Gaps in GaAp – Core Inventories

(a) Use: are necessary to permit a production facility to start operating and to maintain subsequent production;

(b) Physical form: not physically separable from other inventories and interchangeable with them;

(c) Removal: can be removed only when production facilities are abandoned, decommissioned or overhauled or at a considerable financial charge. Sometimes the quality of what can be removed may not be the same as the original inventory, for example, on decommissioning there could be a lot of sludge or waste material.

The issue could be material for some companies, such as in the case of an oil pipeline company where the pipeline runs into several kilometres. In such cases, the impact of the manner in accounting for the initial fill could be very significant.

Query
Whether core inventories should be classified as inventories or fixed assets? How are they subsequently measured?

View 1: Classification under AS-2 Valuation of Inventories

Inventories are defined in AS-2 as (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. Core inventories meet that definition of inventories. The rationale for classification as inventories is that core inventories are ordinarily interchangeable with other inventories, and thus, core inventories held at a particular reporting date will be either consumed or sold in the next period.

On the other hand, AS-10 Accounting for Fixed Assets, defines fixed assets as “Fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business.” Core inventories do not meet this definition because they are held for sale in the normal course business. On the assumption that the unit of account is the smallest unit of the material concerned (ultimately individual atoms), core inventories are classified as inventories because they represent materials that are consumed in the production process

The two different views on subsequent measurement of core inventories are:

(a) Core inventories are measured collectively with other inventories using FIFO or a weightedaverage cost formula. These methods are supported in AS-2.

(b) Core inventories are measured separately from other inventories. The rationale for this accounting treatment is that the accounting transaction does not take place at the time of each inventory’s swap and therefore their value is not stepped up. Support for this may be found in paragraph 14 of AS-2 which states that “The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by specific identification of their individual costs.” However, a more appropriate view may well be that measuring core inventory separately is similar to applying the base stock method which is prohibited in AS-2.

A matter of concern is that if core inventories are accounted for as inventories, an entity would in many cases, need to recognise an immediate loss on writing off to net realisable value, if the inventory is not expected to be fully recoverable when the plant is ultimately decommissioned. Either full quantity is not recovered or some recovery may be in the form of sludge. Also, the net realisable value would factor the cost incurred for recovering the inventory. At other times, such as the initial fill in the case of an oil pipeline company, the net realisable value on account of price changes could fluctuate significantly, and create volatility in the P&L A/c.

View 2: Classification under AS-10 Accounting for Fixed Assets

The rationale for classification as fixed asset is that core inventories are not held for sale or for consumption; instead, their intended use is to ensure that a production facility is operating. Even though core inventories are commingled with ordinary inventories, the characteristics and intended use of a particular part of the inventories remain the same at each individual reporting date. Thus these core inventories need to be accounted for separately.

Core inventories should be classified as fixed asset because they are necessary to bring a fixed asset to its required operating condition. Paragraph 9.1 of AS-10 states 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; any trade discounts and rebates are deducted in arriving at the purchase price. Examples of directly attributable costs are:

i. site preparation;
ii. initial delivery and handling costs;
iii. installation cost, such as special foundations for plant; and
iv. professional fees, for example fees of architects and engineers.”

If core inventories are carried as inventories, it would not properly reflect the fact that core inventories are necessary to operate another asset over more than one operating cycle. On the assumption that the unit of account is the minimum amount of material as a whole, core inventories are classified as fixed asset because they are neither held for sale nor consumed in the production process.

The classification of core inventories should be based on their intended primary use because:

(a) A part of inventories of the same quantity, characteristics and use for an entity is always in the production facility, whether this part is commingled with other inventories or not. Core inventories need to be accounted for separately from ordinary inventories.

(b) The classification based on the intended primary use, rather than on their physical form, would provide more relevant information for the users of financial statements.

The primary use of core inventories is to be held for use in the production or supply of goods or services (meets the definition of a fixed asset), rather than to be sold or consumed in the production process or in the rendering of services (does not meet the definition of inventories).

The loss of core inventories over-time should be recognised as an expense over the useful life of a fixed asset, based on the following:

(a) economic benefits associated with core inventories are consumed over the entire useful life of the fixed asset.

(b) in the case of a systematic allocation, the costs would match with the associated revenues.

Both the above would meet the spirit of the Conceptual Framework on the basis of which Indian accounting standards are drafted.

Some are of the view that only core inventories that could not be substantially recovered from the production facility form an element of fixed asset cost. Otherwise, they may be carried as inventories. The author believes that assets’ recoverability should not change their classification. The classification of core inventories should not be based on their recoverability, because this guidance is not explicitly stated in Indian GAAP. Instead, the depreciation mechanism described in AS 6 addresses accounting in such cases; i.e., core inventories that can be recovered would be depreciated to the extent of their residual value. However, due to price increases over time in core inventories, the residual value would go up significantly, leading to low or no depreciation.