Inventory forms a major part of assets for most businesses — especially retail, manufacturing, and trading firms.
If inventory is valued incorrectly:
- Profit becomes wrong
- Balance Sheet becomes misleading
- Taxation gets affected
To avoid this, AS 2 lays down clear rules on how inventory should be valued and what costs must be included or excluded.
In simple words:
AS 2 tells us — “Value inventory at the right cost, using the right method, consistently.”
Objective of AS 2
To prescribe the accounting treatment for inventories, including:
- How to calculate the cost of inventories
- How to value them at the lower of cost and net realisable value (NRV)
- Which items to include and exclude from inventory cost
Meaning of Inventory
Inventory includes:
- Items held for sale (finished goods)
- Items in the process of production (work-in-progress)
- Materials and supplies consumed in production (raw materials)
Valuation Rule (Golden Rule of AS 2)
Inventory is valued at Lower of Cost and NRV.
This ensures profits are not overstated.
What is Cost of Inventory?
Cost includes three major components:
- Cost of Purchase
- Purchase price
- Import duty
- Taxes (except GST refundable)
- Freight inward
- Trade discounts deducted
- Cost of Conversion
- Direct labour
- Direct expenses
- Production overheads:
- Fixed OH allocated on normal capacity
- Variable OH allocated on actual production
- Other Costs
Only if necessary to bring inventory to its location and condition.
Costs Excluded from Inventory (Must Be Expensed)
- Abnormal wastage
- Storage costs (unless part of production process)
- Administrative overheads not related to production
- Selling & distribution costs
- Interest & finance charges
Students often forget:
Interest is never included in inventory cost.
Methods of Valuation Accepted under AS 2
AS 2 allows consistent use of:
- FIFO (First In First Out)
- Weighted Average Cost Method
Not Allowed:
- LIFO (Last In First Out)
- Base stock method
- Any method resulting in unrealistically low or high value
Numerical Example (Very Important for Exams)
Example: FIFO vs Weighted Average
A company purchases:
- 100 units @ ₹10
- 100 units @ ₹12
- Issues 120 units
FIFO Method
Issue:
- 100 units × ₹10 = ₹1,000
- 20 units × ₹12 = ₹240
Cost of Issue = ₹1,240
Closing Stock = 80 units × ₹12 = ₹960
Weighted Average Method
Total cost = 100×10 + 100×12 = ₹2,200
Avg rate = 2,200 / 200 = ₹11 per unit
Issue = 120 × ₹11 = ₹1,320
Closing Stock = 80 × 11 = ₹880
Notice how valuation methods impact profit and stock value.
What is NRV?
NRV (Net Realisable Value) = Selling Price − Selling Expenses − Completion Cost
If NRV < Cost → Value at NRV
If NRV ≥ Cost → Value at Cost
Special Cases under AS 2
–Raw Materials:
If NRV of finished goods ≥ cost →
Raw material valued at cost
If NRV of finished goods < cost →
Raw material valued at replacement cost
–Work-in-Progress:
Include:
- Materials
- Labour
- Proportionate overheads
Exclude:
- Storage, abnormal losses
–By-Products / Scrap:
Value them at NRV and reduce cost of production.
Disclosure Requirements
A business must disclose:
- Accounting policy for inventory valuation
- Formula/method used (FIFO or Weighted Average)
- Classification of inventory (FG, WIP, Raw Materials)
Common Exam Mistakes
- Confusing cost and NRV
- Including abnormal losses in inventory cost
- Forgetting that fixed overheads are allocated on normal capacity
- Including interest in inventory cost
- Using LIFO (strictly not allowed)
Exam Tip
A very common exam question:
“Explain how fixed overheads are allocated in inventory valuation.”
Correct answer:
On the basis of normal capacity, not actual production.
Motivational Note
“Inventory is like blood in a business. If it’s valued wrongly, everything else becomes unhealthy.” – CA Rohit Sethi
