Introduction
Inventories, a vital current asset, are crucial to the financial health of a business. They typically include raw materials, work-in-progress, finished goods, and consumables. Ensuring the accuracy and valuation of inventories is a critical part of the statutory audit as they directly impact profit calculations and the balance sheet’s integrity.
This comprehensive guide provides detailed directions on auditing inventories under Indian company laws, addressing common queries, and providing practical examples. It also includes a full legal framework and detailed audit procedures for better understanding and execution.
Objectives of Auditing Inventories
- Existence: Verify that inventories recorded in the books of accounts physically exist.
- Valuation: Ensure inventories are valued correctly in accordance with applicable accounting standards.
- Ownership: Confirm the ownership and rights over inventories recorded.
- Classification and Disclosure: Ensure accurate classification and disclosure of inventories in financial statements.
- Compliance with Laws and Standards: Assess compliance with relevant legal and regulatory frameworks.
Audit Methodology
1. Planning the Audit
- Understand the Entity’s Operations: Familiarize with the nature of the business, types of inventories, and their movement.
- Review Inventory Policies: Analyze policies regarding purchase, storage, valuation, and write-offs.
2. Substantive Audit Procedures
Physical Verification
- Attend physical inventory counts at year-end or a designated date.
- Inspect the condition of inventories for obsolescence or damage.
- Reconcile physical counts with book records.
Valuation
- Verify the valuation of inventories in compliance with AS 2 – Valuation of Inventories.
- Ensure inventories are valued at cost or net realizable value (NRV), whichever is lower.
- Examine cost components like direct material, labor, and overheads.
Ownership and Rights
- Review purchase invoices and agreements to confirm ownership.
- Verify inventories held on consignment or as collateral for loans.
Cut-off Testing
- Ensure that transactions near the reporting date are recorded in the correct period.
- Check for proper recognition of goods in transit.
Write-Downs and Provisions
- Identify slow-moving, obsolete, or damaged inventories.
- Verify the adequacy of provisions for diminution in value.
Disclosure and Classification
- Ensure proper classification under Schedule III of the Companies Act.
- Verify disclosures regarding valuation methods, write-offs, and inventories pledged.
3. Analytical Procedures
- Perform trend analysis of inventory balances, turnover ratios, and gross margins.
- Compare inventory valuation metrics with industry benchmarks.
4. Testing Internal Controls
- Assess the effectiveness of internal controls over inventory purchases, movements, and storage.
- Test controls on inventory valuation, physical verification, and approvals.
5. Related Party Transactions
- Identify related-party transactions involving inventories.
- Verify compliance with disclosure requirements under the Companies Act and applicable standards.
Legal Framework
1. Companies Act, 2013
- Section 128 (Books of Account): Requires accurate records of inventory movements and valuation.
- Section 129 (Financial Statements): Mandates that inventories are fairly presented in financial statements following applicable accounting standards.
- Schedule III: Provides guidelines for the classification, grouping, and disclosure of inventories.
2. Accounting Standards
- AS 2 – Valuation of Inventories:
- Prescribes valuation at cost or NRV, whichever is lower.
- Excludes certain costs like abnormal losses and storage unrelated to production.
- AS 9 – Revenue Recognition: Relevant for inventories sold during the period.
3. Standards on Auditing (SAs)
- SA 500: Obtain sufficient audit evidence for inventories.
- SA 501: Requires auditors to attend physical inventory counts.
- SA 530: Use sampling techniques for inventory verification.
4. Income Tax Act, 1961
- Inventories must be valued consistently for tax purposes under Section 145.
- Any discrepancy in inventory valuation can lead to tax implications.
5. Goods and Services Tax (GST)
- Verify compliance with GST on purchases, sales, and inventory adjustments.
Practical Examples
Example 1: Physical Verification Discrepancies
- Scenario: Physical count shows a shortage of ₹5 lakhs compared to book records.
- Audit Approach:
- Investigate reasons for discrepancies.
- Verify whether shortages are due to theft, pilferage, or recording errors.
- Insight: Weak internal controls in inventory management can cause financial misstatements.
Example 2: Obsolete Inventory
- Scenario: Inventory includes items unsold for over three years.
- Audit Approach:
- Assess the realizable value of obsolete inventory.
- Verify write-downs or provisions in books.
- Insight: Non-recognition of obsolescence impacts profitability.
Example 3: Goods in Transit
- Scenario: ₹2 crores worth of goods shipped but not recorded in inventories.
- Audit Approach:
- Review shipping documents and vendor confirmations.
- Verify cut-off procedures.
- Insight: Misstating goods in transit impacts current assets and liabilities.
Example 4: Related Party Transactions
- Scenario: Purchases of ₹50 lakhs from a related party.
- Audit Approach:
- Verify terms and conditions with purchase agreements.
- Check for arm’s length pricing and disclosures.
- Insight: Lack of transparency can lead to regulatory scrutiny.
Example 5: Consignment Inventories
- Scenario: ₹1 crore of goods held on consignment by a third party.
- Audit Approach:
- Verify consignment agreements.
- Reconcile consignor and consignee records.
- Insight: Unrecorded consignment inventories inflate profitability.
Example 6: Incorrect Valuation
- Scenario: Finished goods valued at selling price instead of cost.
- Audit Approach:
- Recalculate inventory costs per AS 2.
- Verify NRV computations.
- Insight: Incorrect valuation distorts profit margins.
Example 7: Slow-Moving Items
- Scenario: ₹10 lakhs of slow-moving items in stock.
- Audit Approach:
- Review sales data for slow-moving items.
- Verify provisions for expected losses.
- Insight: Lack of provision leads to overstatement of assets.
Example 8: GST Impact
- Scenario: GST on inventory adjustments not accounted for.
- Audit Approach:
- Verify GST filings and reconciliations.
- Ensure input tax credit adjustments are recorded.
- Insight: Non-compliance leads to penalties and interest.
Example 9: Work-in-Progress
- Scenario: Misclassification of ₹20 lakhs of WIP as finished goods.
- Audit Approach:
- Review production records and stage of completion.
- Verify cost allocation for WIP.
- Insight: Misclassification impacts both profit and liquidity ratios.
Example 10: Perpetual Inventory System
- Scenario: Errors in perpetual inventory records.
- Audit Approach:
- Test perpetual records against physical counts.
- Verify adjustments made for differences.
- Insight: Poor system implementation causes financial inaccuracies.
Conclusion
Auditing inventories requires a systematic approach encompassing physical verification, valuation checks, and compliance reviews. Practical insights and a robust understanding of legal frameworks ensure accuracy and integrity in financial reporting. Proper handling of inventories is crucial for reflecting the true financial health of an organization.
Author
CA Sourabh Kothari (C.A., B.Com)
He is currently working as Partner – Risk and Transaction advisory with a renowned firm in Jaipur having experience in Internal Audit, IFC Audit, Business consultancy, Due Diligence and Management consultancy.
E-mail: Sourabh.kothari@jainshrimal.in | LinkedIn: Sourabh Kothari
