Inventories are among the most critical assets in any business. They represent the goods held for sale, raw materials waiting to be processed, and supplies required in production. Since inventories directly impact both the statement of financial position and the statement of profit and loss, their correct accounting treatment is essential. To bring uniformity, comparability, and reliability in financial reporting, Ind AS 2 provides a structured framework on how inventories should be measured, recognized, and presented.
We focus on the foundation of Ind AS 2. It examines the objective of the standard, its scope, the exclusions that apply, and the fundamental definitions that underpin the entire framework. These elements form the bedrock upon which the measurement and valuation aspects are built, which will be discussed in subsequent parts.
Objective of Ind AS 2
The main objective of Ind AS 2 is to prescribe the accounting treatment for inventories so that entities report them at a value that reflects their economic reality. The standard requires entities to determine the cost of inventories, recognize them as assets, and later transfer this cost to expense when the related revenue is recognized.
This treatment ensures that inventories are not overstated or understated and that expenses are matched with the revenues they help to generate. The standard also prescribes specific cost formulas to allocate costs to inventories consistently.
For example, in a retail business, inventories consist of goods purchased for resale. They remain as assets until the sale occurs. When sold, their cost is recognized as an expense in the same period in which sales revenue is recorded. This process ensures accurate profit measurement.
Scope of Ind AS 2
Ind AS 2 applies to all inventories that are held by an enterprise in the normal course of business. These include raw materials, work in progress, finished goods, and consumables required in the production process. However, the standard does not apply to certain types of assets, which are governed by more specific standards.
Financial Instruments
Financial instruments such as shares, bonds, derivatives, and other similar instruments are excluded from Ind AS 2. These instruments fall under the scope of Ind AS 109 and Ind AS 32. Their measurement principles differ significantly from inventory valuation because financial instruments are governed by fair value and risk considerations rather than cost-based approaches.
Biological Assets
Living plants and animals, referred to as biological assets, and agricultural produce at the point of harvest are excluded from the scope of Ind AS 2. These are addressed under Ind AS 41 on agriculture.
The logic behind this exclusion lies in the inherent unpredictability and biological transformation of such assets, which necessitate a different valuation framework. By setting clear boundaries, the standard ensures that inventory valuation principles apply only where they are most appropriate.
Exclusions from Measurement
While the scope clarifies what inventories are covered, Ind AS 2 also lays down specific exclusions for measurement purposes. These exclusions apply to two broad categories:
Producers of Agricultural, Forest, and Mineral Products
Producers engaged in activities such as farming, forestry, and mining may measure their inventories at net realizable value in accordance with established industry practices. This exemption acknowledges the difficulty of applying cost-based valuation when active markets and assured sales contracts exist.
For instance, harvested crops ready for sale in a regulated market are often measured at their net realizable value rather than historical cost. Similarly, extracted minerals can be measured at net realizable value if sold under long-term agreements or in markets with minimal selling risks. Any changes in this value are recognized directly in profit or loss for the period.
Commodity Broker-Traders
Another category exempt from measurement requirements includes commodity broker-traders. Their business model revolves around buying and selling commodities for short-term profits, often based on price fluctuations in the market. For such entities, inventories are measured at fair value less costs to sell. The difference between purchase price and market price directly impacts the profit or loss of the same period, which reflects the true nature of their business operations.
It is important to note that in both these cases, the exemption is limited only to measurement. The principles of recognition and disclosure still apply.
Key Definitions under Ind AS 2
A thorough understanding of definitions under Ind AS 2 is essential because they form the conceptual foundation for recognition and measurement.
Inventories
Inventories are defined as assets held for sale in the ordinary course of business, in the process of production for such sale, or materials and supplies that are consumed in the production process or in the rendering of services. This broad definition covers manufacturing, trading, and service industries alike.
In manufacturing, inventories include raw materials, work in progress, and finished goods. In trading, inventories consist of goods purchased for resale. In services, inventories may include materials used for providing services, such as tools and supplies.
Net Realisable Value
Net realizable value, commonly abbreviated as NRV, refers to the estimated selling price in the ordinary course of business, reduced by the costs required to complete the production and the costs necessary to make the sale. NRV is particularly significant because Ind AS 2 requires inventories to be measured at the lower of cost and NRV.
Fair Value
Fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The concept of fair value is derived from Ind AS 113 and represents a market-based approach rather than an entity-specific estimate.
Difference between Net Realisable Value and Fair Value
Though they may appear similar, NRV and fair value serve distinct purposes.
NRV is entity-specific. It reflects the actual amount that the entity expects to realize from the sale of inventory after accounting for completion and selling costs. It considers the business’s internal circumstances, market conditions, and cost structures.
Fair value, in contrast, is market-based. It represents the price at which a transaction would occur between willing participants in a structured market environment. Unlike NRV, it does not depend on the specific conditions of the reporting entity.
For example, if a company holds finished goods costing 500 per unit and expects to sell them at 700 per unit after incurring additional selling expenses of 50 per unit, the NRV would be 650 per unit. If the market price for such goods in an active market is 690 per unit with selling costs of 40 per unit, the fair value less costs to sell would be 650. Both values could converge in some cases but may differ significantly in others.
Recognition Principles
Ind AS 2 emphasizes the principle that inventories should remain recorded as assets until the point of sale. As long as inventories are under the control of the enterprise and hold the potential to generate future economic benefits, they qualify as assets.
When inventories are sold, their cost is recognized as an expense in the same period in which revenue from their sale is recognized. This recognition principle aligns with the matching concept, ensuring that costs and revenues associated with the same transaction are reported together.
For example, a retailer purchases goods at a cost of 100,000. These goods remain as inventory until sold. When sold for 130,000 in the next quarter, the cost of 100,000 is recorded as an expense in the same quarter, producing a profit of 30,000. This treatment ensures that financial statements accurately reflect the results of operations.
Practical Illustration on NRV and Fair Value
Consider a company holding finished goods worth 500,000 at cost. The management estimates that these goods can be sold for 600,000, but additional costs of 120,000 are required to complete and sell them. In this case:
- Net realizable value = 600,000 – 120,000 = 480,000
- Fair value in the active market is 590,000, and selling costs are estimated at 100,000, resulting in fair value less costs to sell of 490,000.
The inventory is valued at the lower of cost (500,000) and NRV (480,000), meaning the company would report inventory at 480,000. This example highlights the conservatism principle embedded in Ind AS 2, preventing overstatement of assets.
Measurement and Cost of Inventories
Inventories form a substantial part of the current assets of most businesses. Their valuation directly impacts profit measurement, financial ratios, and the overall financial position of an enterprise. Ind AS 2 prescribes that inventories must be valued at the lower of cost or net realizable value. This rule ensures that financial statements reflect the true economic value of inventories without overstating profits or assets.
We will explore the detailed provisions for measurement of inventories, components of inventory cost, cost exclusions, treatment of overheads, and related examples that illustrate the application of the standard.
Measurement of Inventories
Ind AS 2 requires inventories to be measured at the lower of cost and net realizable value.
- Cost represents the actual amount incurred to bring inventories to their present condition and location.
- Net realizable value reflects the estimated amount that an entity expects to realize upon sale, after deducting costs of completion and selling expenses.
By applying this principle, companies avoid overstating inventory values in situations where selling prices decline or costs exceed the expected recovery.
Components of Cost
The cost of inventories includes three major components: cost of purchase, cost of conversion, and other costs incurred to bring the inventories to their present condition and location.
Cost of Purchase
The cost of purchase consists of purchase price, import duties, non-recoverable taxes, freight charges, handling expenses, and other directly attributable costs. Trade discounts, rebates, and other similar items are deducted in determining the purchase cost.
For instance, if a company purchases raw material worth 500,000, avails a 10 percent trade discount, and pays import duty of 20,000 and freight of 15,000, the cost of purchase will be calculated as:
- Purchase price after discount: 450,000
- Add import duty: 20,000
- Add freight: 15,000
- Total cost of purchase: 485,000
This amount is capitalized as part of inventory.
Cost of Conversion
Conversion costs are incurred to transform raw materials into finished goods. They include direct costs and allocated overheads.
Direct Costs
Direct labor and direct expenses attributable to the production process form part of conversion costs. For example, wages paid to factory workers engaged in assembling goods are included in inventory cost.
Production Overheads
Overheads include both fixed and variable production overheads that are incurred in converting materials into finished goods.
- Fixed overheads are indirect production costs that remain relatively constant regardless of production volume. These include factory rent, depreciation of production equipment, and salaries of supervisory staff.
- Variable overheads vary directly with production volume, such as indirect materials, indirect labor, and power consumption.
Allocation of fixed overheads is based on the normal capacity of production facilities. This prevents abnormal fluctuations in inventory cost due to temporary overproduction or underproduction.
For example, if fixed production overhead is 1,000,000 and normal capacity is 100,000 units, the allocation rate per unit is 10. If production falls to 80,000 units, the per-unit allocation remains at 10. The unallocated overhead of 200,000 is recognized as an expense. If production rises to 120,000 units, the allocation rate per unit is reduced to 8.33.
Illustrative Example on Conversion Costs
A manufacturer produces 50,000 units during the year. The following expenses are incurred:
- Raw material: 600,000
- Direct labor: 300,000
- Variable overheads: 100,000
- Fixed overheads: 400,000
- Normal capacity: 60,000 units
The allocation of fixed overheads is based on normal capacity. The per-unit fixed overhead rate is 6.67 (400,000 ÷ 60,000). For 50,000 units produced, 333,500 is allocated. The remaining 66,500 is treated as an expense.
Thus, the total inventory cost is:
- Raw material: 600,000
- Direct labor: 300,000
- Variable overheads: 100,000
- Allocated fixed overheads: 333,500
- Total: 1,333,500
Other Costs
Certain other costs can be included in inventory valuation, provided they are necessary to bring the inventory to its current condition and location. Examples include design costs for specific customer orders or specialized packaging required for shipping to overseas clients.
General administrative expenses that do not contribute to bringing inventories to their location or condition are excluded. Similarly, selling costs are not considered part of inventory cost.
Costs Excluded from Inventory Valuation
Not all expenses incurred in relation to inventories are eligible for capitalization. Ind AS 2 clearly identifies costs that must be excluded and recognized as expenses in the period in which they are incurred.
Abnormal Waste
Any abnormal wastage of materials, labor, or overheads is expensed immediately. For instance, material lost due to a factory accident is not included in inventory cost.
Storage Costs
Storage costs are excluded unless they are necessary in the production process before the next stage of production. For example, wine stored for fermentation may include storage cost, while storage of finished goods before sale is excluded.
General Administrative Costs
Administrative overheads not related to production are excluded. Salaries of office staff or expenses of the corporate office do not form part of inventory cost.
Selling Costs
Costs related to marketing, distribution, or selling are never included in inventory valuation. These are recognized as expenses in the period incurred.
Case Study on Cost Inclusion and Exclusion
Alpha Manufacturing Ltd. purchases raw material worth 200,000 with a trade rebate of 5 percent. It incurs customs duty of 30,000, out of which 15,000 is refundable. Ocean freight amounts to 5,000, and clearing charges are 4,000. In addition, warehouse rent of 10,000 and wages of security staff amounting to 5,000 are paid.
The calculation of inventory cost is as follows:
- Purchase price: 200,000 less 5 percent rebate = 190,000
- Add customs duty (net): 15,000
- Add freight: 5,000
- Add clearing charges: 4,000
- Total inventory cost: 214,000
Warehouse rent and security wages are not included, as they do not directly contribute to bringing inventories to their present condition.
Borrowing Costs and Inventories
Borrowing costs can be included in the cost of inventories only when inventories meet the definition of qualifying assets as per Ind AS 23. A qualifying asset is one that takes a substantial period of time to get ready for its intended use or sale. Examples include large infrastructure projects, power plants, or ships.
For most inventories, borrowing costs are excluded and recognized as expenses. However, when inventories require significant time to bring to saleable condition, capitalization of borrowing costs is permitted until the inventory is ready for use or sale.
Deferred Settlement Terms
When inventories are purchased on deferred settlement terms that effectively contain a financing element, the difference between the purchase price under normal credit terms and the amount actually paid is treated as interest expense.
For example, if the cash price of raw material is 100,000 and the entity agrees to pay 150,000 after one year, the cost of inventory is recognized at 100,000. The balance of 50,000 is recognized as interest expense over the credit period.
This treatment prevents overstatement of inventory cost and ensures proper recognition of financing expenses.
Agricultural Produce from Biological Assets
As per Ind AS 41, agricultural produce harvested from biological assets is initially measured at fair value less costs to sell at the date of harvest. This value then becomes the cost of inventory for the purpose of Ind AS 2.
For instance, harvested wheat is measured at fair value less costs to sell on the date of harvest. The value determined at that date is considered as inventory cost under Ind AS 2. Any further valuation is subject to the lower cost and net realizable value test.
Techniques for Measuring Inventory Cost
Ind AS 2 permits certain techniques for measuring cost when they approximate actual cost.
Standard Cost Method
Under this method, inventory is measured using predetermined costs for materials, labor, and overheads. These costs are set based on normal levels of efficiency and capacity utilization. The method is widely used because of its simplicity, but it must be regularly reviewed and adjusted to reflect current conditions.
Retail Method
This method is commonly used in the retail sector where a large number of items are involved and it is impractical to track actual costs individually. The method calculates cost by reducing the sales value of inventory by an appropriate gross margin percentage. Adjustments are made to reflect markdowns and changes in selling prices.
Practical Example on Standard Cost Method
A company uses standard costing to value its inventory. Standard cost per unit is determined as follows:
- Raw material: 50
- Direct labor: 30
- Overheads: 20
- Total: 100
During the year, 10,000 units are produced, but due to inefficiencies, the actual cost per unit is 110. The company records inventory at the standard cost of 100 per unit, subject to review and adjustments. The variance of 10 per unit is recorded separately to ensure transparency and effective cost control.
Cost Formulas for Inventory Valuation
Ind AS 2 prescribes specific cost formulas to assign costs to inventories. These formulas ensure consistency and comparability in reporting.
Specific Identification
This formula is used for items that are not interchangeable or are produced and segregated for specific projects. For example, a construction company may use specific identification to value materials purchased for a particular contract.
First-In, First-Out (FIFO)
Under FIFO, inventories acquired first are sold or consumed first. The closing inventory therefore consists of the most recent purchases. This method closely matches actual physical movement in many industries and results in inventory values that approximate current costs.
Weighted Average Cost
This method calculates the cost of inventory based on the weighted average of costs of similar items at the beginning and purchased during the period. Weighted average can be calculated on a periodic or perpetual basis.
Ind AS 2 requires that the same cost formula be applied consistently to inventories of a similar nature and use within the entity. Different formulas may be justified when inventories differ in nature or function.
Disclosure Requirements under Ind AS 2
Entities are required to disclose sufficient information to enable users of financial statements to understand the impact of inventories on the financial position and performance.
Categories of Inventories
Financial statements must disclose the carrying amount of inventories classified into categories appropriate to the entity. Typical categories include raw materials, work in progress, finished goods, and stores and spares. For service providers, work in progress related to services is also disclosed.
For instance, a manufacturing entity may disclose:
- Raw materials: 2,500,000
- Work in progress: 1,800,000
- Finished goods: 4,200,000
- Spares and consumables: 600,000
Such classification provides clarity to investors and analysts regarding the composition of inventory.
Measurement Basis
Entities must disclose the accounting policies adopted for measuring inventories, including the cost formulas used. For example, whether the entity uses FIFO or weighted average cost must be explicitly stated. This allows comparability with peers and informs stakeholders about potential impacts on profitability and asset valuation.
Amount of Inventory Expensed
The financial statements should disclose the amount of inventories recognized as an expense during the period. This typically represents the cost of goods sold but may also include other consumption of inventories.
For instance, a retailer may disclose that 15,000,000 worth of inventories were expensed as cost of sales during the year.
Write-downs and Reversals
The amount of any write-down of inventories to net realizable value and the reversal of such write-downs must be disclosed separately. This information is critical for understanding how market conditions or internal factors affect the valuation of inventory.
Pledged Inventories
If inventories are pledged as security for borrowings, this fact and the carrying amount of such inventories must be disclosed. This provides users with insights into the company’s financing arrangements and liquidity risks.
Net Realizable Value Adjustments
Inventories are valued at the lower of cost and net realizable value. The need to assess NRV arises because economic conditions, technological changes, or damage to goods may result in inventories not being recoverable at cost.
Determining NRV
Net realizable value is the estimated selling price in the ordinary course of business, less estimated costs of completion and costs necessary to make the sale.
For example, if a company holds goods that can be sold for 800,000 after incurring 50,000 in completion costs and 20,000 in selling expenses, the NRV is 730,000. If the cost of the inventory is 750,000, it must be written down by 20,000.
Situations Leading to Write-downs
Several circumstances may lead to inventories being written down to NRV:
- Decline in selling prices due to competition or market conditions.
- Obsolescence of goods due to technological advancement.
- Damage or deterioration in quality of goods.
- Excess supply of inventory relative to demand.
Recognition of Write-down
Write-downs are recognized as an expense in the period in which they occur. This ensures that the financial statements reflect the reduced economic benefit expected from the inventories.
Reversals of Write-downs
Ind AS 2 permits the reversal of inventory write-downs if the circumstances that caused the write-down no longer exist or if there is clear evidence of an increase in NRV.
For example, if an item of inventory was written down from 500,000 to 400,000 in the previous year due to market decline, but the current market conditions improve and the NRV increases to 450,000, a reversal of 50,000 is recognized.
The reversal is limited to the amount of the original write-down. This prevents inventories from being valued above their historical cost.
Case Study on NRV Adjustments
Consider Beta Electronics Ltd., which manufactures smartphones. At the end of the financial year, the company holds 5,000 units of a model that cost 8,000 each to produce. Due to new launches in the market, the expected selling price of this model has declined to 7,500. Additional selling expenses of 200 per unit are expected.
- Cost per unit: 8,000
- NRV per unit: 7,500 – 200 = 7,300
- Write-down per unit: 700
- Total write-down: 3,500,000
The write-down is recognized as an expense. If in the next year the model regains demand and NRV rises to 7,700, the reversal is 400 per unit, subject to the maximum of the original write-down.
Impact on Financial Performance
Inventory write-downs reduce profit in the period in which they are recognized. Conversely, reversals of write-downs increase profit in the period of reversal. This creates volatility in reported earnings, particularly for industries subject to frequent market price fluctuations such as technology, fashion, and commodities.
Users of financial statements closely monitor such adjustments to assess the sustainability of earnings and to understand the risks associated with inventory management.
Industry Applications of Ind AS 2
Manufacturing Sector
Manufacturing entities often deal with raw materials, work in progress, and finished goods. The proper allocation of fixed and variable overheads is critical in ensuring accurate inventory valuation. Industries such as automobiles and heavy machinery rely heavily on conversion cost allocation to reflect true production costs.
Retail Sector
Retailers typically hold a wide variety of goods that turn over rapidly. The retail method of costing is commonly applied, especially when tracking individual cost is impractical. Write-downs are common due to fashion changes, seasonality, and markdowns. Disclosures regarding reversals of write-downs provide valuable insights into changing consumer trends.
Agriculture and Allied Activities
Agricultural produce harvested from biological assets is initially measured at fair value less costs to sell as per Ind AS 41. Once harvested, such produce becomes inventory under Ind AS 2. For example, harvested wheat is recorded at fair value less costs to sell on harvest date, and thereafter valued at the lower of cost and NRV.
Commodity Traders
Commodity broker-traders are exempt from the measurement provisions of Ind AS 2, as they measure inventories at fair value less costs to sell. Any changes in fair value are recognized in profit or loss. This treatment reflects the fact that for such traders, inventory is held for short-term trading and its fair value is the most relevant measure.
Technology and Electronics
In technology industries, rapid innovation leads to frequent obsolescence of products. Inventories such as smartphones, tablets, or laptops are often written down when new models are introduced. Companies in this sector must continually monitor NRV and make adjustments to avoid overstating assets.
Construction and Real Estate
For entities engaged in construction or real estate development, inventories may consist of land, materials, and work in progress related to projects. Allocation of borrowing costs may be relevant when projects take a substantial time to complete. Disclosures related to pledged inventories are particularly important in this sector.
Practical Challenges in Application
Determining Normal Capacity
One challenge lies in establishing normal capacity for the allocation of fixed overheads. Normal capacity is the production expected to be achieved on average over several periods, taking into account planned maintenance and normal downtime. Entities must exercise judgment in estimating this figure, and variations can significantly affect inventory valuation.
Identifying NRV in Volatile Markets
In industries with fluctuating prices such as commodities or fashion, determining NRV requires careful analysis of market trends and sales forecasts. Errors in estimation may lead to either premature write-downs or delayed recognition of losses.
Treatment of Joint Products
In certain industries, such as oil refining or food processing, multiple products are produced from the same process. Allocating joint costs among these products requires consistent and rational methods. For example, allocation may be based on relative sales value at the point of separation.
Distinguishing Storage Costs
Another challenge arises in distinguishing between necessary storage costs and costs that should be expensed. For example, wine aging involves essential storage costs, whereas storage of finished goods awaiting sale must be excluded.
Illustrative Disclosure Note
To illustrate the requirements, consider the disclosure note of a hypothetical company:
Inventories comprise the following:
- Raw materials: 3,200,000
- Work in progress: 1,500,000
- Finished goods: 4,700,000
- Stores and spares: 800,000
Inventories are valued at the lower of cost and net realizable value. Cost is determined on a FIFO basis. During the year, 18,000,000 of inventories were recognized as an expense. Inventories amounting to 2,000,000 have been pledged as security for borrowings.
During the year, inventories were written down by 600,000 due to obsolescence, of which 200,000 was reversed in the current period as market demand improved. This illustrative disclosure demonstrates how companies can present comprehensive information while complying with Ind AS 2.
Conclusion
Ind AS 2 provides a comprehensive framework for recognizing, measuring, and presenting inventories in financial statements. By prescribing that inventories be valued at the lower of cost and net realizable value, the standard ensures that assets are not overstated and profits are reported prudently. Its requirements on cost determination, allocation of overheads, and permissible cost formulas promote consistency and comparability across entities.
The disclosure provisions enhance transparency by requiring entities to explain the composition of inventories, the measurement policies adopted, and the impact of write-downs or reversals. Industry-specific considerations, ranging from manufacturing and retail to technology, agriculture, and commodity trading, demonstrate the adaptability of the standard to diverse economic environments.
At the same time, challenges remain in applying Ind AS 2, especially in estimating net realizable value in volatile markets, allocating joint costs, and distinguishing between necessary and avoidable expenses. These areas require judgment, industry knowledge, and regular reassessment to ensure accurate reporting.
Overall, Ind AS 2 strikes a balance between providing clear measurement principles and allowing flexibility for practical application. Its proper implementation not only ensures compliance with accounting regulations but also supports informed decision-making by investors, analysts, and other stakeholders.