AS 2 — Valuation of Inventories | Concept Book

2

CA Inter Advanced Accounting · Concept Book

Sequence 4 · 2 Teaching Days

AS 2

Valuation of
Inventories

"Godown Ka Hisaab"

9 / 15 CA Inter Attempts ICAI: Module 2, Chapter 5, Unit 1 Rolly · Sethji · BCPL

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THE STORY

Read this first. The concepts in Layer 2 will land better after this.

Kahaani

Godown Ka Hisaab

It was the last week of March. The financial year was closing.

Rolly had been at BCPL's warehouse in Noida for two days straight — walking the aisles with a clipboard, counting boxes, checking batch numbers, making notes. Sethji's FMCG empire had a big godown: coconut soap in towers of brown cardboard boxes, cooking oil in blue canisters, shampoo sachets in shrink-wrapped bundles, biscuit cartons stacked to the ceiling. Rolly loved this part of the job. Orderly shelves, physical things you could touch and count. No ambiguity.

Now came the valuation.

She opened her laptop, pulled up the stock register, and started filling in the numbers. The logic seemed obvious to her: inventory is worth what you can sell it for. Market price. She typed confidently.

Coconut soap: 2,000 boxes. Current retail price in the market — ₹85 per box. She typed ₹85.
Hair oil: 500 bottles. Current market price — ₹195. She typed ₹195.
Cooking oil: 300 litres. Market rate — ₹130 per litre. Typed.

Total inventory value: ₹1.24 crore. A very healthy number.

Sethji reviewed the sheet that evening and smiled broadly. "Rolly ji, bahut achha! Balance sheet strong dikhega. Bank wale khush ho jaayenge." He was applying for a ₹5 crore expansion loan next month. A strong balance sheet mattered.

Pranav arrived two days later for the statutory audit. He started methodically — invoices matched against entries, physical count reconciliation, then inventory valuation.

He opened Rolly's valuation working. He saw the coconut soap line: ₹85 per unit. He went to the purchase invoices. The last three batches: ₹58, ₹60, ₹62 per box. He made a note.

He moved to the hair oil section and spotted something: a batch of 200 bottles purchased in October. He checked the labels — expiry date: May. He calculated quickly. With only two months to expiry, these bottles could now realistically sell at ₹120 each. But there was a 10% selling commission payable to the distributor. Net realisable value = ₹120 − ₹12 = ₹108 per bottle. Cost of purchase: ₹140. Made another note.

That afternoon, the three of them sat together in the small office at the back of the godown.

"Rolly ji, yeh coconut soap ki valuation — ₹85 per unit. Purchase invoice ₹60 dikhata hai. Yeh ₹85 kahan se aaya?" Pranav's tone was conversational, genuinely curious.

"Market price!" said Rolly. "That's what they're worth right now. If we sold them today, we'd get ₹85."

Sethji leaned forward. "Toh phir kya problem hai, Pranav bhai? Agar bazar mein ₹85 mil raha hai, toh inventory ki value ₹85 hi toh honi chahiye?"

Pranav nodded at the question — it was a fair one. "Sethji, sochiye aage. Agar humne ₹85 pe value ki, toh hum keh rahe hain ki humne ₹25 per box ka profit pehle hi kama liya — jabki soap abhi godown mein hai, bika nahi hai. Ek rupaya bhi nahi aaya. Toh profit kahan hua?"

A pause.

"Jo profit hua nahi, woh balance sheet mein dikhane ka koi haq nahi humein," Pranav continued. "AS 2 ka rule ek hi hai: inventory ko value karo lower of cost and net realisable value pe. Dono mein se jo kam ho. Yahan cost ₹60 hai. NRV ₹85 hai. Cost kam hai. Toh value = ₹60."

Sethji sat with this for a moment. "Toh profit tabhi book hoga jab soap actually bikegi? Delivery hogi, paisa aayega, tab?"

"Bilkul sahi."

Rolly, now leaning in: "Aur agar NRV cost se kam ho jaye? Jaise yeh October wali hair oil batch?"

Pranav pulled out his note. "Exactly. October batch — cost ₹140. Lekin ab yeh sirf ₹108 mein bik sakti hai. NRV ₹108 hai, cost ₹140 hai. NRV kam hai. Toh value = ₹108. Aur ₹32 per bottle ka loss — woh is saal ki P&L mein abhi book hoga."

Sethji looked up. "Loss hone wala hai, toh abhi book karo. Profit hone wala hai, toh ruko jab tak ho na jaye."

"Exactly, Sethji. Anticipate no profits. Provide for all losses. Yahi Conservatism hai. AS 2 isi principle pe khada hai."

Sethji sat back in his chair, nodding slowly. Then he looked at Rolly. "Rolly ji, samajh aayi baat?"

Rolly was already updating the sheet.

Then came the cooking oil question.

"Pranav bhai, ek aur baat." Rolly showed him the cooking oil section. "Teen batches hain — teen alag-alag rates pe purchase kiya tha."

Batch	Quantity	Purchase Rate
Batch 1 (July)	100 litres	₹90/litre
Batch 2 (November)	150 litres	₹95/litre
Batch 3 (February)	200 litres	₹100/litre
Sold during year	330 litres	—
Closing stock	120 litres	?

"Closing stock ki cost kya hogi?" she asked.

Pranav explained two methods.

FIFO — First In, First Out: The oldest stock is assumed to be sold first. July batch went first (100L), then November (150L), then 80 litres of the February batch. Closing 120 litres = remaining from February batch. Value = 120 × ₹100 = ₹12,000.

Weighted Average: Total cost = (100 × 90) + (150 × 95) + (200 × 100) = ₹42,250. Total quantity = 450 litres. Average = ₹93.89/litre. Closing stock = 120 × ₹93.89 = ₹11,267.

"Both give different closing stock values," Rolly noted.

"Haan. Aur AS 2 dono allow karta hai. Koi ek choose karo — lekin consistently follow karo. Saal-saal switch nahi kar sakte convenience ke hisab se."

The revised inventory figure was lower than Rolly's original. She showed Sethji the corrected sheet. He looked at it without any fuss.

"Theek hai, Pranav bhai. Jo sach hai, wahi dikhana chahiye. Bank ko bhi toh asli tasveer chahiye." He paused, then laughed warmly. "Waise — ab godown thoda kam bhaari lag raha hai!"

L2

LAYER 2 — Concept Notes

Sub-topic wise explanation keyed to ICAI para numbers. Read alongside ICAI Study Material, Module 2, Chapter 5, Unit 1.

AS2-1.2

Inventories — Definition and Scope

Three categories of inventory:

Assets held for sale in the ordinary course of business — finished goods of a trader or manufacturer
Assets in the process of production for such sale — work in progress
Assets held for consumption in production of goods/services for sale — raw materials, consumables, stores, loose tools

Key scope exclusions (AS 2 does NOT apply to):

WIP under construction contracts (covered by AS 7)
WIP of service providers (cost of part service rendered)
Shares, debentures, financial instruments held as stock-in-trade (current practice: value at lower of cost and fair value)
Producers' inventory of agricultural/mineral products where NRV valuation is an established industry practice

Quick check for scope: if it will generate future economic benefit by being sold or used in production — it is inventory under AS 2.

Kaam Ki Baat Stock in Transit — Whose Inventory Is It?

At IOCL, total inventory across refineries, depots and retail was approximately ₹26,000 crore. At that scale, even a small question — does this belong to us or not? — becomes a crore-rupee entry.

Purchase side — Ethanol from Tamil Nadu to Patna: IOCL's Patna depot procured Ethanol from sugar refineries in Tamil Nadu. Transit time: approximately 8 days by tanker. The moment the tanker left the supplier's premises, risk and reward transferred to IOCL. Even though the Ethanol had not reached Patna, it was IOCL's inventory from that point. It appeared in the books as Stock in Transit (Inward). Not booking it would understate our inventory and overstate the supplier's.

Sales side — Petrol tankers to retail outlets: When IOCL dispatched petrol tankers to petrol pumps, the sale was complete only when the tanker reached the pump and delivery was confirmed. Transit: sometimes 3–4 days. At year-end, any tanker still in transit was NOT a sale. That quantity was reversed from sales and added back to closing inventory as Stock in Transit (Outward).

The principle: inventory belongs to you when risk and reward belong to you. Legal title may transfer on invoice. But risk and reward — that is the real test.

AS2-1.3

Measurement — Lower of Cost and Net Realisable Value

Rule: Inventories should be valued at lower of cost and net realisable value.

NRV definition: Estimated selling price in the ordinary course of business, less estimated costs of completion, less estimated costs necessary to make the sale.

Story Ref

In the opening story: fresh coconut soap (cost ₹60, market price ₹85) → value at ₹60, because cost is lower. Near-expiry hair oil (cost ₹140, NRV ₹108 after selling commission) → value at ₹108, and the ₹32 loss was booked immediately. Same principle, two directions.

The logic: an asset should not be carried at a value exceeding what it can realise through sale or use. If market value has fallen below cost, carry the loss now — do not defer it to the period of sale.

Inventory │ ┌──────────┴──────────┐ Finished Goods Raw Materials & WIP │ │ If finished goods Lower of: sell at or above cost: Cost vs NRV ↓ Cost │ If finished goods ↓ fall below cost: Value ↓ Replacement Cost

AS2-1.4

Costs of Inventory — The Three Buckets

Cost of inventory = Cost of Purchase + Cost of Conversion + Other Costs

All three must be costs that bring inventory to its present location and condition. That phrase is the test for inclusion.

AS2-1.5

Cost of Purchase

Cost of Purchase = Purchase price + duties and taxes (excluding those recoverable from tax authorities) + other directly attributable acquisition expenditure

Deduct: trade discounts, rebates, duty drawbacks.

Exam Note

Customs duty paid at import is included in cost of purchase (not recoverable in ordinary course). But GST input credit that will be set off against output tax is NOT included — it is recoverable from the tax authority. Students often include both. Only include taxes that cannot be recovered.

AS2-1.6

Cost of Conversion — The Normal Capacity Rule

Conversion costs = direct labour + production overheads (fixed and variable).

The critical rule is for fixed production overheads:

Fixed overheads are absorbed based on normal capacity — the production level the enterprise expects to achieve on average over a number of periods under normal circumstances.

Situation	Fixed Overhead Treatment
Actual production ≈ normal capacity	Absorb at normal capacity rate — same result either way
Actual production < normal capacity	Absorb at normal capacity rate; under-recovery → P&L expense (NOT loaded on inventory)
Actual production > normal capacity	Use actual rate per unit (lower than normal rate); do NOT inflate inventory above cost

Variable overheads: absorbed at actual use of production facilities.

Kaam Ki Baat When Production Goes High and When It Comes Down

At an IOCL refinery, production varies significantly with demand. In certain months, when demand for diesel rises — say, during peak agricultural or harvesting season — the refinery processes crude at a higher throughput than its standard planned rate. In other periods, when demand softens, throughput falls below the base level.

When production is higher than planned: The same fixed refinery overheads (maintenance, depreciation on plant, fixed utilities) are now spread across more units. The per-unit cost of fixed overhead falls. AS 2 says to use the actual (lower) rate in this case — we do not inflate inventory by keeping it at the higher normal rate.

When production is lower than planned: The same fixed overheads are now spread across fewer units. If we used actual rate, per-unit cost would be inflated — inventory would absorb losses that belong to the period. AS 2 says: use the normal capacity rate. The unabsorbed overhead goes directly to P&L for that period.

The principle: inventory should reflect what it actually cost to make, not distorted by abnormally high or low production in a period.

AS2-1.7

Joint or By-Products

When a single production process yields two or more products simultaneously, costs up to the split-off point cannot be traced to individual products. They are allocated on a rational and consistent basis — commonly the relative sale value at split-off point.

By-products, scrap, and waste: Usually not material in value. Valued at NRV. That NRV is then deducted from the cost of the main product.

Memory hook: Joint cost minus by-product NRV = cost of main product. The by-product "pays for itself" from the joint cost.

AS2-1.8

Other Costs

Other costs are included in inventory cost only if they are incurred to bring the inventory to its present location and condition.

Item	Included?	Why
Design cost for a custom-made product	Yes	Directly brings that specific inventory to condition for intended sale
Interest / borrowing costs	Generally No	Not related to location/condition. Exception: inventory that takes substantial time to get ready (wine, aged cheese, certain matured products)
Amortisation of production-related patents	Yes	Part of production cost
Exchange differences	No	AS 11 governs; not part of inventory cost

AS2-1.9

Exclusions from Cost of Inventories

Four costs must NEVER be included in inventory cost. They are period expenses:

Abnormal amounts of wasted materials, labour, or other production costs
Storage costs, unless storage is a necessary stage in the production process before a further production stage (e.g., wine ageing, cheese ripening)
Administrative overheads that do not contribute to bringing inventory to its present location and condition
Selling and distribution costs

The test: if the cost does not make the inventory more available or more ready for its intended use — expense it.

Kaam Ki Baat Normal Loss and Abnormal Loss in Transit

Picture an IOCL petrol tanker leaving IOCL's premises and driving to the petrol pump in your neighbourhood. In summer, petrol evaporates a little during the journey — the heat, the long road, the time in transit. This happens every single time, on every tanker. A small variation of up to 0.5% from evaporation was considered normal loss. Expected. Built into the cost.

So if 1,000 litres left IOCL and 995 arrived at the pump, the cost of those 1,000 litres was now divided by 995. Cost per litre went up slightly. The normal loss is absorbed into the cost of the inventory that arrived safely.

But if that tanker met with an accident — or there was theft — that is an abnormal loss. Not expected. Not every day. That quantity is valued and charged directly to P&L. It does not get loaded onto the cost of the petrol that arrived safely.

The principle: normal loss = part of cost, absorbed quietly. Abnormal loss = P&L expense, shown separately.

AS2-1.10

Cost Formula — FIFO and Weighted Average

When inventory items are identical and interchangeable, individual identification is impractical. AS 2 permits:

Specific Identification: Match the actual cost to the actual item in stock. Best method where items are individually identifiable (e.g., high-value unique assets held as inventory, cars at a dealership).

FIFO (First In, First Out): Oldest stock sold first. Closing inventory = most recent purchases. In a rising price environment, FIFO gives higher closing stock and lower COGS → higher profit.

Weighted Average Cost: Total cost ÷ total units. All units carry the same average cost. Updated on each new purchase (perpetual) or computed on period-end basis.

AS 2 rule: apply the same cost formula to all inventories of similar nature and use. If two items have different natures or uses, different formulas may be applied to each group — but within a group, consistency is mandatory.

Story Ref

In the opening story, Rolly had three batches of cooking oil at ₹90, ₹95 and ₹100 per litre. FIFO valued 120 litres of closing stock at ₹12,000. Weighted Average valued the same 120 litres at ₹11,267. Same physical stock — different cost number — depending on the method. Either is correct; what matters is consistency across years.

AS2-1.11

Other Measurement Techniques

Standard Cost Method: Assign a predetermined standard cost instead of actual. Permitted only if standards fairly approximate actual costs. Standards must be set at normal levels of material consumption, labour efficiency, and capacity utilisation. Regularly review and revise.

Retail Method: Used in retail businesses where large volumes of rapidly changing items make actual cost tracking impractical. Method: take the selling price of unsold stock → reduce by an appropriate gross margin percentage → arrives at approximate cost.

Both are simplification methods and acceptable only where they reliably approximate actual cost.

Exam Note

Margin is on sales; markup is on cost — these are different percentages and produce different results. The question will specify one; do not confuse the two. If margin = 25% on sales: cost = 75% of selling price. If markup = 25% on cost: selling price = 125% of cost. Read the question carefully.

AS2-1.12

Estimates of Net Realisable Value

NRV estimates are based on the most reliable evidence available at the time of estimation — including price movements after the balance sheet date, but only where those movements confirm conditions existing at the balance sheet date (not new developments).

NRV is reassessed at each balance sheet date. If the circumstances that caused a write-down no longer exist (e.g., market price has recovered), the write-down is reversed. The inventory is written back up — but not above original cost.

AS2-1.13

Item-by-Item vs Group Comparison

The comparison of cost and NRV is normally done item by item. Each item stands alone.

Exception: it may be appropriate to group items that are similar or related — for example, items in the same product line that serve the same purpose or end use and cannot practically be evaluated separately.

Exam Note

Do not apply the lower-of-cost-or-NRV test on a portfolio or total inventory basis. A profitable item cannot offset a loss-making item. The comparison must be item by item. Students who add up total cost vs total NRV will often get the wrong answer in a question with mixed items.

Story Ref

In the opening story, Sethji's coconut soap had NRV above cost (no write-down needed), while the near-expiry hair oil had NRV below cost (write-down required). These were valued separately — the soap's surplus did not cancel the oil's write-down. Item by item, always.

AS2-1.14

NRV of Materials Held for Use

Raw materials and supplies held for production are NOT written down below cost if the finished goods they will become are expected to sell at or above their full cost.

But if the selling price of finished goods has fallen below their cost of production, then the raw materials are written down. The most appropriate measure in that situation: replacement cost of the raw material (what it would cost to buy that raw material today).

Kaam Ki Baat Crude Oil and the Petrol/Diesel Price Test

Crude oil is IOCL's primary raw material. Petrol (MS — Motor Spirit) and diesel (HSD — High Speed Diesel) are the finished products.

The question at year-end: should we write down the crude oil inventory?

The AS 2 test: are finished products expected to sell at or above their cost? As long as the price at which petrol and diesel can be sold in the market covers the full cost of production (crude cost + refining + transport + overheads), we do NOT write down crude. It stays at cost.

But if petrol and diesel market prices have fallen below the cost of production — meaning selling at market price would result in a loss — then we need to write down the crude. The measure used: current replacement cost of crude oil (today's market price per barrel for the relevant crude grade).

The finished goods test is the gateway. Pass the test (finished goods recoverable) → crude stays at cost. Fail the test (finished goods unrecoverable) → crude written to replacement cost.

AS2-1.15

Disclosures

Financial statements must disclose:

Accounting policies adopted for measuring inventories, including the cost formula used (FIFO / Weighted Average / Specific Identification)
Total carrying amount of inventories with classification:
- Raw materials and components
- Work in progress
- Finished goods
- Stock-in-trade (goods acquired for trading)
- Stores and spares
- Loose tools
- Others (specify nature)

Schedule III to Companies Act 2013 also requires the valuation method to be stated in the notes.

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ILLUSTRATION GUIDE

Use ICAI Study Material for full working. These notes tell you what each illustration is testing and where students go wrong.

Example 1 (Para 1.3) — NRV of Partly Finished Unit NRV Computation

Tests: NRV computation for WIP. NRV = Estimated selling price of finished unit − Cost to complete − Selling expenses (brokerage, commission). Then compare with cost.

Common mistake: Students forget to deduct selling expenses from the selling price before arriving at NRV. NRV is net — after all costs to complete AND to sell.

Exam Note

NRV ≠ Estimated selling price. Always deduct cost of completion and cost of selling before comparing with cost. If the question says "agent commission 5%", that goes in the NRV deduction, not as a separate line.

Example 2 (Para 1.6) — ABC Ltd, Normal Capacity Fixed Overhead

Tests: Fixed overhead absorption. Three cases: actual = normal (straightforward), actual < normal (under-recovery to P&L), actual > normal (use actual rate — do not over-absorb).

Common mistake: In Case 2 (low production), students absorb at actual rate → overstates per-unit cost → inflates inventory. The rule is always normal capacity rate when actual is lower.

Exam Note

When actual production < normal capacity: per-unit fixed overhead = Total Fixed OH ÷ Normal Capacity (not actual). The balance unabsorbed = period expense, not inventory. Never load the under-recovery onto remaining units.

Example 3 (Para 1.11) — Retail Method Retail / Standard Cost

Tests: How to back-calculate cost from selling price using gross margin or markup.

Exam Note

Margin is on sales; markup is on cost — these are different percentages and produce different results. If margin = 25% on sales: cost = 75% of selling price. If markup = 25% on cost: selling price = 125% of cost. Read the question carefully.

Illustration 1 — Items A, B, C (Lower of Cost/NRV) Item-by-Item

Tests: Para 1.13 — item-by-item comparison.

Classic trap: computing portfolio-level total and taking lower of total cost vs total NRV. Wrong. Each item is compared separately — a profitable item cannot cancel a loss-making item.

Illustration 2 — X Co. (NRV with Agent Commission) NRV Deductions

Tests: NRV deduction for selling costs.

NRV = Expected selling price × (1 − commission%). Do not forget the commission. Selling expenses always reduce NRV — they are a cost necessary to make the sale.

Illustration 3 — Normal vs Abnormal Wastage Normal Loss

Tests: Para 1.9(a). Normal wastage → included in cost of good output (cost per unit rises). Abnormal wastage → charged to P&L at the per-unit cost of normal output.

Calculation: normal loss is budgeted from input quantity; any excess loss = abnormal. Cost of normal output = Total input cost ÷ Normal expected output.

Exam Note

Abnormal loss is valued at the cost of normal output per unit, not at a proportionate share of total input cost. This is the most common calculation error in this illustration.

Illustration 4 — Fixed Overhead at Normal Capacity Normal Capacity

Tests: Para 1.6. Per-unit fixed overhead = Total fixed overhead ÷ Normal capacity (units). Multiply by actual production = overhead absorbed into inventory. Closing stock × cost per unit (including absorbed fixed overhead).

Set up a cost per unit table first: direct material + direct labour + variable OH + fixed OH per unit (at normal capacity). Apply to closing stock quantity.

★

TYK GUIDE

Priority questions for exam readiness. Match each to the concept tested. Full questions and solutions in ICAI Study Material.

Question	Concept Tested	Priority
MCQ 1	Scope — what IS in AS 2 (raw materials ✓)	Medium
MCQ 2	NRV of materials — when NOT to write below cost	High
MCQ 3	Exclusions from cost	High
MCQ 4	Admin overheads — always/never included?	High
Theory Q5	List exclusions from cost (Para 1.9)	Medium
Scenario Q6 (Capital Cables)	Normal loss + abnormal loss calculation	Very High ★
Scenario Q7 (Mr. Mehul)	Raw material + WIP + finished goods — all three tested together	Very High ★
Scenario Q8 (Partly finished unit)	NRV computation with brokerage for WIP	Very High ★
Scenario Q9 (Empty bottles)	What qualifies as inventory — applying the definition	High

Q7 (Mr. Mehul) is the most comprehensive TYK question — it simultaneously tests raw material (write to replacement cost when finished goods below cost), WIP (cost vs NRV), and finished goods (cost vs NRV). If you can solve Q7 cleanly, you have understood AS 2.

Q6 (Capital Cables) tests the normal vs abnormal loss calculation — an entry that confuses most students on first attempt. The cost per unit is computed based on normal expected output (not actual output), and only the abnormal quantity is separately charged.

L3

LAYER 3

One-liners for fast recall. Cover each line and try to recite it. These are your exam anchors for AS 2.

Layer 3 — Rapid Recall

One-Liners for AS 2

1

Inventory = assets held for sale in ordinary course of business, OR in process of production for such sale, OR for consumption in production of goods/services for sale.
2

Inventory is valued at lower of cost and NRV — whichever is less, item by item.
3

NRV = Estimated selling price − Estimated costs of completion − Estimated costs necessary to make the sale.
4

Cost of inventory = Cost of Purchase + Cost of Conversion + Other Costs (all incurred to bring inventory to its present location and condition).
5

Cost of Purchase = Purchase price + duties + attributable costs − trade discounts − rebates − duty drawbacks.
6

Fixed production overheads absorbed at normal capacity rate. Under-recovery when actual < normal → P&L expense, not inventory. Over-production → use actual (lower) rate.
7

Variable production overheads → absorbed at actual use of production facilities.
8

Joint products: common costs allocated on rational and consistent basis. By-products valued at NRV; NRV deducted from cost of main product.
9

Exclusions from cost: abnormal wastage, storage costs (unless required by production process), admin overheads not contributing to location/condition, selling and distribution costs.
10

Cost formulas: Specific identification (where possible) → FIFO or Weighted Average (all other cases). Same formula for all inventories of similar nature. Cannot switch formula for convenience.
11

Materials held for use: NOT written below cost if finished goods sell at or above cost. If finished goods below cost → write materials to replacement cost.
12

NRV comparison is item by item — a profitable item cannot mask a loss-making item.
13

Write-down reversal: If reason for write-down no longer exists — reverse it. But reversal is capped at original cost.
14

Disclosure: accounting policy + cost formula used + carrying amount with classification (raw materials, WIP, finished goods, stock-in-trade, stores/spares, loose tools, others).