Vista Chemicals: normal capacity, unabsorbed overhead and NRV
Vista Chemicals Limited produces a single industrial solvent in a plant designed for 120,000 litres a year. In the year ended 30 June 2025 it produced 90,000 litres. Fixed production overhead incurred was Rs 36,000,000 and variable cost was Rs 400 per litre. Closing inventory is 12,000 litres. The whole closing batch is slightly off-specification: it can be sold for Rs 900 per litre, but each litre needs rework costing Rs 200, and delivery to the customer costs a further Rs 120 per litre. The finance manager has valued closing inventory at Rs 700 per litre (variable Rs 400 plus overhead at the normal-capacity rate of Rs 300, being Rs 36,000,000 ÷ 120,000) and has carried the Rs 9,000,000 of unabsorbed overhead as a deferred cost within other receivables.
1. Compute the correct carrying amount of closing inventory and set out the adjusting journal entries, quantifying the effect on profit.
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Step 1 – The absorption rate is set on normal capacity. Rs 36,000,000 ÷ 120,000 litres = Rs 300 per litre. This part of the finance manager's calculation is right.
Step 2 – But allocation is capped at actual output. IAS 2 requires fixed overhead to be allocated to units actually produced; 90,000 litres × Rs 300 = Rs 27,000,000 is absorbed. The remaining Rs 9,000,000 is unallocated overhead of an abnormal idle period and must be expensed, not carried as an asset.
Step 3 – Cost per litre. Rs 400 variable + Rs 300 fixed = Rs 700.
Step 4 – Net realisable value. Rs 900 selling price − Rs 200 rework − Rs 120 delivery = Rs 580. Rework is needed to make the sale, so it is deducted in full; only costs necessary to complete the sale are deducted.
Step 5 – Lower of cost and NRV. Rs 580 × 12,000 litres = Rs 6,960,000.
Journals
- Dr Cost of sales Rs 9,000,000 / Cr Other receivables Rs 9,000,000 (remove the deferred overhead).
- Dr Cost of sales (inventory write-down) Rs 1,440,000 / Cr Inventory Rs 1,440,000 ([700 − 580] × 12,000).
Effect on profit: the manager's figures overstate profit by Rs 10,440,000 (Rs 9,000,000 deferral + Rs 1,440,000 write-down), and inventory is overstated by the same amount.
2. The managing director argues that the plant was idle only because of a customer dispute expected to be settled next year, so the Rs 9,000,000 is a cost of future benefit and should stay on the balance sheet as a prepayment. Evaluate this argument and state the audit implications.
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The argument fails on both the accounting standard and the conceptual framework.
- IAS 2 is explicit. Unallocated overheads arising from low production or idle plant are recognised as an expense in the period incurred. The standard does not permit capitalising them on the expectation of future utilisation.
- No asset exists. An asset is a present economic resource controlled as a result of a past event with the potential to produce economic benefits. The Rs 9,000,000 has already been consumed; the 'benefit' claimed is the avoidance of a future expense, which is not an economic resource. Deferring it would be a cost-smoothing reserve in disguise.
- The trigger is not the dispute. The relevant fact is that output (90,000 litres) was below the normal capacity used to set the rate; whatever the reason, the recovery is measured against normal capacity.
- Symmetry. Had output been 110,000 litres, the excess absorption would not have been recognised as a gain; the same logic forbids deferral on the downside.
Audit implications
- Propose the adjustment; if management refuses, treat it as an uncorrected misstatement of Rs 10,440,000 in aggregate and assess it against materiality and qualitative factors (it flatters both profit and the current ratio).
- Test the 'normal capacity' figure itself (budget, prior years, engineering capacity) because the rate drives the whole calculation.
- Challenge whether the dispute is genuine and whether it signals a going-concern or impairment indicator for the plant.
- Document the discussion; if the effect is material and uncorrected, modify the opinion.