CARO, 2003 and Inventory Requirements

1. Clause 4(ii)(a) requires the auditor to comment whether the management has conducted physical verification of inventory at reasonable intervals. According to Accounting Standard (AS) 2, “Valuation of Inventories”: “Inventories are assets:

  • held for sale in the ordinary course of business;
  •  in the process of production for such sale; or
  •  in the form of materials or supplies to be consumed in the production process or in the rendering of services.”

Inventories encompass goods purchased and held for resale, for example, merchandise purchased by a retailer and held for resale, computer software held for resale, or land and other property held for resale. Inventories also encompass finished goods produced, or work in progress being produced, by the
enterprise and include materials, maintenance supplies, stores and spares, consumables and loose tools awaiting use in the production process. It may be noted that packing materials are also included in inventories. Inventories do not include machinery spares covered by Accounting Standard (AS) 10, “Accounting for Fixed Assets”, which can be used only in connection with an item of fixed asset and the use of which is expected to be irregular. Physical verification of inventory is the responsibility of the management of the company which should verify all material items at least once in a year and more
often in appropriate cases. It is, however, necessary that the auditor satisfies himself that the physical verification of inventories has been conducted at reasonable intervals by the management and that there is adequate evidence on the basis of which the auditor can arrive at such a conclusion. For
example, the auditor may examine the documents relating to physical verification conducted by the management during the year as also at the end of the financial year covered by the auditor’s report. What constitutes “reasonable intervals” depends on circumstances of each case. The periodicity of the
physical verification of inventories depends upon the nature of inventories, their location and the feasibility of conducting a physical verification. The management of a company normally determines the periodicity of the physical verification of inventories considering these factors. Normally, wherever
practicable, all the items of inventories should be verified by the management of the company at least once in a year. It may be useful for the company to determine the frequency of verification by ‘A-B-C’ classification of inventories, ‘A’ category items being verified more frequently than ‘B’ category and the
latter more frequently than ‘C’ category items.

2. Clause 4(ii)(b) requires the auditor to comment on the reasonableness and adequacy of the inventory verification procedures followed by the management of the company. In case the procedures of physical verification of inventories, in the opinion of the auditor, are not reasonable and adequate in relation to the size of the company and the nature of its business, the auditor has to report the same. An auditor should obtain reasonable assurance about existence and condition of inventories. Observation of physical verification/ examination of records of verification inventory is the primary source of evidence for the purpose of reporting under this clause. While the physical verification of inventories is primarily the duty of the management, the auditor is expected to examine the methods and procedures of such verification. The auditor may, if considered appropriate by him, be also present at the time of stock-taking.

The duties and responsibilities of the auditor while attending a stock taking by the management are governed by the principles laid down in the Auditing and Assurance Standard (AAS) 34, Audit Evidence – Additional Considerations for Specific Items, issued by the Institute of Chartered Accountants of India. The auditor should establish the reasonableness and adequacy of procedures adopted for physical verification of inventories having regard to the nature of inventories, their locations, quantities and feasibility of conducting the physical verification. This would require the auditor to make use of his
professional judgement. There are two principal methods of physical verification of inventories: periodic and continuous. Under the periodic physical verification method, physical verification of inventories is carried out at a single point of time, usually at the year-end or at a selected date just prior to or shortly after the year-end. Under the continuous physical verification method, physical verification is carried out throughout the year, with different items of inventory being physically verified at different points of time. However, the verification programme is normally so designed that each material item is physically verified at least once in a year and more often in appropriate cases. The continuous physical verification method is effective when a perpetual inventory system of record-keeping is also in existence. Some entities use continuous physical verification methods for certain stocks and carry out a full count of other stocks at a selected date. Normally, before commencement of verification, the management should issue appropriate instructions to stocktaking personnel. Such instructions should cover all phases of physical verification and preferably be in writing. It would be useful if the instructions are formulated by the entity in consultation with the auditor. The auditor should examine these instructions to assess their efficacy. The auditor while forming his opinion, in addition to finding answers to the illustrative questions for evaluating the internal controls mentioned in the Appendix IX of the Statement, employs several audit procedures, including examination of the reports of the internal auditor. The auditor has to use his professional judgement regarding the nature, timing and extent of the procedures to be applied informing his opinion for commenting on this clause. The auditor can rely upon the work of an internal auditor provided the auditor complies with the requirements of Auditing and Assurance Standard (AAS) 7, “Relying Upon the Work of an Internal Auditor”, issued by the Institute of Chartered Accountants of India. The auditor should ascertain whether the management has
instituted adequate cut-off procedures. For example, he may examine a sample of documents evidencing the movement of inventories into and out of stores, including documents pertaining to periods shortly before and shortly after the cut-off date, and check whether the inventories represented by those documents were included or excluded, as appropriate, during the stocktaking. The auditor should review the original physical verification sheets and trace selected items – including the more valuable ones – into the final inventories. He should also compare the final inventories with stock records and other corroborative evidence, e.g., inventory statements submitted to banks. Where continuous stock-taking methods are being used by the entity, the
auditor should, in addition to performing the audit procedures discussed above, pay greater attention to ascertaining whether the management:

  • maintains adequate stock records that are kept up-to-date;
  • has established adequate procedures for physical verification of inventories, so that in the normal circumstances, the programme of physical verification will cover all material items of inventory at least once during the year; and
  • investigates and corrects all material differences between the book records and the physical counts.

The auditor should determine whether the procedures for identifying damaged and obsolete items of inventory operate properly. The auditor may determine the reasonableness and adequacy of the procedures of physical verification of inventories by examining the related records and documents.
These records and documents would also include the policy of the company regarding physical verification. The following are the documents which can be examined by the auditor in this regard:

  •  written instructions given by the management to the concerned staff engaged in the verification process;
  • physical verification inventory sheets duly authenticated by the field staff and responsible officials of the company;
  •  summary sheets/consolidation sheets duly authenticated by the responsible officials;
  •  internal memos etc., with respect to the issues arising out of physical verification of inventory;
  • any other relevant documents evidencing physical verification of inventory.

In case where the inventories are material and the auditor is placing reliance on the records, documents, information and explanations provided by the management, it would be desirable that the auditor, in order to substantiate the fact that the physical verification is carried out in accordance with
the procedure explained by the management, attends the physical verification. Where the auditor is present at the time of stock-taking, he should observe the procedure of physical verification adopted by the stock-taking personnel to ensure that the instructions issued in this behalf are being actually
followed. The auditor should also perform test-counts to satisfy himself about the effectiveness of the count procedures. In carrying out the test counts, the auditor should give particular consideration to those inventories which have a high value either individually or as a category of inventories. While
commenting on this clause, the auditor should point out the specific areas where he believes the procedure of inventory verification is not reasonable or adequate.

3. Clause 4(ii)(c) requires the auditor to comment whether the company is maintaining proper records of inventory. The clause also requires the auditor to comment whether any material discrepancies were noticed on physical verification of inventory and if so, whether those material discrepancies
have been properly dealt with in the books of account. What constitutes “proper records” has not been defined. However, in general, records relating to inventories should contain, inter alia, the following:

  •  particulars of the item like nomenclature, nature, etc.
  •  identification code of the item;
  •  details regarding quantity of the receipts, issues, balances and dates of transactions in a chronological manner;
  • relevant document number and department identification, if any;
  •  location.

If priced stores ledger is maintained, the records of the inventory should also disclose the prices at which the recording of the issues and receipts is made. The records should contain the particulars in respect of all items of inventories. The auditor should also satisfy himself that the stock registers are
updated as and when the transactions occur. The auditor should also verify that the transactions entered in stock registers are duly supported by relevant documents. The purpose of showing the location of the inventory is to make verification possible. The record of movement/custody of the inventory should be maintained. In cases where a company is maintaining stock records for work-inprogress, say, for compliance with the requirements of the section 209(1)

4. of the Companies Act, 1956, the auditor would normally be able to obtain relevant information in respect of work-in-progress from such records. However, in many cases, it might be impracticable to maintain stock records for work-in-progress. In such cases, the auditor should consider the fact whether the company, at any point of time, can arrive or calculate the quantity and amount involved in the work-in-progress. Some of the factors that might be used in arriving at the value of work in progress include the production cycle, input/ output ratio analysis, production and stock records for the immediately following period. If the company is able to do so, the auditor may form an opinion that proper records relating to the work-inprogress have been kept and, accordingly, no adverse comment of the auditor under this clause would be required. However, before adopting this as an audit procedure, the auditor should satisfy himself as to the impracticability of maintenance of stock registers of work-in-progress. It is not possible to specify any single form in which the records should be maintained. This would depend upon the mode of account-keeping (manual or computerized), the number of operating locations, the systems of control, etc. The Order further requires the auditor to examine whether material discrepancies have been noticed on verification of inventories when compared with book records. Such an examination is possible when quantitative records are maintained for inventories but in many cases circumstances may warrant that records of individual issues (particularly for stores items) are not separately maintained and the closing inventory is established only on the basis of a year-end physical verification. Where such day-to-day records are not maintained, the auditor will not be able to arrive at book inventories except on the basis of an annual reconciliation of opening inventory, purchases and consumption. This reconciliation is possible when consumption in units can be co-related to the production, or can be established with reasonable accuracy. Where such reconciliation is not possible, the auditor would be unable to determine the discrepancies. If the item for which the discrepancy cannot be established is not material, the discrepancy, if any, will also not be material. For example, an item categorised as ‘C’ in ABC analysis might not be material and therefore, the discrepancy, if any, in regard to such an item would not be material. In other cases, however, the auditor will have to report that he is unable to determine the discrepancy, if any, on physical verification for the item or class of items to be specified.

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