AS 2 is the Accounting Standard for the valuation of inventories and their accounting treatment. This accounting standard covers methods to value the inventory of a business and its disclosure in the financial statements. The general rule mentions valuing inventories i.e. closing stock of a business at cost or market value whichever is lower. Let us understand AS 2 in detail.
Applicability of AS 2
AS 2 applies to the valuation of following types of inventory:
- Raw Materials – input goods or services consumed during the production process of rendering of services.
- Work In Progress – input goods or services that are in the process of production.
- Finished Goods – final goods or services held for sale in the normal course of business.
AS 2 for Valuation of Inventories is not applicable in the following cases:
- Work in progress i.e. WIP stock in the construction business
- WIP stock in the service business
- Shares, debentures, or other financial instruments held as stock-in-trade
- Stock of livestock, mineral oils, agricultural and forest product, etc.
In the above cases, inventory valuation is at net realisable value.
Valuation of Inventory
Follow these steps for valuation of inventory:
- Calculate Cost of Inventory
Cost of Inventory is the sum of purchase cost, conversion cost and other direct costs to bring the inventory in its present condition.
- Calculate Net Realisable Value (Market Value)
Net Realisable Value is the estimated selling price of the inventory in the market i.e. the market value of the inventory.
- Lower of Step 1 or Step 2
Valuation of inventory is the lower of cost or net realisable value (NRV).
For valuation of inventory, we should understand the following terms:
- Purchase Cost – It is the price at which inventory is purchased. It also includes freight inwards, duties and taxes, trade discounts, rebates, duty drawbacks, and other expenses directly related to purchase.
- Conversion Cost – It is the cost incurred in the process of production to convert the raw materials into finished goods. Conversion Costs include both fixed costs (depreciation, maintenance expense, etc) and variable cost (labour cost, raw material cost, etc) incurred in the process of production.
- Other Cost – Any other cost incurred to bring the inventory in its current location and condition should form part of inventory valuation. Other costs include selling and distribution expense, abnormal loss of material or labour, storage cost, etc.
- Net Realisable Value – NRV is the estimated selling price of the inventory after deducting the estimated costs of completion and expenses on the sale of such inventory.
Methods of Inventory Valuation
- First In First Out (FIFO) – As per this method, it is assumed that the goods that come in first are sold out first. The cost of goods sold comprises the cost of goods produced first. The closing inventory will include the goods purchased recently.
- Weighted Average Cost Method (WAC) – Under this method, the average cost of each sale item is calculated. The closing inventory is calculated by taking the weighted average cost of items at the beginning of the year and purchased during the year.
- Specific Identification Method – If each item in the closing inventory is easily identifiable, the business should use a specific identification method to value the inventory. Thus, include the items sold at a specific cost in the cost of goods sold and the cost of items left on hand in the closing stock.
As per AS 2, the financial statements must reflect the following details of inventory of a business:
- Accounting policy and method used for valuation of inventory
- Classification of inventory i.e. raw material, work-in-progress, or finished goods
- Carrying amount of inventory = Fair Value – Sale Cost
- Amount of inventory that business recognizes as an expense
- Amount of inventory that business writes down and recognizes as an expense
- Reversal amount of a write-down identified as a reduction in the inventory amount
AS 2 for Manufacturers & Traders
Any manufacturing or trading business that has inventory or stock must follow the accounting principles for the valuation of a stock.
- Opening Stock – Value of the closing stock of the previous year
- Purchases – Sum of the purchase value and direct expenses incurred during the financial year
- Sales – Sum of sales value during the financial year
- Closing Stock – Value of closing inventory should be lower of cost or market value
- Gross Profit = Opening Stock + Purchases – Sales – Closing Stock
The business should calculate the net profit by deducting other expenses from gross profit, report it as taxable income under the head PGBP and file ITR on income tax website.
What is the cost of inventory for a service provider?
The cost of inventory for a service provider includes labour cost and the cost of personnel who provide the services. It does not include the expenses not directly related to the service.
How to calculate value of inventory using weighted average cost method?
As per the weighted average cost method, you should calculate the value of closing inventory by using the average price of inward values of the inventory. The formula is as below:
Average cost per unit = Total inward value / Total inward quantity