Query No. 25

Subject:

Accounting policy on inventories.¹

A. Facts of the Case

1. A company is a Government of India undertaking incorporated in 1975 under the Companies Act, 1956. The objectives of the company include setting-up of power plants in various geographical locations in the country and supplying bulk power to the various State Electricity Boards/succession entities. The company has 13 coal based generating stations and 7 gas based generating stations located all over the country. Besides these power stations, the company is also setting up hydro- power generating plants.

2. The company, having been registered under the Companies Act, 1956, and being an electricity generating company, is also governed by the provisions of the Electricity Act, 2003. According to the querist, as the government has not prescribed any statement of accounts for the central undertakings engaged in generation of electricity, the company is preparing its accounts in accordance with Schedule VI to the Companies Act, 1956, since its inception, which has been accepted by various audit agencies.

3. The querist has stated that being an electricity generating company, its inventories mainly consist of components and spares, loose tools, coal, fuel oil, naptha, chemicals and consumables, and others, which are in the form of materials or supplies to be consumed in the production process or in the rendering of services as provided in paragraph 3(c) of Accounting Standard (AS) 2, ‘Valuation of Inventories’ (revised 1999), issued by the Institute of Chartered Accountants of India. The company has adopted the following accounting policies for valuation of inventories for the purpose of preparation of accounts:

“Inventories other than scrap are valued at cost, on weighted average basis. Stores-in-transit are valued at cost.”

“Losses towards unserviceable and obsolete stores and spares, identified on review of inventories are provided for in the accounts.”

4. According to the querist, while reviewing the accounts for the financial year 2004-05, the government auditor observed that the above accounting policy for valuation of inventories is not in conformity with AS 2, which states that valuation of such inventories should be done at the lower of cost and net realisable value instead of weighted average cost basis.

5. In the management reply, the company stated that paragraph 5 of AS 2, which requires that the inventories should be valued at the lower of cost and net realisable value, should be read along with paragraphs 20 and 24 of AS 2, which provide as follows:

“20. The cost of inventories may not be recoverable if those inventories are damaged, if they have become wholly or partially obsolete, or if their selling prices have declined. The cost of inventories may also not be recoverable if the estimated costs of completion or the estimated costs necessary to make the sale have increased. The practice of writing down inventories below cost to net realisable value is consistent with the view that assets should not be carried in excess of amounts expected to be realised from their sale or use.”

“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….”

6. The querist has further stated that it may be seen that while the requirement of AS 2 is to ensure that the assets are not carried in excess of the amounts expected to be realised from their sale or use, materials and other supplies held for use in the production of inventories are not written down below cost if the finished products are expected to be sold at or above cost (emphasis supplied by the querist).

7. According to the querist, the above stated accounting policies with regard to valuation of inventory items and providing for unserviceable/ obsolete items are being followed consistently over the years. The querist has stated that since the inventories include only fuel, spares and consumables, the question of determination of realisable value does not arise as the sale of the finished product, viz., “electricity”, is always above the cost of generation. Further, as per the querist, in the ‘notes to accounts’, the company makes the following disclosure:

“In the opinion of the management, the value of the current assets, loans and advances on realisation, in the ordinary course of business will not be less than the value at which these are stated in the balance sheet.”

8. The querist has also referred to an earlier query made by the company, wherein the Expert Advisory Committee of the Institute of Chartered Accountants of India opined “…In case the net realisable value of electricity exceeds its cost of generation calculated from the accounting point of view and the price (replacement cost) of coal has not declined, valuing inventories of coal at the coal stockyard at cost inclusive of costs of merry-go-round (MGR)/coal handling plant would not be in contravention of AS 2.” (Query no. 19 of Volume XXI of the Compendium of Opinions.)

9. As per the querist, the inventories held by the company are not meant for sale; are only for consumption in the process of generation of electricity; and the sale price of the electricity is always above the cost of generation. The querist has stated that the provision for obsolete and unserviceable stores is reviewed every year. The management certification in the notes to accounts includes that the value of current assets on realisation, in the ordinary course of business will not be less than the value at which these are stated in the balance sheet. Considering all these facts, the company is of the view that the accounting policies followed
(as stated in paragraph 3 above) are in conformity with AS 2.

B. Query

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

(i) Whether the above-mentioned accounting policies followed by the company in respect of valuation of inventories are in compliance with the requirements of AS 2.

(ii) In case the answer to (i) above is in the negative, whether the accounting policy should state that the inventories are valued at the lower of cost and net realiasable value.

C. Points considered by the Committee

11. The Committee notes that the basic issue raised in the query relates to the consideration of net realisable value for valuation of components and spares, loose tools, coal, fuel oil, naptha, chemicals & consumables, and others which, according to the querist, are in the form of materials or supplies to be consumed in the production process or in the rendering of services. The Committee, therefore, has not touched upon any other accounting issue arising from the Facts of the Case, e.g., the appropriateness of the weighted average method followed by the company for valuation of inventories.

12. The Committee notes paragraph 24 of AS 2, which states as follows:

“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 further notes that the querist has stated that the finished product of the company, viz., electricity, is always sold at a price above the cost of generation. Thus, on the basis of paragraph 24 of AS 2 reproduced above, the Committee is of the view that inventory items are not required to be written down below cost as the finished product is always sold at above cost. However, the Committee notes that the wording of the accounting policy of the company as given in paragraph 3 above is not appropriate. The accounting policy should state that the inventory is valued at cost or net realisable value, whichever is lower. The Committee also notes that ‘stores in transit’ is a part of inventory and should have the same basis of valuation as that for other inventories. Thus, it does not require a separate mention in the accounting policy. In respect of the unserviceable and obsolete stores and spares identified by the company on review of inventories, the Committee notes that the company is providing for the losses on this account. The Committee is of the view that it would be appropriate to write-off/expense the impairment of unserviceable and obsolete stores and spares in the profit and loss account instead of making a provision therefor as the term ‘provision’ is generally used in respect of liabilities.

D. Opinion

14. On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 10 above:

(i) Please see paragraph 13 above.

(ii) Yes, the accounting policy should state that the inventories are valued at the lower of cost and net realisable value.

¹ Opinion finalised by the Committee on 20.10.2005