Expert Advisory Committee
ICAI-Expert Advisory Committee
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1.16     Query

 

Valuation of Inventories.

 

1.A public sector company is engaged in manufacturing wide range of organic and inorganic chemicals. The time taken from the receipt of raw materials to the manufacture of finished products is between one month to three months. The process plants are working in three shifts and therefore the manufacturing process is continuous.

 

2.For the purpose of valuation of closing stock for annual accounts, an Annual Manufacturing Account is prepared in which all elements of costs are allocated to various cost centres and finally an average cost of production of each product is worked out. The cost of production so worked out is adopted for valuation of the closing stock (subject, of course, to its being less than the net realisable value). The company has been following this method consistently in the past and the same has been accepted by both statutory and Government auditors.

 

3.It has been intimated by the Dy. Director of Commercial Audit, Bombay, that the Comptroller and Auditor General of India has issued instructions that for the purpose of valuation of closing stocks, the cost should represent –

 

                        (a) The cost of purchase,

 

                        (b)The cost of conversion; and

 

(c)Other costs incurred in the normal course of business in bringing the inventories upto their present location and condition.

 

It has been further clarified that he cost of purchase should consist of the purchase price, including duties and taxes, freight inward and other expenses directly attributable to acquisition etc. in respect of such purchases. The cost of conversion should consist of costs which are specifically attributable to units of production, i.e., direct labour, direct expenses and production overheads. The costs other than production overhead incurred in bringing inventories to their present location and condition would include costs like expenditure incurred in designing products for specified customers etc.

 

4.According to the above instructions of the Comptroller and Auditor General, the general administration overheads, research and development cost, selling and distribution expenses and financial charges should usually be considered as not related to putting the closing stock in the present location and condition and, should, therefore, be excluded from the computation of the cost of closing stock.

 

5.If the above instructions of CAG are to be followed for valuation of closing stock, there will be a change in the accounting policy adopted by the company consistently for the last so many years. As per information of the querist, many of the public sector units (PSUs) have also adopted the same method of valuation as is being presently adopted by the company viz., that all the administrative overheads and finance charges are taken as part of cost of production for valuation of closing stock. Thus, the above instructions of CAG would result in change in accounting policy of many public sector units which will vitiate the principle of comparability between two periods in the initial year of the change. Further, it is felt by the querist that the proposed change is not called for even on theoretical grounds as explained below:

 

(i)         It is seen that the instructions of Comptroller and Auditor General are based on Accounting Standard 2 (AS-2) on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India. It is agreed that the cost of closing stock should represent (a) cost of purchase (b) cost of conversion and (c) other costs incurred in the normal course of business in bringing the inventories upto their present location and condition. It is not, however, clear why it has been viewed by CAG that the items mentioned against (b) and (c) above should include only direct labour, direct expenses, and production overheads and exclude general administrative overheads, R&D cost, selling and distribution expenses and financing charges. In fact, in the view of the querist, all the above elements except selling and distribution expenses are legitimately costs of production as they are incurred as part of conversion cost or the cost required for bringing the inventories upto their present location and condition. These costs are incurred necessarily for the main purpose of company’s existence viz., production and hence are legitimately to be allocated to different product lines of the company. 

 

(ii)        The general administrative overheads are salaries and other expenses incurred on administration, accounts etc. and items like insurance. These costs, according to the querist, are necessary for putting the stocks in their present location and condition vide para 28 of the Accounting Standard as these are the expenses incurred on the service departments without which the production department would not be able to produce and store the finished product. Research and development costs of revenue nature include expenditure on account of improvement of process of production. In view of this, the R&D expenditure pertaining to improvement in the process of production etc. should be treated as cost incurred for production of the product.

 

(iii)       As far as the financial charges are concerned, the same are incurred on account of interest both on Government loan and interest paid on borrowings from the bank for the working capital purpose. The Government loans are provided for purchase of fixed assets. The interest on Government loans during construction of asset is capitalised and included in the cost of assets. The interest charges incurred after the date of capitalisation of assets are the actual costs to be included in the cost of production. The interest charges on bank borrowings are for holding stocks of raw materials, stores and spares, sundry debtors, and finished goods inventories. The interest charges on bank borrowing are, thus, cost incurred for putting the inventories in their present location and condition in the view of the querist.

 

(iv)       If the administrative overheads and finance charges are not taken as cost of production for the purposes of valuation of stock, all such costs will be debited to the year in which they are incurred without corresponding credit in the account. Thus, for the year in which the sales are more than production, profits will be unduly inflated whereas in the year in which sales are less than production the position will be reversed. Thus, the profit will be influenced mainly by sales, and the volume of production achieved during the different years will not have its legitimate bearing on the profit for that year. The basic principle of costing that the higher the volume of production, the less the element of fixed cost per ton of production will thus not be correctly reflected if administrative costs and finance charges are not taken into account for valuation of stocks.

 

(v)        The company is maintaining detailed cost accounts and preparing costing profit and loss account at the end of year. In fact, some of the company’s products are also governed, by maintenance of cost accounts under Section 233 B of the Companies Act vide Notification No. 53/396/CAB(87)/CLB dated 27th October, 1987.  In cost accounts closing stock is being valued at cost of production or net realisable value,  whichever is less, and such cost of production is inclusive of all items of administrative overheads, R&D expenses and finance charges. In order that these accounts reflect the same quantum of profit in the published accounts of the company, it is desirable that in the financial accounts the same method of valuation of closing stock is adopted.

 

(vi)       Another aspect to be considered is acceptance of the new method of stock valuation by income-tax authorities. If the company’s profit for the year goes down because of the adoption of new method of valuation suggested by the Audit, the ITO may take a view that the method consistently followed in the past should not have been changed since such a change has adversely affected the profit of the Company u/s 115 J and consequently the tax liability has come down. It will be difficult to argue with the ITO that the method has been changed due to certain valid considerations since view may be held that the administrative costs and finance charges are actual costs related to production of the company’s products and hence to the extent this production was not sold during the year, credit on account of such costs should have been given to the profit and loss account in form of closing stock valuation and consequently the company’s profit should have been more.

 

6.The querist has accordingly sought the opinion of the Expert Advisory Committee as to whether the existing policy to consider the administrative overheads, R & D costs and finance charges as part of cost of production of different products and valuing the closing stock on the basis of cost of production so worked out is in order and needs no change.

  

                                                                         Opinion                                September 13, 1989

 

1.The Committee notes paragraph 6.2, 6.4, 16 and 28 of the Accounting Standard 2 (AS 2) on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, which recommend as below:

 

                        “6.2            ‘Historical Cost’ represents an appropriate combination of the

 

                                    (a)            cost of purchase;

 

                                    (b)            cost of conversion; and

 

(c) other costs incurred in the normal course of business in bringing the inventories upto their present location and condition.

                       

                        6.4            ‘Cost of Conversion’ consists of

           

(i) costs which are specifically attributable to units of production, i.e., direct labour, direct expenses and sub-contracted work; and

 

(ii) production overheads, ascertained in accordance with either the direct costing or absorption costing method.

 

Production overheads exclude expenses which relate to general    administration, finance, selling and distribution.

 

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.”

 

2.The Committee also notes paragraph 11 of Accounting Standard 5 (AS 5) on “Prior Period and Extraordinary Items and Changes in Accounting Policies”, which is as under:

 

“A change in an accounting policy should be made if the adoption of a different accounting policy is required by statute or for compliance with an accounting standard or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements of an enterprise.”

 

3.The Committee also notes the various decisions under the Income-tax Act of various high courts in which it has been held that change of method of valuation on bona fide grounds is proper. [CIT v. National Grindlays Bank Ltd. (1984) 145 ITR 457 (Cal.) CIT v. Carborandum Universal Ltd. (1984) 149 ITR 759 (Mad.) Triveni Engg. Works Ltd. v. CIT (1987) 167 ITR 742 (All.) CIT v. Mopeds India (1988) 173 ITR 347 (AP.)].

 

4.The Committee is also of the view that if different methods of inventory valuation are adopted in cost accounts and financial accounts a reconciliation statement for reconciling the value of stock as per financial books and as per cost records may have to be prepared.

 

5.The Committee notes that although administrative overheads, R& D costs and finance charges are incurred for the purpose of the business, and, in some cases, may be inevitable, yet, in the view of the Committee, these costs are not clearly incurred and directly related in effecting change in the location and condition of inventory items. Only in exceptional cases the said costs can be considered to be clearly incurred and directly related in putting certain inventories in their present location and condition. For instance, interest cost, which is a period related cost, can be included in the valuation of inventories of timber for the period it was kept in store to enable it to mature so that it could be sold in that condition; in this case there is a clear change in the condition of the inventory during the period it was lying in store. However, in the facts and circumstances of the query, such direct nexus in incurrence of the administration, R & D and finance costs and change in the location and conditions the inventories, is not established.

 

6.On the basis of the above, the Committee is of view that the company’s policy of including administration, R & D and finance costs in the cost of production, for the purpose of valuation of inventories, is not in order.

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