of inventories needs to be amplified further to disclose inclusion of other costs in addition to cost of production.

C. Points considered by the Committee

7. The Committee notes paragraph 6 of AS 2 referred to by the querist in paragraph 4 above, which 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."

The Committee notes from the above that the other costs incurred in bringing the inventories to their present ‘location’ should form part of the cost of inventories.

8. The Committee also notes paragraph 13 of AS 2 referred to by the querist in paragraph 4 above which provides as below:

"13. In determining the cost of inventories in accordance with paragraph 6, it is appropriate to exclude certain costs and recognise them as expenses in the period in which they are incurred. Examples of such costs are:

(a) abnormal amounts of wasted materials, labour, or other production costs;

(b) storage costs, unless those costs are necessary in the production process prior to a further production stage;

(c) administrative overheads that do not contribute to bringing the inventories to their present location and condition; and

(d) selling and distribution costs."

9. The Committee is of the view that the term ‘distribution costs’ referred to in paragraph 13(d) of AS 2 reproduced above read with paragraph 6 of AS 2, should be construed as distribution costs which are incurred by the seller in making the goods available to the buyer from the point of sale. In other words, distribution costs comprising the expression ‘selling and distribution costs’ would include only those costs which are incurred for moving the goods from the premises of the seller, whether from the factory or from the stockyard of the seller, to the premises of the buyer. Thus, the costs incurred in moving the goods from the factory to the seller’s stockyard before sale, should be construed as the costs incurred in bringing the inventories to their present location within the meaning of paragraph 6 of AS 2, and, therefore, should be included as part of the cost of inventories lying in the said stockyard.

10. The Committee is further of the view that the handling expenditure incurred towards unloading of the material and stacking in the stockyard, prior to effecting the sale, is also incurred to bring the inventories at the location of the stockyard. It is not clear what expenditure is incurred on segregation of inventories at the stockyards prior to effecting the sale. If such expenditure is also incurred for changing the location, then it should also be included in the cost of inventories.

11. The Committee also notes paragraphs 11 and 17 of AS 2 referred to by the querist in paragraph 4 above. The Committee is of the view that mere classification of the handling charges as ‘selling expenditure’ and freight incurred as ‘freight outwards’ in transfer of materials from the company’s plant to different stockyards is not relevant for determining whether or not the cost of carrying out this activity should be included in the cost of inventories. In other words, the nomenclature of the activity or the place where the activity is carried out is not relevant, the test is whether such activity contributes to bringing the inventories to their present location and condition. The Committee, however, advises that the company should change the nomenclature to avoid confusion.

12. The Committee is of the view that the wording of the accounting policy with regard to valuation of inventories followed by the company indicates that cost for the purpose of valuation of inventories includes only cost of production, which, in view of the facts of the case, is not correct. The Committee, therefore, recommends that wording of the accounting policy should be changed to bring out the fact that the cost also includes other costs incurred in bringing the inventories to their present location and condition. The Committee, however, does not comment on other aspects included in the accounting policy since those have not been raised by the querist.

D. Opinion

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

(a) The freight incurred for transfer of materials from plant to different marketing locations of the company and handling expenditure towards unloading and stacking of the material at the stockyards before sale is effected should be included in the cost for the purpose of valuation of inventories. Expenditure incurred on segregation of inventories at the stockyards should be included in cost if such expenditure is incurred for changing the location of the inventories prior to effecting the sale. The Committee is further of the opinion that it would be appropriate for the company to change the nomenclature so that the said expenditure should not appear to be of the nature of selling and distribution expenses.

 

(b) The wording of the accounting policy should be changed as suggested in paragraph 12 above.

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1Opinion finalised by the Committee on 27.1.2004.