INTRODUCTION

1. This Statement deals with the valuation and presentation of inventories in financial statements in the context of the historical cost system, which .s the most widely adopted basis on which financial statements are presented.

2. This Statement does not deal with inventories accumulated under long-term construction contracts and with inventory treatment of by-products.

Definitions

3. The following terms are used in this Statement with the meanings specified.

Inventories are tangible property (a) held for sale in the ordinary course of business, (b) in the process of production for such sale, or (c) to be consumed in the production of goods or services for sale.

Historical cost of inventories is the aggregate of costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.-

Costs of purchase comprise the purchase price including import duties and other purchase taxes, transport and handling costs, and any other directly attributable costs of acquisition less trade discounts, rebates, and subsidies.

Cost of conversion are those costs, in addition to the costs of purchase, that relate to bringing the inventories to their present location and condition.

Net realizable value is the estimated selling price in the ordinary course of business less costs of completion and less costs necessarily to be incurred in order to make the sale.

EXPLANATION

4. Inventories comprise of a significant portion of the assets of many enterprises. The valuation and presentation of inventories therefore have a significant effect in determining and presenting the financial position and results of operations of those enterprises.

Determination of Historical Cost

5. In determining historical cost as defined in paragraph 3, different interpretations arise in practice as regards production overhead, other overheads and the cost formula to be used.

6. Production overhead is comprised of costs incurred for production other than direct materials and labor. Examples are indirect materials and labor, depreciation and maintenance of factory buildings and equipment, and the cost of factory management and administration.

7. Production overhead requires analysis to determine the portion related to bringing the inventories to their present location and condition and thus to be included in the costs of conversion when determining the historical cost of inventories.

8. Both fixed and variable production overhead incurred during production are usually allocated to costs of conversion. That practice is based on the view that they are both incurred in putting inventories in their present location and condition. Fixed production overhead is sometimes excluded in whole or in part from costs of conversion on the grounds that it is not considered to relate directly to putting inventories in their present location and condition.

9. In a period of low production or if there is idle plant, it is customary to restrict the allocation of fixed production overhead to the costs of conversion by relating it to the capacity of the production facilities and not to the actual level of throughput. Capacity of the production facilities is variously interpreted for example, as the normal production expected to be achieved over a number of periods or seasons or as the maximum production that as a practical matter can be achieved. The interpretation is determined in advance and applied consistently, and is not modified for temporary conditions.

10. Similarly, exceptional amounts of waste - material, labor, or other expenses - which do not relate to bringing the inventories to their present location and condition are excluded from conversion costs.

11. Overheads other than production overhead are sometimes incurred in bringing inventories to their present location and condition, for example, expenditures incurred in designing products for specific customers. On the other hand, selling expenses, general administrative overheads, research and development costs, and interest are usually considered not to relate to putting the inventories in their present location and condition.

12. Several different formulas with widely different effects are in current use for the purpose of assigning costs, including the following:

(a) First-in, First-out (FIFO)

(b) Weighted average cost

(c) Last-in, first-out (LIFO)

(d) Base stock

(e) Specific identification

(1) Next-in, first-out (NIFO)

(g) Latest purchase price

13. The FIFO, weighted average cost, LIFO, base stock, and specific identification formulas use costs that have been incurred by the enterprise at one time or another. The INFO and latest purchase price methods use costs that have not all been incurred and are therefore not based on historical cost.

14. Specific identification is a formula that attributes specific costs to identified items of inventory. This is an appropriate treatment for goods that have been bought or manufactured and are segregated for a specific project. If it is used, however, in respect of items of inventory which are ordinarily interchangeable, the selection of items could be made in such a way as to obtain predetermined effects on profit.

15. The historical cost of inventories may not be realizable if their selling prices have decline, if they are damaged, or if they have become wholly or partially obsolete. The practice of writing inventories down below historical cost to net realizable value accords with the view that current assets should not be carried in excess of amounts expected to be realised. Declines in value are computed separately for individual items, groups of similar items, an entire class of inventory (for example, finished goods), or items relating to a class of business, or they are computed on an overall basis for all the inventories of the enterprise. The practice of writing inventories down based on a class of inventory, on a class of business, or on an overall basis results in offsetting losses incurred against unrealised gains.

16. The sub-classification of inventories in financial statements informs readers of the amounts held in different categories and the extent of the changes from period to period. Common sub-classification are materials, work in progress, finished goods, merchandise and production supplies.

17. "Inventories" in balance sheets usually consist of items included in the definition of inventories in paragraph 3. Other items are sometimes shown under the heading "inventories". e.g., non-production supplies and research and development supplies.

Statement of Standard Accounting Practice 3.8 comprises paragraphs 18-34 of this Statement. The Standard should be read in the context of paragraph 1-17 of this Statement and Explanatory Foreword 3.1 to preface to Statements of Standard Accounting Practice.

Valuation and Presentation of Inventories in the Context of the Historical Cost System

18. Inventories should be valued at the lower of historical cost and net realizable value.

Ascertainment of Historical Cost

19. The historical cost of manufactured inventories should include a systematic allocation of those production of those production overhead costs that relate to putting the inventories in their present location and condition. Allocation of fixed production overhead to the costs of conversion should be based on the capacity of the facilities. If fixed production overhead has been entirely or substantially excluded from the valuation of inventories on the grounds that it does not directly relate to putting the inventories in their present location and condition, that fact should be disclosed.

20.   Overheads other than production overhead should be included as part of the inventory cost only to the extent that they clearly relate to putting the inventories in their present location and condition.

21    Exceptional amounts of wasted material, labor, or other expenses should not be included as part of inventory cost.

22    Except as set out in paragraphs 23 and 24, the historical cost of inventories should be accounted for using the FIFO formula or a weighted average cost formula.

23.   Inventories of items that are not ordinarily interchangeable or goods manufactured and segregated for specific projects should be accounted for by using specific identification of their individual costs.

24. The LIFO or base stock formulas may be used provided that there is disclosure of the difference between the amount of the inventories as shown in the balance sheet and either (a) the lower of the amount arrived at in accordance with paragraph 22 and net realizable value or (b) the lower of current cost at the balance sheet date and net realizable value.

25. Techniques such as the standard cost method of valuing products or the retail method of valuing merchandise may be used for convenience if they approximate consistently the results that would be obtained in accordance with paragraph 18.

26. Estimates of net realizable value should be based on temporary fluctuations of price or cost but on the most reliable evidence available at the time the estimates are made as to what the inventories are expected to realise.

27. Inventories should be written down to net realizable value item by item or by groups of similar items; whichever method is used should be consistently applied.

28. The net realizable value of the quantity of inventory held to satisfy firm sales contracts should be based on the contract price. If the sales contracts are for less than the inventory quantities held, net realizable value for the excess should be based on general market prices

29. Normal quantities of materials and other supplies held for incorporation in the production of goods should not be written down below historical cost if the finished products in which they will be incorporated are expected to be realised at or above historical cost. Nevertheless, a decline in the price of materials may indicate that the historical cost of finished products to be produced will exceed net realizable value in which event a write down of the materials inventories should be made; in this event, replacement cost may be the best available measure of the net realizable value of those materials.

30. The profit and loss of the period should be charged with the amount of inventories sold or used (unless allocated to their asset accounts) and with the amount of any write down in the period to net realizable value.

31. Inventories should be sub-classified in balance sheets or in notes to the financial statements in a manner which is appropriate to the business and so as to indicate the amounts held in each of the main categories.

32. The accounting policies adopted for the purpose of valuation of inventories, including the cost formula used, should be disclosed. A change in an accounting policy related to inventories that has a material effect in the current period or may have a material effect in subsequent periods should be disclosed and treated in accordance with paragraph 8 of Statement of Standard Accounting Practice 3.3, Extraordinary Items and Prior Year Adjustments.

33. If items are shown under the caption "Inventories" other than those comprehended by the definition in paragraph 3, their nature, amounts and basis of valuation should be disclosed.

34. This Statement of Standard Accounting Practice becomes operative for financial statements covering periods beginning on or after 1st July 1982.