Query No. 5

Subject:

Computation of net realisable value of the inventories of diamonds.1

A. Facts of the Case

1. A company is in the business of extraction of iron ore/tuff (ore out of which diamonds are picked)/limestone from various mines in India. The company has developed and completed the expansion and modernisation of its diamond mine and processing plant. The diamond mine has doubled its production capacity to 84,000 carats per annum since April 2001.

2. During the audit of accounts of the company for the year 2002-2003, the government auditors have commented that the net realisable value (NRV) considered by the company for valuation of individual gems produced during the period 1996-97 to 1999-2000 is not realistic and is on the higher side. Consequently, the closing stock of finished goods stood overstated with a corresponding increase in profit for the year.

3. According to the querist, the contention of the auditors was based on the offer received during February 2001 from M/s. XYZ Ltd., for purchase of 656 carats of individual gems produced during the period 1996-97 to 1999-00. M/s XYZ Ltd., had offered a non-negotiable all inclusive rate of Rs. 140 lakh including octroi, sales tax, etc., as against the price of Rs.202.07 lakh indicated by the company. The company did not accept the contention of the auditors.

4. The company’s accounting policy as given in the company’s annual accounts with regard to the finished goods is as below:

Items of inventories as certified by the management are valued on the basis mentioned below: 

Finished Goods – At cost or net realisable value whichever is lower

5. The querist has informed that for the purpose of closing stock valuation, diamonds are classified and valued under the following six categories:

(a) Gems – individual

(b) Gems – packets

(c) Off colour – individual

(d) Off colour – packets

(e) Industrial – individual

(f) Industrial – packets

Good quality individual diamonds of two carats (individual gems)/ three carats (off colour and industrial) and above are valued as individual diamonds and small diamonds of less than two/three carats are grouped and kept under ‘Packets’. The diamond valuation contested by the company is in the ‘Gems–individual’ category.

6. Details of production, sales and closing stock of diamonds for the past four years, as informed by the querist, are given below:

(Carats)

Year	Production	Sales	Closing Inventories
1999-2000	40230	43322	11208
2000-2001	56955	44514	23649
2001-2002	81251	76944	27884
2002-2003	84348	70787	41445

7. The querist has provided the following details of inventories of individual gems for the last four years:

                                                                                          (Carats)

The figures in brackets indicate the value of inventories in Rs. lakh.

8. The querist has informed that the cost of production of diamonds is arrived at as follows:

(i) The total cost for the valuation of inventories of diamonds is worked out by deducting the expenditure on administrative overheads, selling and distribution costs, interest, etc., from the total expenditure incurred during the year.

 

(ii) To the cost thus arrived at, the value of opening stock of tuff is added and the value of closing stock of tuff is deducted to arrive at the cost of tuff processed during the year which is the cost of production of diamonds for the year.

 

(iii) Cost of production arrived at as per (ii) above is apportioned to the six categories (as specified in paragraph 5 above) of diamonds on the basis of weighted average sales realisation during the year. The cost per carat of diamonds is arrived at by dividing such apportioned cost in each category with the carats produced in that category. This rate is adopted for valuation of inventories of diamonds produced during the current year.

 

(iv) In case of unsold diamonds produced in earlier years, cost of production of the respective year of production is adopted.The computation of cost of production, in the opinion of the querist, is in compliance with Accounting Standard (AS) 2, ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India.

9. The querist has informed that the net realisable value (NRV) of the inventories of diamonds is arrived at as below:

The diamonds are sold by way of auction/tender. The sale of diamonds is recognised after the auctioned diamonds are delivered to merchants. In order to arrive at the net realisable value of inventories in each category, the net auctioned value for the year, after deducting the royalty under each of the above six categories, is divided with the auctioned quantity for the year under that category.The cost computed as per paragraph 8 above is compared with the NRV and lower of the two is adopted for valuation of inventories.

10. The contention of the auditors in case of individual gems of earlier production of 1996-97 to 1999-2000 is that such diamonds are continuing as inventories because of lack of demand for these diamonds and, therefore, adopting NRV based on average realisation of the current year sales is not in order. The auditors have suggested that the company should adopt the offer received from M/s XYZ Ltd., as the basis for arriving at the NRV in case of inventories of individual gems pertaining to the years 1996-97 to 1999-2000.

11. The views of the querist on the auditors’ observations are as under:

(a) The offer given by M/s. XYZ Ltd., was very low and could not be considered as a representative price of the lot. Besides, the company has sold, during the year 2002-2003, 88.59 carats out of the inventories of diamonds of 656 carats produced during the period 1996-2000 and the amount realised on sale of these diamonds is at par with the similar diamonds of 2002-2003 production.

 

(b) The company is consistently following the principle of valuation of inventories of unsold diamonds produced in earlier years on the basis of cost of production of the respective years as per paragraph 14 of AS 2 or the NRV of the year, whichever is lower.

 

(c) The procedure adopted by the company for computation of NRV is adequate and it is not practicable to work out NRV for each diamond/packet in view of large quantity of diamonds. There may not be offers for some lots during the current year/ recent past.

 

(d) Diamond is not subject to obsolescence and deterioration in value even if held in stock for a longer period. On the contrary, value of a diamond increases over the years.

 

(e) At present, the auctions are conducted once in a month and about 8000 to 9000 carats are displayed. The average sale quantity is 6000 to 7000 carats per auction. Due to limitation of facilities and also to make the diamond display attractive and interesting to the merchants, not all the unsold diamonds produced in earlier years are displayed at all the auctions held during the year. Only a few diamonds out of the unsold lots, on a rotation basis, are displayed in each auction. The delay in sale is also due to this factor. The company is now planning to liquidate the unsold stock of earlier years’ production of individual gems by conducting auctions at different places of the country.

 

(f) Diamonds have not been sold either because the prices offered were below the reserve price fixed by the company or the Presiding Officer (who conducts the auction) estimated that the diamonds under auction may fetch higher realisation. The delay in sale does not necessarily relate to the quality of the diamonds.

(g) Since there is no other diamond producer in the organised sector in the country, the company is unable to ascertain the industry practice about valuation of inventories of diamonds.

B . Query

12. Opinion of the Expert Advisory Committee has been sought on the following issues:

(a) Whether computation of NRV adopted by the company in case of individual gems produced in earlier years, viz., 1996-97 to 1999-2000, is in order. If not, whether the company can have a different procedure for valuation of inventories of individual gems produced in earlier years.

(b) If a different procedure is to be adopted, what should be the broad guidelines to be considered by the company for determining NRV of inventories of diamonds produced in earlier years?

C. Points considered by the Committee

13. The Committee notes that the basic issue raised in the query relates to computation of NRV in case of inventories of individual gems produced in earlier years, viz., 1996-97 to 1999-2000. The Committee has, therefore, considered only this issue and has not touched upon any other issue arising from the facts of the case such as computation of cost of production of different categories of diamonds, recognition of revenue in respect of sale of diamonds, etc.

14. The Committee notes the definition of the term ‘net realisable value’ contained in paragraph 3 of AS 2, which is reproduced below:

"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."

15. The Committee also notes paragraph 22 of AS 2 which states 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."

16. On the basis of the above, the Committee is of the view that for the purpose of determination of net realisable value, it is necessary to consider the price at which the items of inventories are expected to be sold in the ordinary course of business. The Committee notes that in the present case there can be different bases of estimation, e.g., on the basis of a sale order in hand, past trends, etc. The events occurring after the balance sheet date but before finalisation of accounts can also be considered for estimating the selling price for the purpose of determining the net realisable value. For example, if certain diamonds have been sold out of the inventories of individual gems produced during 1996-1997 to 1999-2000, subsequent to the balance sheet date, the company can adopt the selling prices as the basis for valuation of unsold inventory after making appropriate adjustments, if necessary. The Committee notes that the basis for computation of net realisable value, as contended by the government auditors, relates to an offer made during February 2001. The Committee is of the view that this may not necessarily represent the net realisable value of individual gems produced during 1996-1997 to 1999-2000 at the balance sheet date for the financial year 2002-2003.

D. Opinion

17. On the basis of the above, the Committee is of the following opinion on the issues raised in paragraph 12 above:

(a) The net realisable value of inventories of individual gems produced during 1996-1997 to 1999-2000 should be determined considering the factors as suggested in paragraph 16 above.

 

(b) The broad guidelines to be considered by the company for determining NRV of inventories of diamonds produced in earlier years have been explained in paragraph 16 above.

1 Opinion finalised by the Committee on 26.5.2004