AS-2 has advocated to value inventories at the lower of historical cost and net realisable value.
“Inventories are held in the expectation of deriving revenue directly or indirectly from their sale or use. In order to determine the results of a business for a given period, it is necessary to carry forward the cost related to inventories until the inventories are sold or consumed. However, if there is no reasonable expectation that net realisable value would cover the cost incurred (as a result, for example, of deterioration, obsolescence or a change in demand), it is necessary that cost which cannot be recovered should be charged against the revenue of the current period. Therefore, inventories are normally stated at the lower of historical cost and net realisable value.”
According to AS-2:
1. Historical Cost represents an appropriate combination of the:
(а) Cost of purchase;
(b) Cost of conversion, and
(c) Other costs incurred in the normal course of business in bringing the inventories up to their present location and condition.
2. Cost of Purchase consists of the purchase price including duties and taxes, freight inwards and other expenditure directly attributable to acquisition, less trade discounts, rebates, duty drawbacks and subsidies, in the year in which they are accounted, whether immediate or deferred, in respect of such purchase.
3. Cost of Conversion consists of:
(i) Costs which are specifically attributable to units of production, i.e., direct labour, direct expenses and sub-contracted work; and
(ii) Production overheads, ascertained in accordance with either the direct costing or absorption costing method.
Production overheads exclude expenses which relate to general administration, finance, selling and distribution.
AS-2 has suggested to apply different cost formula for determination of historical cost which are listed below:
Several different formulae with widely effects are in current use for the purpose of assigning costs, including the following:
(a) First in first out (FIFO),
(b) Average cost,
(c) Last in first out (LIFO),
(d) Base stock,
(e) Specific identification,
(f) Standard cost,
(g) Adjusted selling price (also called retail inventory method) and
(h) Latest purchase price.
(i) FIFO, average cost, LIFO, base stock and specific identification formulae use costs that have been incurred by the enterprise at one time or another. Latest purchase price formula uses costs that may not have been incurred for the specific item in inventory and is therefore not based on historical cost.
(ii) The base stock formula proceeds on the assumption that a minimum quantity of inventory (base stock) must be held at all times in order to carry on business. Inventories up to this quantity are stated at the cost at which the base stock was acquired. Inventories in excess of the base stock are dealt with on some other basis, e.g., any one of the above mentioned formulae.
The base stock formula requires a clear existence of the circumstance that a minimum level of inventory must be held at all times and therefore has a limited application. Most enterprises customarily maintain certain minimum stock level at all times but that is not by itself a justification for use of base stock method because there must exist clear circumstances to permit use of base stock method.
(iii) The specific identification formula attributes specific costs to identified goods that have been bought or manufactured and are segregated for a specific purpose.
(iv) Adjusted selling price (also called retail inventory formula) is used widely in retail business or in businesses where the inventory comprises items the individual costs of which are not readily ascertainable. The historical cost of inventory is estimated by calculating it in the first instance at selling price and then deducting an amount equal to the estimated gross margin of profit on such stocks.
The calculation of the estimated gross margin of profit may be made for individual items or groups of items or by departments, as may be appropriate to the circumstances. This formula is also used by some manufacturing organisations for valuing the inventory of finished products held against forward sale contracts.
(v) Standard cost formula is often used to arrive at historical cost for the purpose of inventory valuation. The use of standard cost for determining the cost of inventories requires that standards are realistic, are reviewed regularly and, where necessary, revised in the light of current conditions and that there exists a proper system of pro-rating significant variances between the cost of sales and the inventories.
(vi) Cost of Conversion — Cost of conversion includes direct labour, direct expenses and production overheads and can be segregated into fixed costs and variable costs. The two main methods of dealing with fixed costs are direct costing and absorption costing. There is substantial support for use of either of these methods of inventory valuation.
In applying the absorption costing method, regard should be had to the normal level of production. The normal level of production depends on the facts of each case having regard to such factors as available capacity of the plant, production achieved in the earlier years, and in the current year.
(vii) Costs other than production overheads are sometimes incurred in bringing inventories to their present location and condition, for example, expenditure incurred in designing products for specific customers. On the other hand, selling and distribution expenses, general administration overheads, research and development costs and interest are usually considered not to relate to putting the inventories in their present location and condition. They are, therefore, excluded from determining the valuation of inventories.