1. Scope
NAS 2 applies to all inventories,
except:
- Work
in progress under construction contracts (→ NAS 11 Construction
Contracts).
- Financial
instruments (→ NAS 32, NAS 39).
- Biological
assets related to agriculture & agricultural produce at harvest (→ NAS
41).
2. Definitions
(a) Inventories
Assets:
- Held
for sale in the ordinary course of business (Finished goods).
- In
process of production for sale (Work-in-progress).
- In
the form of materials/supplies to be consumed in production (Raw
materials).
(b) Net Realisable Value (NRV)
= Estimated Selling Price – (Cost of
Completion + Selling Costs)
👉
Represents the expected selling price in normal course of business.
(c) Fair Value
= Price that would be received to
sell an asset in an orderly transaction between market participants at
measurement date.
🚨
Difference: NRV = Entity-specific; Fair Value = Market-based.
3. Measurement of Inventory
📌
Inventories are measured at the Lower of:
- Cost,
or
- Net
Realisable Value (NRV).
4. Cost of Inventories
👉
Inventory Cost = Costs of Purchase + Costs of Conversion + Other Costs
1. Costs of Purchase
These are costs incurred to acquire
inventory:
- Purchase
price
- Import
duty & non-refundable taxes
- Freight
inwards & transport
- Insurance
during transit
- Handling
charges
Less: Trade discounts, rebates, subsidies
📊
Example:
Invoice price = Rs. 1,00,000
- Import
duty = Rs. 10,000
- Freight
inwards = Rs. 5,000
– Trade discount = Rs. 5,000
Cost of Purchase = Rs. 1,10,000
2. Costs of Conversion
Costs incurred to convert raw
materials → finished goods.
(a) Direct Costs
- Direct
wages
- Direct
expenses (e.g., power for machines)
(b) Production Overheads
- Variable
OH → Allocated based on actual production.
- Fixed
OH → Allocated on the basis of normal capacity.
- Unabsorbed
portion (if production < normal capacity) → charged to P&L.
📊
Example:
Direct Wages = Rs. 50,000
Variable OH = Rs. 30,000
Fixed OH = Rs. 1,00,000
Normal capacity = 10,000 units; Actual = 8,000 units
Absorbed Fixed OH = (1,00,000 ÷ 10,000) × 8,000 = Rs. 80,000
Unabsorbed = Rs. 20,000 → P&L
Cost of Conversion = 50,000 + 30,000
+ 80,000 = Rs. 1,60,000
3. Other Costs
Include only costs that bring
inventories to present location & condition. Examples:
- Product
design cost for specific customer
- Packing
cost (if necessary for production/sale)
- Storage
cost (only if necessary in production, e.g., aging of wine)
❌
Exclude abnormal waste, selling costs, general admin, interest.
📊
Format to Calculate Cost of Inventory
Particulars |
Amount (Rs.) |
A. Costs of Purchase |
|
Purchase price |
xx |
+ Import duties & non-refundable taxes |
xx |
+ Freight & handling charges |
xx |
– Trade discounts/rebates |
(xx) |
Total Costs of Purchase (A) |
xx |
B. Costs of Conversion |
|
Direct labour |
xx |
+ Direct expenses |
xx |
+ Variable production overheads |
xx |
+ Allocated fixed production overheads |
xx |
Total Costs of Conversion (B) |
xx |
C. Other Costs |
|
Design / production-related costs |
xx |
Packing cost (if necessary) |
xx |
Total Other Costs (C) |
xx |
Total Cost of Inventories (A+B+C) |
xx |
5. Costs Excluded (Expensed
Directly)
❌
Abnormal waste of material, labour, overhead.
❌
Storage costs (unless necessary in production).
❌
Selling & distribution costs.
❌
Administrative overheads not related to production.
❌
Interest/borrowing cost (except qualifying assets under NAS 23).
6. Allocation of Fixed Overheads
👉
Fixed overheads = Costs that remain relatively constant regardless of
production volume (e.g., factory rent, supervisor salary, machine
depreciation).
🔑
Rule:
- Allocate
based on normal capacity (average/expected production over a
period, considering downtime, maintenance, demand fluctuations).
- Do
not artificially inflate or deflate per-unit costs when production varies.
1. If Actual Production = Normal
Capacity
👉
No problem. Fixed OH is fully absorbed.
📊
Example:
- Fixed
OH = Rs. 1,00,000
- Normal
Capacity = 10,000 units
- Actual
= 10,000 units
Absorption rate = 1,00,000 ÷ 10,000
= Rs. 10 per unit
Total absorbed = Rs. 1,00,000
(No over/under absorption)
2. If Actual Production > Normal
Capacity
👉
Absorb only up to normal level.
👉
The “extra” fixed OH is not absorbed into inventory → charged as expense
in P&L.
📊
Example:
- Fixed
OH = Rs. 1,00,000
- Normal
Capacity = 10,000 units
- Actual
= 12,000 units
Absorption rate = 1,00,000 ÷ 10,000
= Rs. 10 per unit
Applied to 12,000 units = Rs. 1,20,000 → but only Rs. 1,00,000 can be
absorbed.
⚡
Excess Rs. 20,000 = expensed in P&L (not included in inventory).
3. If Actual Production < Normal
Capacity
👉
Allocate fixed OH based on actual production, but do not increase the
per-unit cost beyond normal rate.
👉
Any under-absorbed OH → charged to P&L.
📊
Example:
- Fixed
OH = Rs. 1,00,000
- Normal
Capacity = 10,000 units
- Actual
= 8,000 units
Normal absorption rate = 1,00,000 ÷
10,000 = Rs. 10 per unit
Applied to 8,000 units = 8,000 × 10 = Rs. 80,000
⚡
Unabsorbed Rs. 20,000 → charged to P&L.
📌
Important: We don’t increase rate to Rs. 12.5 (1,00,000 ÷ 8,000) because
that would artificially inflate inventory value.
📊
Tabular Illustration
Scenario |
Fixed OH |
Normal Capacity (units) |
Actual Production (units) |
Absorption Rate (Rs./unit) |
Absorbed OH |
Unabsorbed/Excess OH |
Actual = Normal |
1,00,000 |
10,000 |
10,000 |
10 |
1,00,000 |
Nil |
Actual > Normal |
1,00,000 |
10,000 |
12,000 |
10 |
1,00,000 |
20,000 (expense) |
Actual < Normal |
1,00,000 |
10,000 |
8,000 |
10 |
80,000 |
20,000 (expense) |
7. Deferred Settlement Terms
👉
When inventories are bought with deferred payment terms (credit period
longer than normal), the difference between:
- Purchase
price under normal credit terms (cash price),
and
- Amount
actually payable (including the extra for long credit period)
…is not included in inventory
cost.
Instead:
- Inventory
→ recorded at cash price equivalent
- Extra
amount (interest component) → recognized separately as finance/interest
expense in P&L over the credit period
📊
Example 1: Normal vs Deferred Payment
- Normal
credit price (cash price) = Rs. 100,000
- Supplier
offers 2 years deferred payment = Rs. 120,000
➡️
Inventory recognized at Rs. 100,000 (not 120,000)
➡️
Extra Rs. 20,000 → interest expense allocated over 2 years (Rs. 10,000
each year).
📊
Example 2: Import with Extended Credit
Suppose a company imports raw
material:
- CIF
Price (normal cash price) = Rs. 5,00,000
- Payment
after 3 years = Rs. 6,50,000
➡️
Inventory recorded = Rs. 5,00,000
➡️
Finance expense = Rs. 1,50,000 spread across 3 years (Rs. 50,000/year).
8. Treatment of Settlement Discount
- If
settlement discount is received (early payment benefit),
👉 Deduct it from purchase cost of inventory.
9. Joint Products, By-products &
Scrap
(a) Definitions
- Joint
Products
- Two
or more products of significant value produced simultaneously from
the same process or input.
- Example:
Crude oil refining → produces petrol, diesel, kerosene.
- By-products
- Secondary
products of minor value compared to main products.
- Example:
Sawdust from timber industry; Molasses from sugar manufacturing.
- Scrap
- Residual
waste material with very small value.
- Example:
Metal shavings in a machine shop.
(b) Allocation of Joint Costs
👉
When several products are produced from a common process, the joint
costs (e.g., material, labor, overhead before split-off point) must be
allocated.
Common Methods:
- Relative
Sales Value at Split-off → Allocate based on proportion
of sales value.
- Net
Realizable Value (NRV) method → Deduct further processing
cost, then allocate.
- Physical
Measure (e.g., weight, volume, units)
→ less common.
(c) Treatment of Immaterial
By-products
- If
by-product value is immaterial →
Value them at NRV and deduct from joint cost. - This
reduces cost of main product(s).
📊
Illustrations
Illustration 1: Joint Cost
Allocation (Sales Value Method)
- Joint
cost = Rs. 1,00,000
- Output:
- Product
A (Sales Value Rs. 80,000)
- Product
B (Sales Value Rs. 20,000)
👉
Total Sales Value = 1,00,000
Allocation:
- A
= (80,000 ÷ 1,00,000) × 1,00,000 = Rs. 80,000
- B
= (20,000 ÷ 1,00,000) × 1,00,000 = Rs. 20,000
Illustration 2: By-product NRV
Deduction (Immaterial Value)
- Joint
cost = Rs. 1,00,000
- Main
product = Rs. 80,000
- By-product
= Rs. 20,000
- By-product
NRV = Rs. 5,000
👉
Treatment:
- Deduct
NRV of by-product (5,000) from joint cost.
- Net
joint cost = 1,00,000 – 5,000 = Rs. 95,000
- Entire
Rs. 95,000 allocated to Main product A.
So,
- Main
Product A = Rs. 95,000
- By-product
B = Rs. 5,000 (NRV → directly recorded in income).
Illustration 3: Scrap
- Scrap
metal sold for Rs. 1,000
- Treatment:
Credit scrap value (1,000) to factory overheads or deduct from
joint cost.
10. Techniques for Measurement of
Cost
NAS 2 allows certain techniques
to estimate inventory cost when direct tracking is impractical. The two
main techniques are:
1. Standard Cost Method
Definition:
- Inventory
cost is calculated using predetermined standard rates for
materials, labour, and overheads.
- Standards
reflect normal levels of consumption and efficiency.
- Periodically
revised to reflect actual costs.
Key Points:
- Useful
when inventory is produced continuously or in large quantities.
- Variances
(difference between standard cost and actual cost) are analyzed
separately:
- Material
Variance → price & usage
differences
- Labour
Variance → efficiency & rate
differences
- Overhead
Variance → fixed & variable
differences
Example:
- Standard
cost of 1 unit =
- Materials
= Rs. 50
- Labour
= Rs. 20
- Overhead
= Rs. 10
- Total
standard cost/unit = Rs. 80
- Produced
1,000 units → Standard Inventory Cost = 1,000 × 80 = Rs. 80,000
- Actual
cost = Rs. 82,000 → Rs. 2,000 variance analyzed separately
2. Retail Price Method
Definition:
- Inventory
cost is estimated by reducing the selling price by the gross profit
margin.
- Commonly
used by retail businesses where inventory is difficult to track
individually (e.g., supermarkets, clothing stores).
Formula:
Steps:
- Record
inventory at retail price (selling price)
- Calculate
cost-to-retail ratio (COGS ÷ retail value of goods available)
- Apply
ratio to inventory at retail → estimate inventory at cost
Example:
- Goods
available for sale:
- Cost
= Rs. 3,00,000
- Retail
price = Rs. 4,00,000
- Cost-to-Retail
Ratio = 3,00,000 ÷ 4,00,000 = 0.75
- Closing
inventory at retail = Rs. 50,000
- Inventory
at cost = 50,000 × 0.75 = Rs. 37,500
11. Cost Formula
(a) Specific Identification
- Used
for non-interchangeable items (e.g., cars, jewelry).
(b) Interchangeable Goods
When inventory items are similar
or interchangeable (e.g., bulk raw materials, identical products), NAS 2
allows cost formulas to assign cost to inventory and COGS.
1. FIFO (First-In, First-Out)
Definition:
- Assumes
that oldest inventory (first purchased/produced) is sold first.
- Closing
inventory consists of the most recent purchases/production.
Example:
Date |
Units Purchased |
Unit Cost (Rs.) |
Total Cost (Rs.) |
Jan 1 |
100 |
50 |
5,000 |
Jan 5 |
100 |
55 |
5,500 |
Jan 10 |
100 |
60 |
6,000 |
- Total
Units = 300
- Sold
180 units → COGS = 100×50 + 80×55 = 9,400
- Closing
Inventory = 20×55 + 100×60 = 11,000
2. Weighted Average Cost (WAC)
Definition:
- Assigns
a weighted average cost to all units available during the period.
- Closing
inventory and COGS valued at same average cost per unit.
Formula:
Example:
Date |
Units Purchased |
Unit Cost (Rs.) |
Total Cost (Rs.) |
Jan 1 |
100 |
50 |
5,000 |
Jan 5 |
100 |
55 |
5,500 |
Jan 10 |
100 |
60 |
6,000 |
- Total
Units = 300
- Total
Cost = 5,000 + 5,500 + 6,000 = 16,500
- Weighted
Average Cost per Unit = 16,500 ÷ 300 = 55
- Sold
180 units → COGS = 180 × 55 = 9,900
- Closing
Inventory = 120 × 55 = 6,600
❌
LIFO not allowed under NAS 2.
(c) Change of Method
- From
FIFO to Weighted Average allowed if results in better presentation &
disclosure required.
12. Net Realisable Value (NRV)
(a) NRV vs Fair Value
- NRV:
Selling price – costs of completion & selling.
- Fair
value: Market-based exit price.
(b) Item by Item Approach
- Each
item valued separately → cannot offset one item’s loss against another’s
profit.
(c) Raw Material & Supplies
1. Finished Goods Expected to Sell
at Cost or Above
Rule:
·
Raw materials can
be recorded at cost.
·
Reason: The cost
of raw material will be fully recovered in the sale of finished goods.
Example:
·
Raw material cost
= Rs. 50,000
·
Expected finished
goods sale price = Rs. 80,000
·
Expected cost of
finished goods = Rs. 60,000
✅
Since finished goods will sell at cost or above, raw material
is recorded at Rs. 50,000 (cost).
2. Finished Goods Expected to Sell
Below Cost
Rule:
·
Raw materials
must be written down to NRV.
·
Reason: If
finished goods are sold below cost, some raw material cost cannot be recovered
→ reduce inventory value to NRV.
Example:
·
Raw material cost
= Rs. 50,000
·
Finished goods
expected cost = Rs. 60,000
·
Expected sale
price = Rs. 55,000
·
NRV of finished
goods = Rs. 55,000
·
Raw material
proportion = (50,000 ÷ 60,000) × 55,000 = Rs. 45,833
⚡
Raw material written down from Rs. 50,000 → Rs. 45,833
🔑 Key Points
Situation |
Valuation of Raw Material |
Finished goods expected to sell ≥
cost |
Keep at cost |
Finished goods expected to sell <
cost |
Write down to NRV (recoverable portion) |
(d) Events After Reporting Period
Definition:
·
Events after the
reporting period are events that occur between the balance sheet date
and the date when financial statements are authorized for issue.
·
Some of these
events provide evidence about the inventory value at the balance sheet
date.
1. Sale After Year-End as Evidence
Rule (NAS 2):
·
If inventory is sold
after the balance sheet date at a price lower than cost,
this is considered evidence that NRV at the balance sheet date was
lower than cost.
·
Inventory must
then be written down to NRV at the reporting date.
Example 1: Finished Goods Sale After
Year-End
·
Balance Sheet
Date: 31 Dec 2025
·
Inventory Cost:
Rs. 100,000
·
January 2026:
Inventory sold for Rs. 90,000
Analysis:
·
The sale shows
that the recoverable amount at 31 Dec 2025 was likely ≤
Rs. 90,000
·
Adjust Inventory
value at 31 Dec 2025 = Rs. 90,000 (write-down of Rs. 10,000)
Example 2: Multiple Units
·
Inventory: 500
units × Rs. 200/unit = Rs. 1,00,000
·
After year-end,
100 units sold at Rs. 180/unit → indicates NRV < cost
·
NRV for sold
portion = Rs. 18,000
·
Write-down
inventory = (Cost – NRV for sold portion) = (100 × 200 – 100 × 180) = Rs. 2,000
Remaining inventory (400 units) → assessed
separately for NRV
🔑 Key Points
1.
Post-year-end
sale at lower price → NRV at
reporting date must be adjusted downward.
2.
Post-year-end
sale at higher price → No upward
adjustment allowed (cannot inflate inventory above cost).
3.
Ensures conservatism
principle: inventory not overstated.
(e) Firm Sales Contracts
- If
contract price < cost → inventory valued at contract price (NRV
evidence).
(f) Review of NRV
- At
each reporting date, reassess NRV.
- If
write-down reasons no longer exist → reversal allowed (up to original
cost).
13. Disclosure Requirements
Financial statements must disclose:
- Accounting
policies for inventory measurement.
- Cost
formula used (FIFO / WAC).
- Total
carrying amount of inventories, classified as:
- Raw
materials
- Work
in progress
- Finished
goods
- Stores/spares
- Amount
of inventory recognized as expense (COGS).
- Write-downs
and reversals.
📊
Example of Disclosure Table:
Particulars |
Amount (Rs.) |
Raw Materials |
50,000 |
WIP |
30,000 |
Finished Goods |
70,000 |
Spares & Consumables |
20,000 |
Total Inventory |
1,70,000 |
🔑
Quick Exam Capsule
- Rule:
Inventory = Lower of Cost or NRV.
- Methods:
FIFO, WAC, Specific. (LIFO ❌)
- Exclusion:
Abnormal cost, selling cost, admin, interest.
- NRV
≠ Fair Value (entity-specific vs
market-based).
- By-product:
Deduct NRV from main product cost.
- Reversal
allowed if NRV increases later.