1.7 Query
Valuation of inventories in tea industry.
1. A firm engaged in the manufacture of tea has been consistently valuing stock of manufactured tea (‘made tea’) on the basis of absorption costing method, taking into account the future destination point of sale. A specific case is cited below:
“Stock of made tea lying at Calcutta warehouse on the balance sheet date meant to be sold in U.K. is valued at a cost which includes expenditure like marine insurance, ocean freight, shipping charge, and other incidental costs which are to be incurred later than the balance sheet date to send the stock to its future destination selling point.”
2. Regarding the stock of made tea, which is meant to be sold in the Indian market, the aforesaid firm follows the practice of including the Calcutta warehouse charges in the valuation of stock.
3. The company has been consistently following the practice cited above. Regarding the inclusion of post balance sheet costs, the querist feels that the stated practice suffers from the drawbacks of inclusion of certain expense items which may not necessarily have been incurred as on the balance sheet date and/or even incurred to bring the stock to its present location and condition. About the same practice, the querist has further mentioned that “the valuation of closing stock of made tea is overstated which, however, is offset by the corresponding inclusion of liabilities in the accounts. Thus, there will be no impact on profit on account of the said inclusion. Yet, it may be inferred that there is both overstatement in the value of stock and the corresponding expenses aforesaid which remain as liabilities outstanding”.
4. Regarding the case of Calcutta warehouse charges, stated in paragraph 2 above, the querist feels that the practice “does not seem proper as per Accounting Standard 2, since such costs have nothing to do with bringing the stock to its present location and condition.” Also warehouse charges actually represent stock carrying cost. The manufacture of made tea is complete at the garden level, and, therefore, at most, the transportation charges from the garden to the warehouse can be included in the valuation and definitely not the warehouse charges which are basically in the nature of selling and distribution overhead.
5. The querist has sought the opinion of the Expert Advisory Committee on the following issues arising from the above:
(a) whether the above mode of valuation of stock having regard to the practices followed by tea industry in general, is fair and proper? and
(b) whether “Plantation”, which is specifically stated to be outside the purview of Accounting Standard 2 dealing with ‘Valuation of Inventories’ does cover stock of ‘made tea’ or only stock of ‘plucked green (raw) tea?’ If “Plantation” is to cover stock of made tea, then what would be the appropriate method of valuation of stock of made tea?
Opinion February 11, 1988
1. The Committee is of the view that the term “plantation” which is specifically stated to be outside the purview of Accounting Standard 2 ‘Valuation of Inventories’, covers only the stock of ‘plucked green (raw) tea’ and it does not cover stock of ‘made tea’. ‘Made tea’ involves a manufacturing process and is therefore a manufacturing and not ‘plantation’ activity. Therefore, the mode of inventory valuation prescribed in Accounting Standard 2 shall be applicable in this case.
2. The Committee also notes that the Accounting Standard 2 requires that subject to certain exceptions stated therein “inventories should be valued at lower of historical cost and net realizable value” (para 24). Net realizable value has been defined as “the actual/estimated selling price in the ordinary course of business, less cost of completion and cost necessarily to be incurred in order to make the sale” (para 6.9). Accordingly, the expenses expected to be incurred after the balance sheet date (in the case of this company the expected expenditure on marine insurance, ocean freight, shipping charges) to send the stock to its future destination selling point, should be deducted from the expected selling price and the net amount should be compared with the historical cost which should not include the aforesaid expenses.
3. Regarding the treatment of Calcutta warehouse charges, the Committee is of the view that such expenses belong to the sales and distribution activities, since a ‘warehouse’ is normally not used for any activity to put inventories in their saleable condition, but for the purpose of storage thereof. About such costs, the Accounting Standard 2 recommends in paras 16 and 28 as below:
“16. Costs other than production overheads are sometimes incurred in bringing inventories to their present location and condition, for example, expenditure incurred in designing products for specific customers. On the other hand, selling and distribution expenses, general administration overheads, research and development costs and interest are usually considered not to relate to putting the inventories in their present location and condition. They are, therefore, excluded from determining the valuation of inventories.
28. Overheads other than production overheads should be included as part of the inventory cost only to the extent that they clearly relate to putting the inventories in their present location and condition”.
4. On the basis of the above, the opinion of the Expert Advisory Committee on the issues raised by the querist in para 5 of the query is as follows:
(i) The mode of valuation of stock followed by the company is not fair and proper in view of the recommendations in Accounting Standard 2.
(ii) “Plantation”, which is specifically stated to be outside the purview of Accounting Standard 2, covers only the stock of ‘plucked green (raw) tea’ and it does not cover stock of ‘made tea’. In view of this AS 2 will apply to ‘made tea’.
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