AS – 2 (Revised)

VALUATION OF
INVENTORIES
OBJECTIVE
The objective of A.S-2 is to develop the
methods of Computation of Cost of Inventories
or Stock and to determine the value of
Inventories / Stock to be shown in the Balance
Sheet.
APPLICABILITY
A. S. – 2 is not applicable in the following cases:
(1) Work in Progress arising under Construction
Contract.
(2) Work in Progress arising in the ordinary course of
business of service providers.
(3) Shares, Debentures, Bonds and other financial
instruments held as stock in trade.
(4) Producer’s Inventories like Livestock, Agricultural
and Forest Products, Mineral Oils, Ores and Gases.
Such Inventories are valued at Net Realisable value.
Inventories means,
• Inventories Held for sale in the ordinary
course of business (finished goods)
• Inventories In the process of production of
such sale (raw material and work-in-progress)
• Inventories In the form of materials or
supplies to be consumed in production
process or in the rendering of services
(stores, spares, raw material, consumables).
 VALUATION PRINCIPLE
Inventories should be valued at Cost
or at Net Realisable Value,
whichever is lower.
Note: -
On the basis of above Valuation Principle,
stock can not be valued at above its cost,
but it may be valued at lower of its cost, if
the market value is lower than cost.
Step for Inventory Valuation: -
(1) Determination of Cost of Inventories.
(2) Determination of Net Realisable Value
(NRV) of Inventories.
(3) Comparison between the Cost and Net
Realisable Value.
Lower of step 1 and step 2 is the value of
Inventory.
Step 1: Determination of cost of Inventory
Cost of Inventory includes: -
(1) Cost of Purchase
(2) Cost of Conversion
(3) Other Cost (Incurred in bringing the
inventories to their present Location and
Condition).
Cost of Purchase: - Includes
(a) Purchase Price of Raw Material
(b) Duties and Taxes
(c) Freight Inward
(d) Other expenditure directly attributable to the acquisition.
But excludes:-
(a) Duties and Taxes recoverable by enterprises from Taxing
Authorities.
(b) Trade Discount
(c) Rebates
(d) Duty Drawbacks
(e) Other Similar Items.
 Cost of Conversion

Includes

Direct Wages Production Overheads

Variable Production
Overheads Fixed Production
Overheads
Direct wages: -
These are the payments made to
the workers, directly attached to
the production.
Production Overheads: -
Fixed And Variable Production
Overheads are systematically
allocated in converting the raw
material into finished goods.
Variable production overheads:
These are those indirect costs of
production that vary directly, or
nearly directly, with the volume
of production, such as indirect
materials and indirect labour.
Fixed production overheads
These are those indirect costs of
production that remain relatively
constant regardless of the volume of
production, such as depreciation and
maintenance of factory buildings and
equipment, and the cost of factory
management and administration.
The allocation of fixed production
overheads to the costs of conversion is
based on the normal capacity of the
production facilities.

Normal capacity is the production

expected to be achieved on an average
under normal circumstances during a
given period.
 Fixed Production Overheads as a part of cost
of conversion can be understand through
two situations:-
Situation I - Actual Production is lower than the
Normal Production:-
In this situation, the following steps should be
taken into consideration: -
Step – 1:- Per unit fixed overheads cost shall be
calculated by applying the formula:

Per Unit Fixed Overheads Cost => Total Fixed Overheads

Normal Production (in units)
Step – 2: - To calculate the amount of Fixed
Production Overheads to be included in cost
of conversion, per unit fixed overheads cost
will be multiplied with the actual production.
Fixed Production Overheads = Actual
Production X per Unit Fixed Overheads
NOTE: Amount of fixed overheads not
covered in actual production, should be
recognised as unallocated fixed overheads
and transferred to Profit & Loss account as
an expense.
Situation II - Actual Production is higher than the
Normal Production:-
In this situation, per unit fixed overheads cost
should not be based on normal production. But it
should be calculated by dividing the total fixed
overheads cost by the total number of units
produced, so that per unit fixed overheads cost is
reduced.
Per Unit Fixed Overheads Cost = Total Fixed Overheads
Total Units Produced
NOTE: This calculation is based on the principle
that inventory can not be valued at above its cost.
JOINT PRODUCTS
In the case of Joint Products, the cost of conversion
of each product is not separately identifiable and
they are to be allocated between the products on a
rational and consistent basis, e.g., on the basis of
relative sales value at split of point.
BY PRODUCTS
Normally, By Products has no material value and
produced unintentionally. By Products is valued at
Net Realisable Value and deducted from the cost of
conversion.
Other Cost
This cost is incurred in bringing the
Inventories to their present condition
and location e.g., cost of designing
product for certain customers. It
means it is the specific cost which is
incurred by the enterprises on the
basis of requirement of customers.
Exclusions from the Cost of Inventories
The following cost should not be
included in the value of inventories:
(a) Amount of abnormal loss (such as wasted materials,
labour or other production cost) should be transferred to
Profit & Loss A/c and not included in cost of inventory.
(b) Storage cost
(c) Administrative overheads
(d) Selling & distribution overheads
(e) Interest and borrowing cost
(f) Amount of Depreciation which is not related with factory.
Cost Formula
The cost of inventories of items that
are not ordinarily interchangeable
shall be computed by using specific
identification method. This is the
appropriate treatment for items that
are segregated for a specific project,
regardless of whether they have
been bought or produced.
In the case of inventory that are ordinarily
interchangeable, shall be computed by using
the First-In, First-Out (FIFO) or Weighted
average cost formula. An Entity shall use the
same cost formula for all inventories having a
similar nature and use to the entity. For
inventories with a different nature or use,
different cost formulas may be justified.
Cost Formula
As per A.S. - 2 Cost of inventories can be determined on the
basis of the following cost formulas:
Specific Identification Method
FIFO
Weighted Average.
Standard Cost
Retail Method
(a) Specific identification Method
In specific identification method, we can directly link the cost with
specific items of inventories .This method should be used in the
following cases:
When item of inventory are not ordinarily interchangeable
Goods & Services produced and segregated for specific projects.
(b) FIFO
Under this method, it is assumed that the items
of inventory which are purchased or produced
first, are consumed or sold first and the items of
inventory most recently purchased or produced
remain in the closing stock.
(c) Weighted Average
Under this method, the cost of each item is
determined by dividing the total cost of
purchased or produced by the total number of
units purchased or produced.
(d) Standard Cost Method
Under this method, the following points should be taken into
consideration:
Levels of consumption of material and supplies
Labour Efficiency
Capacity Utilisation

(e) Retail Method

Under this method, the cost of inventory is determined as under:
Sales value of inventory XXX
Less: Gross Margin XXX
Cost of Inventory XXX
Note: LIFO method is not covered under A.S. 2.Therefore this
method will not be used to value the inventory
Step 2: Step 2: Determination of Net
Realisable Value (NRV) of Inventories
Net realizable value means the estimated
selling price in ordinary course of business,
less estimated cost of completion and
estimated cost necessary to make the sale.
It refers to the net amount that an entity
expects to realise from the sale of inventory in
the ordinary course of business.
Step 3: Comparison between the Cost
and Net Realisable Value
Cost of Inventory NetRealisable
Value

Lower of the two is the value of inventory.

Situation–I: - If the cost of finished goods is
lower than the Net Realisable Value, then
there is no need of an adjustment.
Situation–II: - If the cost of finished goods
is higher than the Net Realisable Value,
then the reduction in cost should be
recognised through the following journal
entry: -
Profit & Loss A/c Dr XXX
To Stock A/c XXX
Valuation of Work In Progress (W.I.P.)
Work in progress is valued normally at cost
because the calculation of Net Realisable
value of work in progress is not so easy, but if
it is valued at Net Realisable value the
calculation should be made as follows:
Net Realisable value of work in progress
= (Selling price) – (Estimated cost of completion)
– (Estimated cost to make the sale)
Valuation of Raw Material
The valuation of raw material is totally based on the value
of finished goods. There are two situations:-

Situation I:-If the finished product in which raw material

and supplies are used is valued at cost, then valuation of
raw material should also be made only at cost .No valuation
principle is required to value the raw material.

Situation­ II:- If the finished product in which raw material

or supplies are used is valued at below cost, then the raw
material or supplies should be valued at its replacement
price.
Disclosure
Accounting policy adopted in measuring inventories.
Cost formula used.
Classifications of inventories are:
(i) Raw materials and components
(ii) Work-in-progress
(iii) Finished goods
(iv) Stock-in-trade (in respect of goods acquired for
trading)
(v) Stores and spares
(vi) Loose tools
(vii) Others(specific nature)