A. Facts of the Case

1. A company is engaged in transmission, processing and marketing of natural gas. Besides sale to different customers, natural gas is also used internally by the company as a major raw material for the manufacture of LPG, polymers and other value added products and also as a fuel.

2. Inventories of the company include various items of stores and spares (the value of stores and spares is about Rs. 350 crore) and according to the querist, it is not practically possible to estimate the realisable values of all the items of inventories. As per the accounting policy currently being followed by the company, “in case of surplus/obsolete stores and spares, provision at the rate of 2% of the value of stores and spares except those in transit, is made for likely loss on sale/disposal and charged to revenue.”

3. In respect of capital stores/items (except those in transit), the company is presently making provisions for the loss/obsolescence on an item-by-item basis.

B. Queries

4. The querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) Whether the accounting policy of the company regarding stores and spares, as described in paragraph 2 above, is in order and in accordance with Accounting Standard (AS) 2, ‘Valuation of Inventories’.

(b) Whether the policy of making provision at the rate of 2% of the value of stores, except those in transit, can be applied in the case of capital inventory, keeping in view the requirement of AS 2 of valuing the inventory at the lower of cost and net realisable value.

(c) In case provision for capital stores/items is made/valuation is done at realisable value (if it is lower than cost), whether the amount of provision should be charged to cost of capital work-in-progress for which the capital stores/items were procured or whether it should be debited to profit and loss account.

C. Points Considered by the Committee

5. Paragraph 5 of AS 2 requires that “inventories should be valued at the lower of cost and net realisable value”.

6. Paragraph 24 of AS 2 states the following:

“24. Materials and other supplies held for use in the production of inventories are not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost. However, when there has been a decline in the price of materials and it is estimated that the cost of the finished products will exceed net realisable value, the materials are written down to net realisable value. In such circumstances, the replacement cost of the materials may be the best available measure of their net realisable value.”

7. Based on the above, the Committee is of the view that inventories of stores and spares held for use in the production of inventories are not to be written down below cost if the related finished products are expected to be sold at or above cost. However, inventories of stores and spares that cannot be considered as being ‘held for use in the production of inventories’ (e.g., stores and spares surplus to production requirements and obsolete stores and spares) would need to be valued at the lower of their cost and net realisable value. In this regard, the Committee notes that the company is presently making an overall provision in respect of surplus/obsolete stores at a specified percentage of the total value of stores and spares on hand and is not estimating the net realisable values separately for different items or groups of similar items of such stores and spares. The Committee is of the view that the adequacy of the provision made by the company can be judged only after a detailed examination of the extent of shortfall of realisable values of surplus/obsolete stores and spares vis-à-vis their cost. The Committee is unable to comment, based on the information available, whether the provision made by the company is adequate or not.

8. The querist has made a reference to the manner of making provision on account of loss/obsolescence of ‘capital stores/items’ and has sought the opinion of the Committee, inter alia, as to whether the amount of such provision should be charged to the cost of capital work-in-progress for which the capital stores/items were procured or whether it should be debited to profit and loss account. The Committee presumes that in the present context, the term ‘capital stores/items’ refers to those stores/items which have been procured for the purpose of use in the construction of a capital asset.

9. The Committee takes note of the following definition of the term ‘inventories’ as given in paragraph 3 of AS 2.

“Inventories are assets:

(a) held for sale in the ordinary course of business;

(b) in the process of production for such sale; or

(c) in the form of materials or supplies to be consumed in the production process or in the rendering of services."

The Committee is of the view that capital stores/items do not fall within the definition of ‘inventories’ as given in AS 2. Therefore, the requirements of AS 2 are not applicable to their valuation.

10. Accounting Standard (AS) 10, ‘Accounting for Fixed Assets’, states (paragraph 9.1) that “the cost of an item of fixed asset comprises its purchase price, including import duties and other non-refundable taxes or levies and any directly attributable cost of bringing the asset to its working condition for its intended use”. The Committee is of the view that in the case of self-constructed fixed assets, the reference to purchase price in the above definition should be construed to the purchase price of various components. Accordingly, as a general rule, stores held for use in the construction of a capital asset should be shown at their cost. However, if certain capital stores are surplus to the requirements or are obsolete, they should be included in the financial statements at their net realisable value.

11. As regards the treatment of difference between the cost of surplus/obsolete capital stores and their net realisable value, the Committee is of the view that such difference should be treated as a part of the cost of the asset and, therefore, included in the capital work-in-progress.

D. Opinion

12. Based on the above, the Committee is of the following opinion on the issues raised in paragraph 4:

(a) The accounting policy being followed by the company regarding stores and spares is not correct. As per AS 2, stores and spares held for use in production are not to be written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost. However, inventories of stores and spares that cannot be considered as being ‘held for use in the production of inventories’ (e.g., stores and spares surplus to production requirements and obsolete stores and spares) would need to be valued at the lower of their cost and net realisable value. The provision made by the company in respect of surplus/obsolete stores and spares as per the accounting policy being followed by it may not necessarily be adequate to bring down such stores and spares to their net realisable value.

(b) Capital stores/items, as construed in paragraph 8, are not ‘inventories’ within the meaning of this term under AS 2. Such stores held for use in the construction of a capital asset should be shown at cost. However, surplus/obsolete spares of this kind should be included in the financial statements at their net realisable value. The provision at a pre-determined rate may not necessarily be adequate to bring down surplus/obsolete capital spares to their net realisable value.

(c) The amount of write down of capital spares to their net realisable value should be included in the capital work-in-progress.



Opinion finalised by the Committee on 22.4.2000