1. Assumption for this write up:
a. The Company understands and accepts that their raw material, WIP and finished goods qualify under the definition of AS 2.
b. The Company follows standard costing method of accounting.
c. The Company has followed the AS 2 requirements for measuring the Cost of Inventories, Costs of Purchase, Costs of Conversion and other defined costs
2. Purpose of write up
a. To throw light on whether standard costing is an accepted method of costing
b. To identify method of Valuation disclosure in case of adoption of standard costing method of valuation.
3. Important extracts from AS 2, Valuation of Inventories:
a. As per paragraph 14 - “The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by specific identification of their individual costs.”
b. As per paragraph 15 –“Specific identification of cost means that specific costs are attributed to identified items of inventory. This is an appropriate treatment for items that are segregated for a specific project, regardless of whether they have been purchased or produced. However, when there are large numbers of items of inventory which are ordinarily interchangeable, specific identification of costs is inappropriate since, in such circumstances, an enterprise could obtain predetermined effects on the net profit or loss for the period by selecting a particular method of ascertaining the items that remain in inventories.”
c. As per paragraph 16 – “The cost of inventories, other than those dealt with in paragraph 14, should be assigned by using the first-in, first-out (FIFO), or weighted average cost formula. The formula used should reflect the fairest possible approximation to the cost incurred in bringing the items of inventory to their present location and condition.”
d. As per paragraph 17 – “A variety of cost formulas is used to determine the cost of inventories other than those for which specific identification of individual costs is appropriate. The formula used in determining the cost of an item of inventory needs to be selected with a view to providing the fairest possible approximation to the cost incurred in bringing the item to its present location and condition.
e. As per paragraph 18 – “Techniques for the measurement of the cost of inventories, such as the standard cost method or the retail method, may be used for convenience if the results approximate the actual cost. Standard costs take into account normal levels of consumption of materials and supplies, labour, efficiency and capacity utilisation. They are regularly reviewed and, if necessary, revised in the light of current conditions.”
f. As per Paragraph 26 – “The financial statements should disclose:
i. (a) the accounting policies adopted in measuring inventories, including the cost formula used; and
ii. (b) the total carrying amount of inventories and its classification appropriate to the enterprise.”
g. As per Paragraph 27 – “Information about the carrying amounts held in different classifications of inventories and the extent of the changes in these assets is useful to financial statement users. Common classifications of inventories are raw materials and components, work in progress, finished goods, stores and spares, and loose tools.”
4. Interpretation of the above mentioned extracts of AS – 2 in context with the standard costing method of costing:
a. As per Paragraph 17, the underlying principle for using a particular cost formula for valuing inventory is to provide the fairest possible approximation to the cost incurred in bringing the item to its present location and condition and as per paragraph 18, standard costing method can be used for convenience if the results approximate the actual cost. Hence, standard costing is an accepted form of inventory valuation under AS -2.
b. As per Paragraph 16, the inventory costing has to be done using FIFO or weighted average cost formula only in those cases where specific identification of costs is inappropriate or not possible. Specific identification of costs is inappropriate of cost is defined in paragraph 14 & 15. Since, the products of the Company are a result of differentiated input & conversion process, the valuation of the output will be specific. Management has to establish that the standard costing results in specific identification of the costs for each of the product, if management does so, then, their method of costing is acceptable under paragraph 16.
5. Conclusion:
a. As per AS 2, FIFO and weighted average cost are not the only two methods of inventory valuation; they are only two popular methods.
b. AS 2 permits Company to use standard costing or retail costing or any other specific identification of individual costs method, as a method of inventory valuation, provided they can establish that their method of costing results in specific identification of the costs for each of the product, i.e., more appropriate than FIFO or WAC.
c. The Company has to ensure the disclosure of the accounting policy in measuring inventory (inventory measurement at cost or net realisable value – lower of the two), cost formula (usage of Standard Costing method of Inventory Valuation), the total carrying amount of inventories and its classification appropriate to the enterprise.
d. Consistent accounting policy should be used, i.e., there should be same valuation policy for entire range of Raw material or WIP or Finished Goods.
By: CA. Aparna RamMohan
caaparnasridhar@gmail.comAny doubt on accounting standard, you can reach me at caaparnasridhar@gmail.com
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