CruxFinancial Accounting

Revenue is what a business earns from its ordinary work: the sale of goods, the rendering of services, and interest, royalties and dividends earned when others use its resources. It is measured by what the business charges its customers (AS 9, para 4.1; see C07).

Business income (also called net profit or net income) is the excess of the revenue realised in a period over the costs expired in the same period, losses included. Two words carry the idea:

• Realised revenue: revenue that has been earned in the period, whether or not the cash has come in.
• Expired cost: the part of a cost whose benefit has been used up in the period. The unexpired part is still an asset (stock in hand, prepaid insurance, the undepreciated cost of a machine).

Seen from the owner's side, revenue is any increase in the owner's equity that comes from operating the business, and an expense is any decrease. Income is the difference. Money the owner puts in is not income, and money the owner takes out is not an expense.

The accountant measures money income, not the "real income" or well-being an economist talks about. Real income turns on personal valuation and is too subjective to record.

There are two ways to arrive at the same figure.

1. Transaction (matching) approach. List the revenue of the period, then the expenses that belong to it, and subtract. This is what the Profit and Loss Account does.
2. Change in capital (net assets) approach. Compare the owner's capital at the end of the period with the capital at the start, after removing what the owner put in or took out.

Three ideas make periodic measurement possible.

(a) Accounting period (periodicity). The true income of a business is known for certain only when it closes and every asset has been turned into cash. Owners, lenders and managers cannot wait that long; they need results at regular intervals to act on them. So the life of the business is cut into equal periods, usually a year (the financial year), with shorter interim reports for management. Cutting a continuous stream of activity into years is somewhat arbitrary. That is why measuring one period's income is the hardest problem in accounting: every sale, cost and estimate must be placed in the right year.

(b) Continuity doctrine (going concern). The business is assumed to go on for the foreseeable future. This is what allows the accountant to:

• carry assets at cost, not at what they would fetch in a forced sale;
• spread the cost of a long-lived asset over the years that use it (depreciation);
• carry unexpired costs, such as stock and prepaid expenses, into the next period instead of writing them off now;
• separate capital expenditure (benefit beyond the year) from revenue expenditure.

If the business is about to close, these rules stop working and assets are valued at what they will realise.

(c) Matching concept. Once the period's revenue is fixed, the costs of earning that revenue are set against it in the same period. Work in two steps:

1. Fix the revenue of the period (the realisation and accrual rules). Revenue is earned when the goods or services are supplied for a consideration, not when the order is received or the cash comes in.
2. Fix the expenses that belong to that revenue. An expense is recognised in a period when:
   • it is directly linked with that period's revenue (the cost of the goods sold);
   • it is linked with the period itself, though not with any one sale (office salaries, rent);
   • the benefit of an asset has run out in the period even without earning revenue (a loss by flood or fire).

This gives four cases of expenditure and expense:

The other conventions also shape the figure: consistency (use the same methods year after year, and disclose the effect of any change), full disclosure (show material items such as large arrears of wages separately), and conservatism (do not anticipate profits, but provide for known losses).

Finding the profit of the period is the main aim of financial accounting. Owners earn a return on their money only by sharing in the income, so they and investors watch it most closely. The figure serves several purposes:

1. Return to owners. It shows how much the business earned on the capital invested.
2. Distributable income. It shows what can be paid out as dividend or drawn by the owner without eating into capital.
3. Keeping capital intact. Charging the cost of assets used up (depreciation) before arriving at profit stops the owner from withdrawing money needed to replace them.
4. Judging management (stewardship). Profit is the usual measure of how well managers used the resources entrusted to them.
5. Decisions of outsiders. Investors, lenders and creditors judge earning power, the safety of a loan and the ability to pay interest from it.
6. Tax. Income tax is levied on business income, worked out from the accounting profit.
7. Planning and control. Comparing income of different periods, or of different departments, shows where to act.

The same business can report different profits in a year from the same transactions, because many figures rest on choices and estimates: the useful life and method of depreciation, the inventory cost formula, provisions and the valuation of intangibles. Over the whole life of an asset or a stock of goods the total charged is the same; what changes is which year bears it.

• Depreciation (C05). A method that charges more in the early years (written down value) gives lower profit in those years and higher profit later than the straight line method.
• Inventory valuation (C06). A higher closing stock means a lower cost of goods sold and a higher profit this year, and a higher opening stock (so a lower profit) next year.

Revenue under AS 9 (para 4.1) is the gross inflow of cash, receivables or other consideration that arises from an enterprise's ordinary activities from three sources:

1. the sale of goods;
2. the rendering of services; and
3. the use by others of the enterprise's resources, which yields interest, royalties and dividends.

It is measured by the charges made to customers for goods and services, and by the charges and rewards for the use of resources. Two points follow:

• An agent recognises only its commission as revenue, not the full amount it collects for the principal.
• Amounts collected for others, such as GST, are not revenue, because they do not belong to the enterprise.

AS 9 is mainly about timing: in which period revenue is recognised. The amount is usually fixed by agreement; doubts about the amount or its costs can delay recognition.

Outside AS 9 (para 2). Special rules apply, so AS 9 does not deal with revenue from:

• construction contracts (AS 7);
• hire-purchase and lease agreements;
• government grants and similar subsidies;
• insurance contracts of insurance companies.

Not revenue at all (para 3). These gains do not count as revenue for AS 9:

• gains on disposing of, or simply holding, non-current assets (a rise in the value of fixed assets);
• unrealised holding gains on current assets, and natural increases in herds and in agricultural and forest produce;
• gains from changes in foreign exchange rates and from translating foreign statements;
• gains from settling an obligation for less than its carrying amount, or from restating an obligation.

For a sale of goods, performance is achieved (AS 9, para 11) when both conditions hold:

1. Ownership (the property in the goods) has passed from seller to buyer for a price, or the seller has passed on all significant risks and rewards of ownership and keeps no effective control over the goods of the kind an owner has; and
2. There is no significant uncertainty about the amount of consideration the sale will bring.

Usually property and risks pass together. Where they part, revenue follows the risks and rewards. They can part when delivery is delayed by the fault of one party (the goods are then at that party's risk), or when the parties agree that risk passes at another time.

Revenue from sales or services is then recognised once performance is achieved, provided ultimate collection can reasonably be expected at that time (para 10). If collection cannot reasonably be expected when the claim is raised, recognition is postponed.

Presentation. Turnover is shown on the face of the statement as gross turnover, less excise duty, giving net turnover (explanation to para 10).

Revenue from services is recognised as the service is performed, by one of two methods (paras 7 and 12), whichever relates the revenue to the work done:

Under either method, performance counts only when there is no significant uncertainty about the amount of the consideration.

When others use the enterprise's resources, revenue is recognised only if there is no significant uncertainty about measuring or collecting it (para 13), on these bases:

Discount or premium on debt securities held is usually spread over the period to maturity. Where income from abroad needs exchange permission and remittance is uncertain, recognition may have to wait.

Revenue must be measurable, and at the time of the sale or service it must be reasonable to expect that the money will finally be collected (para 9.1). Uncertainty affects revenue in two ways, depending on when it arises.

When postponed revenue is finally recognised, it is revenue of the period in which it is recognised, not of the earlier period (para 9.5). If there is no doubt about collection, revenue is recognised at the time of sale even when payment comes in instalments.

The same reasoning covers a price concession agreed after the sale because of the buyer's own later difficulty (not a defect in the goods): sales stay at the amount first recorded, and the concession is charged to profit and loss as an expense of the year. Netting it off would understate turnover, though profit is the same either way.

The illustrations to AS 9 apply the rules to common situations. They are not part of the standard itself, but they show how it works.

Trade discounts and volume rebates given are deducted in arriving at revenue. Those received are not revenue at all; they reduce the cost of purchases. Goods returned by customers reverse the sale, so they too come off revenue.

• The accounting policies for revenue, under AS 1.
• The circumstances in which revenue recognition has been postponed because significant uncertainties are still to be resolved (para 14).

Goods moved between divisions of the same enterprise are not sales. An ICAI announcement, noted in a footnote to AS 9, calls recording them as sales an inappropriate treatment, inconsistent with the standard.

AS 10 tells users how much a business has invested in its long-lived physical assets and how that investment changes. Its main questions are: when to recognise the asset, at what amount to carry it, and how much depreciation and impairment loss to charge.

Property, plant and equipment (PPE) (AS 10, para 6) are tangible items that pass two tests:

1. they are held for use: in producing or supplying goods or services, for renting to others, or for administrative purposes; and
2. they are expected to be used for more than twelve months.

Land, buildings, plant, machinery, vehicles, furniture and office equipment are the usual examples. "Administrative purposes" is read widely: assets used for selling, finance or personnel work are PPE too. Assets bought for safety or environmental reasons are PPE if, without them, the other assets could not earn their benefits.

Scope. AS 10 applies to all PPE unless another standard requires or permits a different treatment (para 2). It does not apply to (para 3):

• biological assets of agricultural activity, other than bearer plants (it covers bearer plants, but not the produce growing on them);
• wasting assets: mineral rights, and spending on exploring for and extracting minerals, oil, natural gas and similar resources that do not regenerate.

It still applies to PPE used to develop or maintain those assets. Some other standards decide recognition while AS 10 governs the rest: leased PPE is recognised under AS 19 but depreciated under AS 10 (para 4); investment property under AS 13 uses only AS 10's cost model (para 5).

Recognition (para 7). The cost of an item becomes an asset only if both hold:

• it is probable that future economic benefits from the item will flow to the enterprise; and
• its cost can be measured reliably.

Spare parts, stand-by and servicing equipment are PPE when they meet the definition; otherwise they are inventory (para 8). AS 10 does not fix the unit of recognition: small items such as moulds and tools may be grouped, and an immaterial item may simply be expensed (para 9).

An item of PPE is first measured at cost (para 16): the cash or cash equivalent paid, or the fair value of anything else given, to acquire or build it (para 6).

What goes into cost (para 17):

1. Purchase price, with import duties and purchase taxes that cannot be recovered, after taking off trade discounts and rebates.
2. Directly attributable costs of bringing the asset to the place and condition needed for it to work as management intends (para 18): employee costs arising directly from building or buying it, site preparation, initial delivery and handling, installation and assembly, testing (less the net sale proceeds of samples made while testing), and professional fees.
3. The first estimate of the cost of dismantling and removing the item and restoring its site, where the enterprise takes on that obligation.

What does not go into cost (paras 20 to 22):

• costs of opening a new facility (inauguration), introducing a new product (advertising), or doing business in a new place or with new customers (staff training);
• administration and general overheads;
• costs after the asset is ready for use: while it waits to be used or runs below capacity, initial operating losses, and costs of relocating or reorganising;
• income and expenses of incidental operations, such as using a building site as a car park before work starts (these go to profit and loss).

Other points:

• A self-built asset is costed like a bought one; internal profits and abnormal waste are left out (para 23).
• If payment is deferred beyond normal credit, cost is the cash price; the extra is interest over the credit period (para 25).
• In an exchange for another non-monetary asset, the new item is measured at fair value, unless the exchange lacks commercial substance or no fair value can be measured reliably; then it takes the carrying amount of the asset given up (para 26).
• Several items bought for one price share it in proportion to their fair values (para 29).
• Repairs and maintenance (day-to-day servicing) are expenses (para 12). A major replacement part is added to cost if it meets the recognition test, and the replaced part is removed (para 13).

AS 10 (para 6) defines depreciation as spreading an asset's depreciable amount over its useful life on a systematic basis. In plain words: the cost of an asset is spread as an expense over the years that use it.

Why charge it.

1. To find the true profit: the part of the asset used up in earning the year's revenue is a cost of that year (matching, C17).
2. To keep funds for replacing the asset: profit after depreciation stops the owner from drawing out money that the asset's cost represents.
3. To show the asset at a fair figure in the balance sheet.

What causes it. Wear and tear from use; passage of time; obsolescence (a better machine comes to market); accidents; a fall in market value. Land usually has an unlimited life and is not depreciated; buildings are (para 60).

The three figures you need.

Useful life is the life to this enterprise, which may be shorter than the asset's physical life. It turns on expected use, physical wear (shifts worked, maintenance), technical or commercial obsolescence, and legal limits such as a lease's end (para 58).

Components. Each part whose cost is significant in relation to the whole is depreciated separately, for example an aircraft's body and its engines (paras 45, 46).

When it starts and stops (para 57). Depreciation starts when the asset is available for use, that is, installed and ready, even if it is not yet used. It stops when the asset is held for disposal or derecognised, whichever is earlier. It does not stop because the asset is idle, unless it is fully depreciated; under a usage method the charge can be nil while nothing is produced. Depreciation is charged even if the asset's fair value is above its carrying amount, so long as the residual value is below the carrying amount (para 54).

The year's depreciation goes to the Statement of Profit and Loss, unless it forms part of the cost of another asset (factory machinery depreciation becomes part of the cost of goods made) (paras 50, 51).

Impact on business income. Depreciation is a real cost even though no cash goes out in the year. Leaving it out overstates profit. The method and life chosen decide how the cost is shared between years, and so the profit of each year (C17, section 4).

The method must reflect the pattern in which the asset's benefits are expected to be used up (para 62). AS 10 names three (para 64):

A method based on the revenue an asset helps to earn is not allowed: revenue depends on prices, volumes and other inputs, not on how the asset is used up (para 65).

Part of a year. Charge depreciation only for the months the asset is held: from the date it is available for use to the year end, and from the start of the year to the date of sale. A question may lay down its own practice (a full year in the year of purchase and none in the year of sale); follow it when stated.

The DU text also describes methods built for special cases: the annuity method (charges interest on the money locked in the asset), the depreciation fund (sinking fund) and insurance policy methods (set money aside to replace the asset), the machine hour rate method (life in hours), the depletion method (mines and quarries, per tonne extracted) and the revaluation method (loose tools and livestock, valued each year).

Depreciation can be recorded in two ways.

In both, the Depreciation account is closed to Profit and Loss (Profit and Loss A/c Dr, To Depreciation A/c).

Sale or scrapping (derecognition). An item is removed from the books when it is disposed of, or when no future benefit is expected from it (AS 10, para 74). Steps:

1. Charge depreciation on it up to the date of sale.
2. Find its carrying amount on that date: cost less all depreciation on it.
3. Gain or loss = net sale proceeds − carrying amount (para 79). It goes to the Statement of Profit and Loss; a gain is not revenue (para 75).
4. Under the provision method, close the item through a Disposal account: debit its cost, credit its accumulated depreciation and the proceeds; the balance is the gain or loss.

Part of an asset sold. Take out that part's share of cost and of depreciation to date, as if it were a separate machine.

Loss by fire or accident. Treat it as a disposal on the date of the loss. The carrying amount less any scrap realised and any insurance claim admitted is a loss to Profit and Loss. Compensation from an insurer is income when it becomes receivable, and is a separate event from the loss and from buying a replacement (paras 71, 72).

An item retired from use and held for disposal is shown at the lower of its carrying amount and net realisable value; any write-down goes to profit and loss (para 73).

AS 10 requires a review at least at each financial year end of:

• the residual value and the useful life (para 53); and
• the depreciation method (para 63).

The method is changed only when there has been a significant change in the expected pattern in which the asset's benefits are used up (or when a statute requires a method that better reflects that pattern, para 64). Every such change, of method, life or residual value, is a change in an accounting estimate under AS 5. A change in estimate is applied prospectively: to the current year and later years only. Past depreciation is not recomputed, and there is no "deficiency" or "excess" for past years.

How to work it.

1. Run the old method up to the date the change takes effect.
2. Take the carrying amount (written down value) of each asset still held on that date.
3. Apply the new method to that carrying amount for the remaining life:
   • new written down value rate: rate × carrying amount;
   • new straight line over a revised remaining life: (carrying amount − residual value) ÷ remaining years;
   • where a question gives only a straight line rate after the change, apply the rate to the carrying amount at the date of change.
4. Assets sold before the change takes effect are outside it.
5. A change decided during a year applies to the whole of that year, from its first day, because the year's depreciation is charged once, at the year end (unless the question fixes another date).

Disclose the nature and the effect of the change, as AS 5 asks for any change in estimate (AS 10, para 84).

After recognition the enterprise chooses one model as its policy and applies it to an entire class of PPE (para 32), such as land, buildings, machinery, vehicles or furniture (para 40).

Rules of the revaluation model.

• Only items whose fair value can be measured reliably are revalued, usually by professional valuers from market evidence (para 35).
• Revaluations are kept up to date, so that the carrying amount does not differ materially from fair value at the balance sheet date; volatile items may need yearly revaluation, others every three or five years (paras 34, 37).
• If one item is revalued, its whole class is revalued, to avoid picking only the items that suit (paras 39, 41).

Where the change goes.

The surplus may be moved to revenue reserves when the asset is retired or sold, or bit by bit as it is used (the extra depreciation on the revalued amount). Such transfers never pass through profit and loss (para 44). On revaluation, accumulated depreciation is either restated in proportion or eliminated against the gross amount (para 38). Depreciation after revaluation is based on the revalued amount.

AS 10 sends impairment to AS 28, Impairment of Assets (para 70). An asset is impaired when its carrying amount is more than the amount it can recover.

When to test. At each balance sheet date, look for signs of impairment (AS 28, para 6; the minimum list of signs is in para 8). Outside signs: a sharp fall in market value; adverse changes in technology, market, economy or law; higher interest rates that lower value in use; net assets above market capitalisation. Inside signs: obsolescence or physical damage; plans to stop using or to restructure; internal reports showing the asset is doing worse than expected. Only if a sign exists is the recoverable amount estimated.

Treatment.

1. Reduce the carrying amount to the recoverable amount (AS 28, para 57).
2. Charge the loss to profit and loss at once; for a revalued asset, treat it as a revaluation decrease, debited first to that asset's revaluation surplus (paras 58, 59).
3. Base later depreciation on the reduced carrying amount, less residual value, over the remaining life (para 61).
4. A later reversal is income, but the asset cannot be written back above the carrying amount it would have had, after depreciation, without the impairment (paras 101, 103).

For each class of PPE (AS 10, paras 81 to 84):

• the measurement basis (cost model or revaluation model);
• the depreciation methods used;
• the useful lives or depreciation rates used, saying so if they differ from those in the governing statute;
• the gross carrying amount and the accumulated depreciation (with impairment losses), at the start and end of the period;
• a reconciliation of the carrying amount: additions, assets held for disposal, revaluations, impairment losses and reversals, depreciation and other changes;
• restrictions on title and assets pledged as security, spending on assets under construction, commitments to buy PPE, and compensation received for assets lost;
• the nature and effect of any change in an accounting estimate (residual value, useful life, method).

An intangible asset (AS 26, para 6.1) is a non-monetary asset with no physical substance, which is identifiable and is held for use in producing or supplying goods or services, for renting to others, or for administrative purposes.

Three tests come from the definition (para 8):

1. Identifiable. It can be told apart from goodwill. It usually is if it is separable (it could be sold, rented or exchanged on its own), or if it comes from legal rights (paras 11 to 13).
2. Controlled. The enterprise can obtain its benefits and keep others from them, usually through legal rights (para 14). A skilled team, staff training, customer loyalty and market share are usually not controlled, so they are not intangible assets (paras 16, 17).
3. Future economic benefits. More revenue, lower costs or other gains from using it (para 18).

If an item fails these tests, what was spent on it is an expense.

Common intangible items (para 7): computer software, patents, copyrights, motion picture films, customer lists, licences, import quotas, franchises, marketing rights, and goodwill (bought or self-generated). Para 7 also lists customer loyalty and market share. Not every such item passes the three tests above (para 8): customer loyalty and market share, for example, usually fail on control.

A patent kept on paper or software on a disk is still intangible: the physical part is minor (para 9). Software that a machine cannot run without (or a computer's operating system) is part of that hardware and goes under AS 10; other software is intangible (para 10).

Outside AS 26 (paras 1, 2, 5): intangible assets covered by another standard (goodwill on amalgamation under AS 14 and on consolidation under AS 21; assets held for sale under AS 2 and AS 7; leases under AS 19; deferred tax assets under AS 22), financial assets, mineral rights and exploration for minerals, oil and gas, insurers' contracts with policyholders, termination benefits, and share issue expenses and discount on shares.

An intangible asset is recognised only if (para 20):

• it is probable that the future economic benefits from it will flow to the enterprise; and
• its cost can be measured reliably.

It is first measured at cost (para 23).

Never recognised as assets:

• Internally generated goodwill (para 35). It is not an identifiable resource the enterprise controls, and it cannot be measured reliably at cost. The gap between the market value of a business and its net assets is not the cost of any intangible asset (para 37).
• Internally generated brands, mastheads, publishing titles, customer lists and similar items (para 50). Their cost cannot be separated from the cost of building the business as a whole.

Always an expense when incurred (para 56):

• research (section 3);
• start-up costs: preliminary expenses of setting up a legal entity, pre-opening and pre-operating costs (unless they are part of the cost of PPE under AS 10);
• training;
• advertising and promotion;
• relocating or reorganising the enterprise.

An amount once written off as an expense is never brought back later as part of an asset's cost (para 58).

To judge an internal project, split it into two phases (para 39):

A development cost is recognised as an asset if, and only if, the enterprise can show all six:

1. it is technically feasible to complete the asset so that it can be used or sold;
2. it intends to complete it and use or sell it;
3. it is able to use or sell it;
4. how it will earn probable future benefits: a market for its output or for the asset itself, or, if used inside, its usefulness;
5. it has the technical, financial and other resources to complete, use or sell it;
6. it can measure reliably the spending on it during development.

If the research phase cannot be told apart from the development phase, treat the whole project as research (para 40).

Cost of an internally generated asset is only what is spent from the date the conditions are first met (para 52). It includes materials and services used, salaries of staff directly engaged, fees to register a legal right, and overheads that can be allocated reasonably (para 53). It excludes selling, administrative and general overheads, inefficiencies and early operating losses, and staff training (para 54).

Capitalised development cost written off over the benefit. Older papers call development spending carried forward "deferred research and development cost". Once it is carried as an asset, it is written off over the years that benefit, in the pattern of the benefit; expected sales are a common measure. If at any point no further benefit is expected, the whole unamortised balance is written off at once (para 87).

Amortisation is the depreciation of an intangible asset: its depreciable amount (cost less residual value) spread systematically over its useful life (paras 6.7, 6.8). After recognition the asset is carried at cost less accumulated amortisation and impairment losses (para 62).

Period (paras 63 to 71).

• Spread the cost over the best estimate of useful life, starting when the asset is available for use.
• There is a rebuttable presumption that the useful life does not exceed ten years from that date. With persuasive evidence of a longer specific period, the enterprise uses it, tests the asset for impairment every year, and discloses why the presumption was rebutted.
• A useful life may be very long but is always finite. Software and similar assets are likely to have short lives because technology changes fast.
• Where control comes from legal rights for a fixed period, the life cannot exceed that period, unless the rights are renewable and renewal is virtually certain.
• With both economic and legal limits, the useful life is the shorter of the two.

Method (paras 72, 73). The method should follow the pattern in which the asset's benefits are used up: straight line, diminishing balance or units of production. If that pattern cannot be found reliably, use the straight line method. A method giving less accumulated amortisation than the straight line will rarely be justified.

Residual value is taken as nil (para 75), unless a third party has agreed to buy the asset at the end of its life, or there is an active market that will give the value and is likely to exist then.

Review (para 78). The period and the method are reviewed at least at each financial year end:

• if the expected life is significantly different, change the period;
• if the pattern of benefits has changed significantly, change the method.

These are changes in an accounting estimate under AS 5, so they apply from the review onwards. Spread the carrying amount at the date of change over the remaining life by the new method; earlier years are not restated.

Later spending (paras 59 to 61) on an intangible asset is an expense, unless it will probably let the asset earn more than its originally assessed standard of performance and can be measured and attributed to the asset reliably. Then it is added to cost. Later spending on brands, mastheads, publishing titles and customer lists is always an expense.

Impairment is tested under AS 28, as for PPE (C05, section 8). Two intangibles must have their recoverable amount estimated at every year end even without a sign of impairment (para 83): one not yet available for use, and one amortised over more than ten years.

Retirement and disposal (paras 87 to 89). Remove the asset from the balance sheet when it is disposed of or when no future benefit is expected. Gain or loss = net disposal proceeds − carrying amount, taken to profit and loss.

Disclosure (paras 90 to 96), for each class, internally generated assets apart from the rest:

• useful lives or amortisation rates, and the methods used;
• gross carrying amount and accumulated amortisation at the start and end of the period, with a reconciliation;
• the reasons for a life of more than ten years;
• the total research and development expenditure charged as an expense in the period.

Inventories (AS 2, para 3.1) are assets that are:

1. held for sale in the ordinary course of business (finished goods, goods bought for resale);
2. in the process of production for such sale (work in progress); or
3. materials or supplies to be used up in production or in rendering services (raw materials, stores, consumables, loose tools).

They include goods bought for resale (a retailer's merchandise, software or land held for resale), finished goods, work in progress, materials, maintenance supplies, consumables and loose tools (para 4). They exclude spare parts, servicing and stand-by equipment that meet the definition of property, plant and equipment; those go under AS 10.

A trader's inventory is mainly finished goods. A manufacturer's has three layers: raw materials, work in progress and finished goods.

Outside AS 2 (para 1):

• work in progress under construction contracts, with directly related service contracts (AS 7);
• work in progress of service providers;
• shares, debentures and other financial instruments held as stock-in-trade;
• stocks held by producers of livestock, farm and forest produce, and mineral oils, ores and gases, so far as long-standing practice in those industries carries them at net realisable value.

Ind AS 2 (for companies on Ind AS) has a similar but not identical scope:

Is it our inventory. Count only goods the business owns.

Why inventory valuation matters.

1. Profit. Cost of goods sold = opening stock + purchases + direct expenses − closing stock. Overstating closing stock overstates profit; overstating opening stock understates it (and the reverse for understatement).
2. Financial position. Closing stock appears in the Trading Account and again as a current asset in the balance sheet, often the biggest one.
3. Liquidity. The current ratio and the liquid ratio depend on it.
4. Control. Both too much and too little stock hurt production and profit.
5. Compliance. AS 2 sets the basis, and the accounts must disclose the policy and the classification (section 9).

Net realisable value (NRV) (para 3.2) is the expected selling price in the ordinary course of business, less the expected costs to complete the goods and the expected costs of selling them.

Why cost may not be recovered (para 20): goods are damaged, wholly or partly obsolete, their selling prices have fallen, or the costs to complete or sell them have risen. An asset should not be shown at more than it is expected to bring in. This is the prudence (conservatism) convention: provide for expected losses, but never anticipate gains, so stock is written down but never written up above cost.

How to compare.

• Item by item is the normal basis (para 21).
• Similar or related items of one product line, with similar uses, made and sold in the same area, may be grouped where they cannot practicably be valued separately.
• Writing down by a whole class (all finished goods) or a whole segment is not allowed.

Other rules.

• NRV is estimated on the most reliable evidence at the time, including price changes after the balance sheet date that confirm conditions existing at that date (para 22).
• Stock held for a firm sales contract is valued on the contract price; any excess quantity on general selling prices (para 23).
• Raw materials are not written down below cost if the finished goods they will go into are expected to sell at or above cost. Only if the finished goods will sell below cost are the materials written down; their replacement cost may then be the best measure of NRV (para 24).
• NRV is assessed afresh at each balance sheet date (para 25).

Cost (para 6) is everything spent to bring the goods to their present location and condition. It has three parts.

Fixed production overheads are spread on the normal capacity of the plant: the average output expected over several periods in normal conditions (para 9).

• With low output or idle plant, the rate per unit is not raised; the overhead not absorbed is an expense of the year.
• With abnormally high output, the rate per unit is lowered, so stock is not valued above cost.
• Variable overheads are charged on actual use.

Joint products and by-products. Where joint costs cannot be separated, share them on a rational, consistent basis, such as relative sales value. A minor by-product is often valued at NRV and that value is deducted from the main product's cost (para 10).

Left out of cost and charged as expenses (paras 12, 13):

• abnormal waste of materials, labour or other production costs;
• storage costs, unless storage is needed in production before a further stage;
• administrative overheads that do not help bring the goods to their present place and condition;
• selling and distribution costs;
• interest and other borrowing costs, as a rule.

A cost formula decides which purchase prices go into the cost of goods sold and which stay in closing stock when identical goods were bought at different prices.

• Standard cost uses normal levels of material, labour, efficiency and capacity use, and is reviewed regularly.
• Retail method: used by retailers with many fast-changing items of similar margin. Cost = sales value of the stock − the appropriate gross margin percentage, allowing for goods marked down below their original price.

Specific identification is not allowed for large numbers of interchangeable items, because choosing which units are "sold" would let the firm pick its profit (para 15). Ind AS 2 (para 25) adds that the same formula must be used for all inventories of a similar nature and use.

LIFO. AS 2 names only specific identification, FIFO and weighted average. Last in, first out (LIFO) is not among them, so it cannot be used in accounts under AS 2 (or Ind AS 2). Its effect on income is still studied (section 8).

Two systems find the quantity and cost of stock sold and in hand.

Each cost formula (FIFO, LIFO, weighted average) can be worked under either system. FIFO gives the same result under both. LIFO and the weighted average usually give different results, because under the perpetual system each sale is costed with only the goods on hand that day.

Stock taken on another date. If the count is made a few days after the year end, work back to the balance sheet date at cost.

First in, first out (FIFO) assumes the units bought or made first are sold or used first. So closing stock is made up of the latest purchases. The assumption is about cost, not about how the goods physically move.

The working example for sections 6 to 8 (prices rising):

Goods available = 400 units costing ₹8,900. Units sold = 330; sales = ₹10,260; closing stock = 70 units.

Perpetual FIFO keeps a stores ledger with three columns: received, issued, balance. Each issue takes the oldest layers first.

Cost of goods sold = ₹3,100 + ₹4,050 = ₹7,150, the same as periodic FIFO.

Special entries in a FIFO ledger.

• Purchase return: the units go back at the price of the purchase they came from.
• Sales return: the units come back into stock at the cost at which they were issued.
• Normal loss (evaporation, breakage within normal limits): take the units from the earliest layer in stock; their cost is part of the cost of goods sold.
• Abnormal loss (fire, theft): take the units out at their FIFO cost, but charge that cost to profit and loss as a loss, not to cost of goods sold; abnormal waste is never part of the cost of inventory (AS 2, para 13).
• When a sale and a purchase fall on the same day, take them in the order the question gives.

Merits and limits. FIFO is easy to follow, matches the usual physical flow, and shows closing stock near current prices. When prices rise it charges older, cheaper costs against current revenue, so profit looks higher (sometimes called "paper profit").

Under the weighted average formula each unit carries the average cost of the similar units available. AS 2 allows the average to be worked for the whole period or afresh as each shipment arrives (para 17).

Periodic (simple period) average. One average for the whole period, from opening stock plus all purchases.

Moving (perpetual) average. A new average is struck after every receipt, and each issue is costed at the average ruling on its date. This is the basis the answers use for a perpetual weighted average.

Cost of goods sold = ₹3,200 + ₹4,104 = ₹7,304; closing stock ₹1,596; gross profit = ₹10,260 − ₹7,304 = ₹2,956.

Special entries in a moving average ledger.

• Normal loss is absorbed: the lost units leave the balance, but their cost stays in it, so the average of the units left rises. For example, 200 units costing ₹4,400 (₹22 each) with a normal loss of 20 units become 180 units costing ₹4,400, an average of ₹24.4444.
• Abnormal loss is taken out at the current average and charged to profit and loss: 20 units × ₹22 = ₹440 in the same case.
• Purchase return: out at the price of the purchase returned; then strike a new average.
• Sales return: back in at the cost at which the units were issued; then strike a new average.
• Work rates to four decimal places and amounts to the paisa; check that issues plus closing stock equal opening stock plus net purchases.

Merits and limits. The average smooths price swings and is simple with frequent purchases, and it suits goods whose lots lose their identity (oil, grain, ore). The average may differ from current prices, and rates run into long decimals.

Last in, first out (LIFO) assumes the latest units are sold first, so closing stock carries the oldest costs. It is not allowed under AS 2 (section 4), but its effect is part of the syllabus.

The general pattern:

Weighted average lies between the two in both cases.

What follows for business income.

• Under rising prices FIFO matches old, cheap costs with current revenue: profit and the balance sheet stock are higher, and so is the tax on that profit. Part of the profit is only a gain from holding stock while prices rose.
• LIFO matches the latest costs with current revenue, giving a lower and more current profit in inflation, but it shows stock in the balance sheet at old prices, and profit can be steered by timing year-end purchases.
• The weighted average smooths the effect of sudden price changes.
• Over the life of the business total profit is the same; the formula moves profit between years. So the formula must be used consistently, and any change disclosed with its effect.

The financial statements disclose (AS 2, paras 26, 27):

• the accounting policies used to measure inventories, including the cost formula;
• the total carrying amount of inventories, classified suitably: raw materials and components, work in progress, finished goods, stock-in-trade (goods bought for trading), stores and spares, loose tools, and others.

Under Ind AS 2 (para 34), when goods are sold their carrying amount becomes an expense in the period the related revenue is recognised. Any write-down to NRV, and any loss of inventory, is an expense of the period in which it occurs.