Whether unprovided depreciation should be included

in cost for inventory valuation purposes.

1.A company, ‘X’ limited, includes depreciation consistently in its stock valuation. In the year 1986, ‘X’ Limited, decided not to provide for depreciation in the books of account, mainly because of lack of profits. The company, however, intended to include depreciation in stock valuation for the annual accounts of 1986 even though depreciation was not charged to the profit and loss account during the year.

2.In the above context, the querist has mentioned that there can be two divergent views which are discussed in the following paragraphs.

3.As per the querist, according to the first view, depreciation cannot be inventorized because of following reasons:

(i) ‘Carry forward’ of ‘costs related to inventories’ is the intent of stock valuation vide para 7 of AS-2. This cannot be done in the present case as what is not debited to profit and loss account cannot be carried forward.

(ii) Since closing stock is valued for the purpose of determining cost of goods sold, inventorizing depreciation would vitiate cost of goods sold through violation of the matching principle.

(iii) The relationship of total overheads content of stock to the materials and labour content of stock would not be comparable with the corresponding relationship of total costs of the year.

(iv) If unprovided depreciation is included in stocks, it will result in non-proportional changes in profits for different levels of stock at a given production level. Hence, the policy would be faulty.

(v) Only net depreciation needs to be qualified by auditors and not the higher gross depreciation figure.

4.According to the second view, as per the querist, depreciation should be inventorized because of the following reasons:

(i) Stock valuation is independent of cost of production recognised in the profit and loss account. In needs only be ascertained that relevant ‘historical costs’ are ‘incurred’, (vide para 6.2 (c) of AS-2). There is no requirement of incurrence plus recognition by way of debit to the profit and loss account.

(ii) Consistency in stock valuation is more important and should not be upset, because the non-provision of depreciation is purely temporary and will be made up retrospectively without option in future years.

(iii) Working out of depreciation component in stock is cumbersome as, in many cases, net realisable value will be lower than cost. Hence, the exercise would be avoided.

(iv) Future years profits/losses will be vitiated (inflated) as a consequence of stock being stated lower, hence, it should be included in the current year itself.

(v) Auditors can make a shorter qualification, which is much better, because only gross depreciation will then need to be qualified and no reference in this regard needs to be made in MAOCARO report, because, stocks valuation is consistent.

5.On the basis of the above, the querist has sought the opinion of the Expert Advisory Committee on the following:

(a) Even though the management of the company may not provide for depreciation due to inadequacy of profits or otherwise, is it entitled to include it as an element of cost in the closing stock?

(b) In case the answer to (a) above is in the affirmative can this principle of stock valuation be extended to other items of costs also, such as (i) unprovided depreciation on assets in the year of their sale, (ii) unpaid excise duties accounted on a payment basis, (iii) Crop liability of plantation companies, accounted for on cash basis, when prices are fluctuating substantially on an estimated basis in processed stocks-at-close?

(c) What is the duty of the auditor in this regard and what should be the disclosure in his report (both main and MAOCARO reports) in case (i) unprovided depreciation is included in stock? (ii) unprovided depreciation is not included in stock?

Opinion December 18, 1988

1.The Committee notes that the Accounting Standard 2 (AS-2) on ‘Valuation of Inventories’, issued by the Institute of Chartered Accountants of India, recommends in para 27 that the “historical cost of manufactured inventories may be arrived at on the basis of either direct costing or absorption costing”. The term ‘Absorption Costing’ has been defined in the Standard as “the method whereby the cost of inventories is determined so as to include the appropriate share of both variable and fixed costs, the latter being allocated on the basis of normal level of production.” The Committee is of the view that depreciation, being a fixed cost, should be included for the purpose of determination of historical cost of inventories in case the company is following the absorption costing system.

2.The Committee is of the view that if an expense is not debited to the profit and loss account, it means that it is not recognised as cost by the management. If the management does not recognise an item as cost for the purpose of debiting to the profit and loss account, it can not be recognised as an item of cost for the purpose of inventory valuation. The Committee is therefore of the view that depreciation, if not debited to the profit and loss account, can not be considered as an element of cost for the purpose of inventory valuation.

3.The Committee notes that according to the Accounting Standard 6 (AS-6) on ‘Depreciation Accounting’, issued by the Institute of Chartered Accountants of India, the “depreciable amount of a depreciable asset should be allocated on a systematic basis to each accounting period during the useful life of the asset” (para 21). Thus, in the view of the Committee, in case depreciation is not provided in the accounts, the auditor should qualify his report or give a negative opinion, depending on the materiality of the amounts involved, in the manner required in the Statement on Qualifications in Auditor’s Report, issued by Institute of Chartered Accountants of India.

4.On the basis of the above, the opinion of the Committee on the issues raised by the querist in para 5 of the query, is as below:

(a) No.

(b) Since the answer to (a) above is in the negative, answer to this question does not arise.

(c) (i) In case depreciation is included for valuation of inventories but not debited to profit and loss account, the auditor should qualify his main report or give a negative opinion, depending on the materiality of amounts involved, in the manner required in the Statement on Qualifications in Auditor’s Report issued by Institute of Chartered Accountants of India. In MAOCARO report, the auditor should report that inventory valuation is not fair and proper as per the normally accepted accounting principles.

(ii) In case depreciation is not included for the purpose of valuation of inventories though the company is following absorption costing system for this purpose, the valuation will not be in accordance with AS-2 and therefore, not in accordance with normally accepted accounting principles in this regard. The auditor should qualify his main report as suggested in (c) (i) above. The auditor should also report as required in para 4 (A) (iii) of MAOCARO issued under section 227 (4A) of the Companies Act, 1956, that the valuation of the said inventories is not fair and proper as per the normally accepted accounting principles and that it is not on the same basis as in the earlier years. He should also report the effect of the said deviation, if material.

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