Inventories are valued at year end and deducted from the cost of goods so as to ensure that only the cost of goods consumed or sold during the accounting period is charged to the profit and loss account. One way to do this alternatively would be by identifying those goods which are consumed or sold and writing off such cost to the profit and loss account.

The balance goods could be shown as assets at cost. However, conservative accounting principles require that if the goods still lying in stock will eventually not realise the cost paid for it, such fall in value should also be charged in that period itself. Hence, the purpose of inventory valuation isto ensure that any fall in value in inventories is properly charged off in that period itself but any appreciation, since it is unrealised, is not taken into account.

Except by elaborate procedures, it is usually not possible to identify out of interchangeable items, which specific items that have been consumed or sold and which specific items are in stock. The standard recognises this and provides for recognised methods to work out the value. The standard also deals with, in great detail, the method and procedures for working out the cost of inventories which undergo some process. Inventory valuation has always been a classic technique to window-dress accounts for showing the desired profits or for favourable tax treatment. Hence, the standard also focuses on minimising this.

Typically, the cost of inventory would include not only its purchase price, but also various other costs such as transportation, duties, etc. However, to ensure that unrelated items are not added to the cost, the standard providesthat only those costs that are incurred in bringing inventories to their present location and condition should be added. For example, selling and distribution costs are obviously not incurred, in the normal course, for bringing the inventories to their present location and hence are to be excluded. A controversial item is of interest. The argument for including interest in the cost of inventories is that where the production process is very long and capital is blocked for such period, it would be appropriate to add interest on such capital for the purpose of valuation. While this argument has some merit, interest is also seen to have remote connection with the production process. Permitting this may also enable companies find an additional technique of window dressing. The standard, therefore, frowns at this policy and provides that it should usually not be included.

An important change now is that the standard permits only two methods: first-in-first-out (FIFO) and weighted average cost. The controversialmethod of last-in-first-out (LIFO) is now not permitted. The LIFO method reasoned that in days of high inflation, inventory prices are rising, and therefore it would be inappropriate to charge the lower cost of earlier purchases. Profits would be reflected fairly if the latest cost is charged. However, there were several arguments against also and, particularly, the tax authorities generally disapproved this method.

The standard cost method and retail method are also permitted if the value arrived by such methods approximate the actual cost.

The standard provides that inventories should be valued at the lower of cost or net realisable value. The method of determination of net realisable value has been provided for in great detail.

The standard recognises the fact that specific identification method leaves scope for window dressing of accounts when the items are interchangeable. The entity could identify those items which have a higher (or lower) cost, as its suits it, to have the desired effect on theaccounts. The accounting standard provides that where the items are interchangeable, the cost should be arrived at by the two recognised methods, as described above, only. The standard recognises that items and components, which are not to be sold by the enterprises in that form, may have a lower realisable value. The standard accordingly provides that they may be valued at cost and not at their net realisable value if it is expected that the finished goods of which they would become part would realise at least the cost.

The standard also provides for valuation of by products and joint products as also of waste. When it is possible to identify and segregate the cost of the different joint or by products, this is permitted provided the allocation is done on a rational and consistent basis. However, where by products or waste are immaterial in value, it is permitted that they can be valued at their net realisable value and this value in the deducted from the cost of the main product. The standard thus tacklesthe controversial area of inventory valuation, minimise scopes for window dressing and provides for fewer standard methods of inventory valuation. The fact that accounting standards notified by the Institute of Chartered Accountants of India are mandatory would result in enforcement of this standard.

The author is a Mumbai-based chartered accountant