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THEME

Valuation in Oil Sector – Significance and Review

A
s per Accounting Stan- the 66$ per barrel mark con- tory Costs”. The provisions of
dard (AS) 2 on “Valu- tinue to remain the biggest this statement are effective for
ation of Inventories” concern for domestic as well as inventory costs incurred dur-
issued by the ICAI, inventories global economy. ing fiscal years beginning after
are defined as assets held for sale With valuation of inven- 15th June 2005. Earlier appli-
in the ordinary course of business tories having a direct bearing cation is permitted for inven-
or in the process of production for on the profits of an organisa- tory costs incurred during fiscal
such sale or in the form of materi- tion the importance of accu- years beginning after the date
als or supplies to be consumed in racy, consistency and fairness this statement is issued. The
the production process or in ren- in the valuation and depiction provisions of this statement
dering of services. An efficient in financial accounts of an en- shall be applied prospectively.
system of inventory manage- terprise becomes eminent. The Similarly, the International
ment is essential for the success said elements are extremely im- Accounting Standards Board
of any enterprise. portant in inventory reporting (IASB), introduced Interna-
Organisations worldwide for decision-making both inside tional Accounting Standard
look for systems and tools for (management) and outside the (IAS) 2 “Inventories” the re-
inventory controls and pro- organisation. This information vised version (2003) of which
cesses to reduce storage and is primarily required by man- is effective from 1st of January
transportation costs and man- agement for decision-making 2005.

Oil accounts for about 37 per cent of the total energy consumption in the world. Prices of
oil and petroleum products have risen drastically worldwide during 2004-05 due to shortage
of supply and increased demand, creating an imbalance in the world economies and thereby
enhancing inflationary tendencies. Oil is expected to be the dominant energy source worldwide
with a share of about 39 per cent of total energy consumption across the globe by 2025. With
an upsurge in the global crude oil prices and the huge quantum of working capital tied up in
inventories, the accounting policy for control and valuation of inventories in oil sector is very
important to ensure strict compliance with accounting standards and at the same time to mini-
mise the costs of holding inventories. The study in this article provides a glimpse of the account-
ing policy being followed by some of the oil companies in India, the constituents of costs and
Net Realisable Values, inventory valuation criterion, adherence to accounting standards, some
techniques of inventory control, importance of economic order quantity, need for control over
Aseem Bhargava
inventory carrying costs and effects of errors in inventory valuation.
and Pankaj Goel
(The authors are mem-
bers of the Institute) age and use inventory to the regarding timing for placement In India, the council of the
optimum. of order and ordering quantity Institute of Chartered Accoun-
Generally, inventories con- (i.e. Economic Order Quantity tants of India (ICAI) has issued
stitute second major item in (EOQ) decisions). Accounting Standard (AS) 2
the total assets of an enterprise “Valuation of Inventories”. This
(specially in case of manufac- Review Of Legal Provisions revised standard came into ef-
turing companies). In case of On the above subject un- fect in respect of accounting
oil sector companies it accounts der the US GAAP, an amend- periods commencing on or af-
for about 30-40 per cent of the ment to AICPA’s Accounting ter 01.04.1999 and is manda-
total assets of the company. Research Bulletin (ARB) 43, tory in nature. The statement
Any effort for inventory con- Chapter 4, has been intro- deals with the ascertainment of
trol may, thus, yield significant duced by Financial Accounting the cost of inventories and any
benefits for the enterprise. Ris- Standards Board (FASB) in write down thereof to the Net
ing crude oil prices breaching the form of FAS 151 “Inven- Realisable Value.

1036 The Chartered Accountant January 2006


Every organisation is re- able Value, whichever is lower. petroleum product returned
quired to depict in its signifi- For this purpose the term to an oil processing company
cant accounting policies, the ‘Actual Cost’ shall comprise the (refinery) by an oil marketing
accounting policy it follows following: company shall be considered
for valuation of inventories in (a) All purchase costs; at specific cost i.e. Refinery
accordance with Accounting (b) Costs of conversion; and Transfer Price (RTP) plus cost
Standard (AS) 1 “Disclosure of (c) Any other costs incurred of freight involved. This shall
Accounting Policies”. for bringing the invento- then be compared with its Net
ries to their present loca- Realisable Value for the pur-
Accounting for Inventories tion or condition. pose of valuation.
The objective of accounting The following costs need Apart from above, the cost
for goods in inventories is the to be excluded while determin- of inventory shall be calculated
matching of appropriate costs ing the costs of inventories: at First-in-First-out (FIFO)
against revenues in order that l Abnormal costs and wast- basis or Weighted Average cost
there may be a proper determi- ages; basis. An alternative Last-in-
nation of realised income. The l Storage costs unless First-out (LIFO) earlier al-
inventory at any given date is forming an integral part lowed under IAS 2 and ARB
the balance of costs applicable of production; 43, has now been done away
to goods on hand remaining l Administrative overheads with.
after matching of absorbed not contributing to bring-
costs with concurrent revenues. ing the inventory to their Classification of
This balance is carried to fu- location or condition; Inventories
ture periods provided it does l Selling and Distribution In case of Oil sector com-
not exceed an amount properly costs. panies (specially those in the
chargeable against the revenues The cost of inventory of business of refining), invento-
expected to be realised from items that are not ordinarily in- ries may broadly be classified as
ultimate disposition of goods terchangeable and are capable follows:
carried forward. of being segregated shall be on (a) Raw Materials;
Inventories are valued at ‘Specific Cost’ basis. For exam- (b) Intermediate Stock or
Actual Cost or the Net Realis- ple, the cost of any identifiable work-in-progress; and

Figure 1

January 2006 The Chartered Accountant 1037


(c) Finished Goods Stock. oil such as Bonny Realisable Value’
Note: It may be noted that Light, Labuan, Arab then valuation shall
the type of crude oil to be pro- Mix, Dubai crude, be at ‘Actual Cost’;
cessed and products that may etc. The main sourc- - If ‘Actual Cost’ is
be produced may vary from es of procurement more than the ‘Net
refinery to refinery, depending of imported crude Realisable Value’
upon their configuration and oil are countries like then the valuation
design Nigeria, Iran, Saudi shall be at ‘Replace-
Arabia, Kuwait, Ma- ment Cost’.
Valuation Criterion laysia, etc. The term ‘Actual Cost’
Classification wise valua- Crude oil is valued at ‘Ac- comprises the following:
tion of inventories as shown in tual cost’ or ‘Replacement cost’ l In case of indigenous
Figure 1 on the previous page whichever is lower. As per Ac- crude oil, the total costs
may be summarily explained counting Standard 2, in case of involved in bringing the
as follows: - raw materials when there has crude oil to their present
been a decline in the cost of location or condition. It
(A) Raw Material: raw materials and they are to shall include all payments
Raw Material includes be written down to NRV, the made for purchase of
Crude oil stock that may in- replacement cost of raw mate- crude oil to oil supplying
clude high sulphur crude or rial may be considered as the companies, transportation
low sulphur crude or both. best available measure of their costs if any, cess, ocean
This may further be catego- Net Realisable Value. freight, insurance, etc. in
rised into: The criteria for crude oil case of offshore crude oil;
l Indigenous crude valuation shall, thus, be: and
oil that may either l If ‘Actual Cost’ is less l In case of imported crude
be offshore such as than ‘Replacement Cost’ oil, shall include all costs
from Bombay high, then valuation shall be at incurred in the course of
Panna-Mukta, etc., ‘Actual Cost’; or import of crude oil up to
or on-shore crude l If ‘Actual Cost’ is more the point of storage or
oil such as South than ‘Replacement Cost’ processing which shall
Gujarat, North Gu- then: comprise FOB, Marine
jarat, Assam, etc. - If ‘Actual Cost’ is freight, Marine Insur-
l Imported crude less than the ‘Net ance, Wharfage and other

Scenario-A Scenario-B Scenario-C Scenario-D Scenario-E


Crude oil cost 10000 10000 10000 10000 10000
Conversion cost 200 200 200 200 200
Total cost 10200 10200 10200 10200 10200
Realisable Value 11500 9500 11500 9000 9600
of product
Replacement cost 10500 10200 9500 9500 9500
of crude oil
Valuation as per 10000 10000 10000 9500 9500
AS-2
Reason Replacement Replacement Though the re- Though the realis- Since realisable value
cost of crude cost of crude placement cost able value of prod- and replacement cost
oil is higher oil is higher of crude oil is ucts is lower than are lower than the
than the ac- than the ac- lower than the the actual as well cost, valuation made
tual cost. tual cost. actual crude cost, as replacement based on replacement
realisable value cost, the crude oil cost of the crude oil,
of products is cost will not be which is lower than
more than actual valued lesser than realisable value of
crude oil cost. the replacement products
cost.
Table1

1038 The Chartered Accountant January 2006


landing charges, Customs Realisable Value of Qty in MT Rate Per Value Rs.
Duty, Transportation Production MT Lacs
costs and Entry Tax if
applicable. ILP-April
The above shall constitute Estimated Crude Processing 1000
purchase costs.
The term ‘Replacement LPG 50 25000 13
Cost’ of crude refers to the Petrol 100 32000 32
prevailing price of same type Diesel 400 30000 120
of crude in the market at the
time of finalisation of annual Kerosene 200 24000 48
accounts, in order to deter- ATF 30 26500 8
mine the change in the cost of
crude with respect to the bal- Others 50 20000 10
ance sheet date. Intermediate Stock Differential 100 22000 22
The term ‘Net Realisable Total 930 27150 252
Value’ refers to the estimated
realisation from the sale of Losses & Wastages 70
products produced from the Total Crude Processing 1000 25200 252
crude oil in stock as at the valu-
ation date. This is done on the ILP-MAY 1500
basis of actual product pattern Estimated Crude Processing
considered from the Inventory LPG 85 25000 21
Logistics Plan (ILP) drawn for Petrol 125 32000 40
the subsequent month(s) fol-
lowing the date of the balance Diesel 610 30000 183
sheet. The prices prevailing or Kerosene 275 24000 66
expected to prevail during the
next month are considered for ATF 70 26500 19
this purpose. Others 100 20000 20
In all the above cases, Intermediate Stock Differential 145 22000 32
weighted average costs are ar-
rived at and a comparison is Total 1410 27000 381
done amongst them as afore- Losses & Wastages 90
mentioned.
The above valuation cri- Total Crude Processing 1500 25400 381
teria may be well understood Average Realisation May Thus Be:
with the help of an illustration ILP April 1000 25200 252
as has been stated in Table 1
on the previous page. ILP May 500 25400 127
The calculation of ‘Net Total 1500 25267 379
Realisable Value’ may be done
following the method stated Less: Operating Cost / Mt Of Crude Processing 300
Table 1. This may be under- (Budgeted Figure May Be Considered)
stood by considering a hypo- Average Net Realisable Value Per Mt Net Of 24967
thetical illustration stated in Operating Cost For Comparison Purposes
Figure 2: Table 2
Considering a crude oil
stock of 1500 Metric Tonnes
(MT) at the end of the finan- to the stock of goods that are The valuation of such
cial year 2004-05 (i.e. as on in semi-finished form and are goods is done as follows:
31.03.2005), realisable value held between manufacturing ‘Actual Cost plus conver-
calculation, considering Inven- stages. At every point of time sion costs’ or ‘Net Realisable
tory Logistics Plan (ILP), may there are certain goods that Value’ whichever is lower.
be done as shown in Table 2. are neither fully complete nor ‘Actual Cost’ in case of
may be categorised as raw ma- intermediate stock shall in-
(B) Intermediate Stock: terials. Such goods fall in this clude conversion costs. The
Intermediate stock refers category. practice followed by most of

January 2006 The Chartered Accountant 1039


zene, Toluene, Paraffin Wax, sulted in the under-recoveries
etc. to the Oil Marketing Compa-
The valuation followed in nies (OMC) and affected their
this case is as follows: profits.
‘Actual Cost plus conver- For Oil Marketing Com-
sion costs’ or ‘Net Realisable panies, the final ‘Ex-Storage
Value’ whichever is lower. Point Price’ is arrived at by
Since the oil industry in- adding to the RTP, the mar-
volves a single input (crude oil) keting margin and marketing
and multiple outputs through costs comprising basic mar-
one or several processing lev- keting costs, working capital
els, it becomes quite difficult costs, storage losses, etc. The
to assess the actual cost of cost of product for marketing
production using the direct companies shall be the price
cost allocation method. In this at which these companies re-
regard, a generally accepted ceive the product from refin-
practice is the elimination of ing companies.
profit percentage from the The ‘Net Realisable Value’
selling price of the products. shall be the price of the prod-
Since the dismantling of uct prevailing in the market
Administered Price Mecha- on the first of the subsequent
nism (APM) i.e. 01.04.2002, month.
the prices of all petroleum
the oil companies is to con- products except Kerosene Disclosure Requirements
sider intermediate stock as (PDS) and LPG (Domestic) The disclosure require-
half-processed (or 50 per cent are market driven though the ments in relation to inventory
processed). The actual cost of government has still not fully valuation shall comprise the
such stock may, thus, be cal- deregulated market price de- following:
culated by arriving at the value termination of Petrol and l The accounting policies
of Equivalent Crude used in Diesel. adopted in inventory val-
such stock after considering In case of LPG (Domestic) uation, including the cost
the proportion of relevant and Kerosene (PDS), govern- formula used;
losses. Similarly, the propor- ment provides subsidies in the l In case of any change on
tion of all relevant conversion final price to the consumers. the above basis, the na-
costs involved is added to the The rate of subsidy has been ture of such change and
total cost. fixed on the basis of import if material, the effect of
‘Net Realisable value’ in parity rates. Oil companies such change in income
the present case is calculated have been prevented from re- should be disclosed in
considering the same basis as vising the rates even though accordance with the Ac-
in case of crude oil. This NRV the international prices of counting Standard 5 “Net
is then adjusted for the pro- these commodities have been Profit, Prior period items
portion of losses and conver- increasing substantially. and Changes in account-
sion costs in order to bring it In the case of Refining ing policies”;
on a common platform with Companies, the Refinery l Carrying amount of in-
actual cost and, thus, form the Transfer Price (RTP) is de- ventories carried at ‘Net
basis for comparison. termined under the concept Realisable Value’ (or Re-
of Import Parity Price (IPP). placement Cost in case of
(C) Finished Stock: Such a price is based on the raw materials, as the case
Finished stock consists of landed cost of the product at may be);
those goods that are complete the nearest refinery port (plus l Total carrying amount in
in all respects and are ready transportation cost, if any) for inventories and its classi-
for sale or distribution in the the import of such product. fication.
market. This adjusted price is referred Disclosure requirements under
These finished goods may to as ‘Ex-Refinery Price’ and Section 145A of Income Tax Act,
be either Straight Run Prod- is inclusive of refining margin. 1961
ucts such as Petrol, Diesel, Thus, the refineries are being Section 145A of the In-
Kerosene, LPG, etc. or Spe- paid the RTP as per the inter- come Tax Act, 1961 intro-
ciality Products such as Ben- national prices, which has re- duced by the Finance Act,

1040 The Chartered Accountant January 2006


1998 for the financial years Lamiya Lokhandwala
1998-1999 onwards, requires
that for the purpose of de-
termining “Profits and Gains
from Business and Profession”
valuation of purchase and sale
of goods and inventory:
(a) Shall be in accordance
with the method of ac-
counting regularly fol-
lowed by an enterprise;
and
(b) Shall include in the value
of purchase and sale of
goods or inventory, any
amount of duty, cess,
tax, etc. as a part of the
cost of such goods or
inventory.
In this regard, the ICAI
has issued a “Guidance Note
on the Accounting Treatment
of Modvat/Cenvat” effective
from 01.04.2000, whereby it
has been recommended that
the depiction/disclosure of
inventories in the books of
accounts should be done on
“gross basis” without taking
into consideration the credit
for CENVAT. The revised
Accounting Standard 2 also l Storage costs, which The primary objective of
supports this view. involve: inventory management and
v Tax, depreciation, control should, thus, be identi-
Significance Of EOQ fication of EOQ so that all the
repair & mainte-
As the heading connotes, above costs may be minimised.
nance of building;
Economic Order Quantity is The most commonly used
v Insurance against
that level of quantity at which mathematical approach for
the total relevant cost is mini- fire and theft;
v Pilferage and obso- calculation of EOQ is given
mum. by the following equation:
Economic Order Quan- lescence costs; and
v Serving costs such Where,
tity (EOQ) is an optimum
ordering quantity that gives as labour costs. 2AB
maximum economy in the l Opportunity costs EOQ = C
purchasing or ordering of any consisting of (in-
material. The relevant costs in terest on capital)
funds utilised to A = Annual Usage of in-
determination of EOQ are: ventory (units)
(a) Ordering cost which in- finance the acquisi-
tion of inventories B = Buying / Ordering cost
volves the cost for prepa- per order; and
ration of orders for receiv- that would other-
C = Inventory Carrying
ing goods and other costs wise have earned a
Costs per unit per annum.
for securing the supplies return.
This technique of inventory
of materials; (c) Stock-Out costs involv-
control may be highly useful in
(b) Inventory Carrying costs ing loss of contribution,
case of oil sector considering
which involve the costs of loss of goodwill, cost due
the huge quantum of work-
holding and maintaining to Shut-downs/restarts
ing capital in inventories since
inventories and can be di- due to shortage of raw
a small percentage reduction
vided into two categories: materials, etc.

January 2006 The Chartered Accountant 1041


in working capital tied-up in more and more stock though rors, thus, result in timing
inventories shall mean a sub- sales are not increasing at par differences.
stantial saving amount. But with stock increase. Amongst Any such errors in inven-
complete benefits of such a the four oil majors, BPCL has tory valuation occurring after
technique are yet to be earned the highest inventory turnover the balance sheet date or clos-
taking into account the volatil- whereas RIL has the lowest ing of accounts, materially af-
ity involved in prices and de- ITR. fecting the true and fair view
mand in hydrocarbon industry. In order to keep this ratio of the state of affairs, should
at a higher level, an effective be disclosed in the Director’s
A Comparative Analysis of system of inventory controls
Report as part of “Events oc-
Inventory Usage may be exercised by the oil
An analysis of efficiency in sector. curring after balance sheet
the use of inventory may be date” in accordance with the
done by an enterprise with the Errors In Inventory Accounting Standard AS 4
help of turnover ratios. Valuation and Their Impact ‘Contingencies and Events
Inventory Turnover Ra- on Profitability occurring after Balance Sheet
tio is highly useful in identi- Valuation of inventory has date’.
fying as to how many times a an impact on the profits of
company’s inventory has been two financial years– the year Conclusions
sold during the year. in which it appears as ‘Closing A sound system of inven- Valuation
Although, the higher the Stock’ and the subsequent year tory control is essential for of inven-
ratio the better it is but it var- in which it appears as ‘Open- every organisation specially tory has
ies from company to company. ing Stock’. Thus, an error in in case of manufacturing an impact
The above ratio may be higher one accounting period shall concerns. on the
The main purpose of in- profits of
Cost of Goods Sold ventory control is to minimise two finan-
Inventory Turnover Ratio = cial years
the costs of funds employed
Average Inventory – the year
or tied-up in inventories and
in which
at the same time maintain an it appears
Opening Stock + Closing Stock uninterrupted supply of raw
Average Inventory = as ‘Closing
materials for production at Stock’ and
2
minimum possible inventory the subse-
in Oil Marketing Companies have an impact on profits of carrying and holding costs. quent year
in comparison to Oil Refining two accounting years. An er- Valuation of inventories, in which it
Companies. ror in inventory valuation shall on the other hand, depicts appears as
A comparative study be- directly affect the Gross Prof- the total amounts tied-up in ‘Opening
low of the trend of Inventory its of an organisation. the inventories and thereby Stock’.
Turnover Ratios over a period An overstatement in in- form the basis for inventory
of 3 years, of 4 major oil sector ventory valuation shall lead control. Proper inventory
companies in India, provide an to an overstatement of prof- valuation, thus, attains more
insight into the efficiency in its for that year and also significance.
inventory utilisation by them. the understatement of prof- The global economy has
It is evident from the its for the subsequent year witnessed a sharp rise in the
above table that over the pe- and vice-versa. It is worth international price of crude
riod of three years all the oil mentioning that the com- oil over the last one year or
IOCL BPCL HPCL RIL1 so from around $30 a barrel
in 2003-04 to $45 a barrel
YEAR 2003-2004 9.26 12.30 10.99 7.63 in 2004-05 reporting an in-
YEAR 2002-2003 10.15 13.26 12.45 8.03 crease in crude oil prices by
YEAR 2001-2002 11.17 12.80 11.89 12.48 about 50 per cent. But crude
oil prices hitting an all time
1
Note: Reliance Industries Ltd. considered as a whole, of which petroleum busi-
ness is a major segment. high of $66 per barrel mark
in the second week of August
sector companies show a de- bined profits of the said two 2005 has given the biggest
cline thereby indicating that years shall, however, remain oil shock of the last 25 years.
oil companies are keeping unchanged. Inventory er- With increased volatility

1042 The Chartered Accountant January 2006


in crude oil trading, New York Mercantile Ex-
change (NYMEX) data shows outstanding op-
tions contracts to buy crude oil for December
2005 delivery at a whooping $80 a barrel, there
is a hazard that the economic growth of most
world economies might go for a toss.
Such a situation can not only bring down the
economic growth in India to levels as low as 2-3
per cent per annum, but can also increase infla-
tion to alarming heights of 13-15 per cent per
annum.
Though the Organisation of Petroleum Ex-
porting Countries (OPEC), the producer of
about 40 per cent of world’s crude oil, is pumping
crude oil as much as it can to increase inventories
and production, yet the efforts do not seem to
pay off. The situation, thus, remains grim.

Suggestions
ü Optimum capacity utilisation:
Having been confronted with such a precari-
ous state of affairs, efforts need to be made to
rethink upon our present inventory levels and
an endeavour should be made to attain optimum
utilisation of available refining capacities in or-
der to meet as much energy demand as possible.
ü Usage of better Inventory Control Techniques:
Opportunities may be explored by usage of
various inventory control techniques like EOQ,
for reducing ordering and carrying costs and
thereby attaining a healthy inventory turnover
ratio. Since inventory valuation has a direct
bearing on the profits of an organisation (spe-
cially in case of manufacturing concerns) and
profits in turn have a bearing on the share prices
of the organisation, it may be said that inventory
valuation has a bearing on the market prices of
shares and, thus, needs to be dealt with utmost
caution.
ü Strict legal compliance - Role of Chartered Ac-
countants and other auditors:
It is evident that Accounting Standards need
to be strictly followed for a true and fair depic-
tion of the state of affairs. Chartered Accoun-
tants engaged in the audit of companies falling
under the oil sector, need to keep in mind the
above implications and in a country like India
where most of the oil sector companies are Gov-
ernment of India undertakings, the issue of In-
ventory Valuation and Control attains apex im-
portance. Chartered Accountants should, thus,
be more stringent and cautious while auditing in
the oil sector, so that an accurate, relevant, true
and fair view may be presented in the interest
of the nation. r

January 2006 The Chartered Accountant 1043