Finance & Accounting

All you Need to Know about AS 2 (Valuation of Inventories)

calendar20 Jun, 2024
timeReading Time: 6 Minutes
AS 2-Valuation of Inventories

While it can be seen that prior knowledge and local management’s experience are the major factors in the recognition of certain transactions, in the field of financial accounting such factors as established standards are essential. AS 2 refers to Accounting Standard 2, whereby policies in recognition of inventories can be properly evaluated for the value at which such inventories are stated before a particular sale is considered in the accounting records.

 As adopted below, this standard is important in ensuring that records are clear, unambiguous, and uniform in the financial field. AS 2 deals primarily with the valuation of inventories, which is an important area given that inventory constitutes a large proportion of the total assets of an enterprise.

According to accuracy and reliability, there are distinctive valuation techniques that are crucial in the cases where organizations will provide correct and transparent results, for the auditors and the stakeholders.

Definitions under AS 2

AS 2 is the standard issued by the Accounting Standards that deals with the control and valuation of inventories. This standard evidences methods of valuing inventories and how they should be reported on the firm’s financial statements. AS 2 states that inventory should be at a lower cost and net realizable value.

1.   Inventory

Inventory is represented by products that are almost complete and are kept to meet the demand of normal sales. Those items that are still in the production process or are still being regarded as work in progress.

Any material and article of food, fuel, lubricant, stores, and spare parts used in the manufacture of the product or rendering of the service.

2.   Finished Goods

It refers to products that are either fully produced or available in the market for consumption. The finished goods are the final product of the manufacturing process, which are sometimes taken to stock until they are sold to consumers. Relating these items to their value is a critical factor in assessing the correct financial position of the company.

3.   Work in Progress (WIP)

Work In Progress implies that products are still in the production cycle and have not been manufactured to their complete potential. These items should be properly accounted for since they entail the cost of material, labour, and overhead cost as at the valuation point. It is important to account for WIP suitably to prepare accurate financial statements that portray the actual state of production.

4.   Raw Materials and Consumable Stores

It is the materials that are taken in their natural form and are used for the production of finished products. Examples of consumable stores are items that are used in the production process are consumed in the process of production, and are not used on the product at the end of the process, such as oils for lubrication, detergents, and items used for maintenance, among others.

Raw material and consumable stores are critical to cost determination and inventory values; hence, assigning the correct value to them is crucial.

Valuation Principles

AS 2 stipulates that inventories should be valued at a lower cost or net realizable value (NRV). The value of inventories is not overstated in the financial statement and shall be ensured by this principle.

1.   Cost

The cost of Inventory represents all the costs involved in bringing the inventory into the present location and condition. It can include the purchase cost, conversion costs, and other costs to prepare the inventory for sale.

2.   Net Realizable Value (NRV)

NRV is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.

3.   Cost Formulas

AS 2 outlines acceptable cost formulas for the inventory valuation, which shall include:

4.   First In First Out (FIFO)

With reference to the order in which they are acquired, the FIFO approach suggests that the products are consumed one by one without skipping any. It implies that in a manufacturing system, the first procured inventories are utilized in the first instance, and in a sales system, the first purchased inventories are sold first. Therefore, the last purchases, or rather the final balance on the inventory account, are the recent purchases of the period.

5.   Weighted Average Cost

It includes the process of calculating the average price of all the products available for sale in the market. This price is determined using the average cost of acquiring or making equivalent items for the year and the value of the inventory at the beginning of the year. Furthermore, the average price is reached after considering unsold stock from the previous value of the closing stock. The estimated rate is always updated, or changed whenever there is any information received that will change the previous calculated rate.

6.   Specific Identification

For this method to work, every item sold and the inventory must be clearly identifiable. This method needs sufficient space where made purchases are segmented out through an actual physical barrier. It enables organizations to record the sale price of goods sold in a specific accounting period and include the value of goods remaining in their stock as an asset. This approach particularly applies to businesses that sell or order products with distinct values that customers cannot easily replace, such as cars, furniture, jewellery, etc.

Advantages of AS 2

AS 2 and Accounts Payable standards ensure transparency in the process of financial reporting. Now, let’s come to the significant benefits of AS 2-

Advantages of AS 2
  • Accuracy and Reliability: Ensures that inventory values are accurate and reliable, providing a true financial position for the company
  • Regulatory Compliance: to follow the requirements of AS-2 and Ind AS-2 (valuation of inventories), the company should disclose the following details concerning inventory. These include the value of inventories at carrying amount, the measurement of inventories by recognized accounting standards, the cases that allow the reversal of the write-down of inventory, and the part of inventories recognized as expenses.
  • Gross Profit Determination: The gross profit can be determined by adding the Cost of the Goods Sold plus the direct revenue earned. Thirdly, you have to identify the cost of goods sold to calculate gross profit as a formula continues from this point.
  • Assists in Liquidity Analysis: The Inventory is an important component of working capital, and any current asset is not intended to be held for more than a short time. It is employed as a means to measure the firms’ liquidity position. Normally, the stock turnover ratio is usually above average since it measures the number of times the company has stocked up and then sold the inventories.

Differences Between AS 2 and Ind AS 2

1. Scope and Applicability

  • AS 2: Applies primarily to inventories in general and provides guidelines for their valuation.
  • Ind AS 2: It has a much broader scope and is applicable to a wider range of entities, aligning with the International Financial Reporting Standards (IFRS). It includes those listed on stock exchanges.

2. Cost Formulas

  • AS 2: Allows the use of both the FIFO method of costing hierarchy and the weighted average cost method of costing hierarchy. The specific identification method is also allowed but is normally only implemented for items that are not ordinarily interchangeable.
  • Ind AS 2: Similar to AS 2, it permits the net realizable method but does not use any specific method. It allows for the FIFO and the weighted average cost access methods but does not allow for the LIFO method (last in, first out).

3. Write-downs and Reversals

  • AS 2: Ongoing or to-be-sold inventories are valued at the lower of cost or net realizable value. It is important to note that the requirements of AS 2 do not contain specific provisions with regard to the reversal of write-downs.
  •  Ind AS 2: It is written down to the net realizable value if the cost is higher for inventories. As contrary to AS 2, Ind AS 2 calls for the removal of any previous write-off if the Net Realizable Value thereafter rises.

4. Guidance and Convergence

  • AS 2: It is prepared in accordance with standards of Generally Accepted Accounting Practice (GAAP) in India and does not provide sufficient information about the conformity with the International Standards.
  • Ind AS 2: This was aimed at aligning with the IFRS, therefore presenting a structure in consonance with international trends, which is advantageous to organizations that have operations in different countries worldwide.

5. Disclosure Requirements

  • AS 2: Outlines the accounting policies used to measure inventories, their total value, their classification on the statement of affairs, and the number of inventories expensed out.
  • Ind AS 2: Includes more detailed information on the accounting policies used to measure inventories, the total quantity and nature of inventories, the cost of inventories sold during a given period, any write-downs or adjustments to a lower cost or market, and any reversals of those write-downs.

Conclusion

In summary, AS 2 (Accounting Standard 2) offers significant information that can be used for the evaluation of the inventories to be included in financial statements. This section covers definitions of what is acceptable for valuation and cost, using the lower of cost or the net realizable value, among which the acceptable cost formulas include the first in, first out, the weighted average cost, and the method of specific identification.

Adhering to the AS 2 assists in determining the correct and reliable figure for the inventory, calculating gross profit and facility valid and accurate figures for liquidity, and, most importantly, meets the requirements of the regulatory body. While AS 2 was created in reference to the established principles of GAAP in India, Ind AS 2 offers greater similarity to International Financial Reporting Standards (IFRS).

Frequently Asked Questions

  1. What is AS 2?

    AS 2 refers to Accounting Standard 2, which provides guidance on the valuation and accounting treatment of inventories.

  2. What types of inventories does AS 2 cover?

    AS 2 covers finished goods, work-in-progress (WIP), and raw materials/consumable stores used in production.

  3. What are the main valuation principles under AS 2?

    The main principle is that inventories should be valued at a lower cost or net realizable value (NRV).

  4. What cost formulas does AS 2 allow?

    AS 2 permits the use of first-in-first-out (FIFO), weighted average cost, and specific identification cost formulas.

  5. How does Ind AS 2 differ from AS 2?

    Key differences relate to scope, allowed cost formulas, treatment of write-downs/reversals, level of IFRS convergence, and disclosure requirements.

  6. When is Ind AS 2 required over AS 2?

    Ind AS 2 broadly aligns with IFRS and may be required for listed companies and those with multinational operations.

  7. What are the disclosure requirements under AS 2?

    Disclosures include accounting policies, inventory values/classifications, and amounts expensed.

Read our article Tips To Improve Your Accounts Payable Process

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