Complete what, why and how of Inventory verification

Posted @ 12/21/2016 4:25:34 AM by admin Under( Inventory verification)

Periodic Physical verification of inventories is one of the most important internal control tools of an organization over company assets. Inventory means any stock held by an entity for resale or use in the course of manufacture of goods. The main intention of this exercise is to verify the accuracy of inventory register which consists of quantity, quality, carrying amounts, state of inventory like finished goods or work-in-progress, etc. The ultimate aim of this is to reflect accurate information in the financial statements of the organization.
It is to be appreciated that inaccurate inventory records can lead to misrepresentation in financial records, erroneous management forecasts and estimates, under-reporting or over reporting of slippages, pilferage and theft of inventory assets. Since a number of functions influence the inventory records, internal controls and checkpoints are a must to provide better assurance over the data accuracy.
To cater to this requirement and establish proper assurance over the reliability of inventory records, the best tool is Physical counting and verification of Inventory and comparing the result to the inventory register of the organization. Any resulting variances from this exercise can be investigated into.
While conducting inventory checking and verification, it also throws insights as to the areas where the internal controls of the organization are lacking. Depending on the experience and expertise of the inventory verification service provider, in-depth analysis and control suggestions can be provided so as to point out the weaknesses in the existing process and ways to curb the same.
Various regulatory requirements of Inventory Verification in India -
The various Indian regulators appreciate the importance of correct inventory records for an organization and thus the emphasis on the same via various laws, guidelines and enactments.
  •  Companies(Auditor’s Report) Order, 2016
Companies Act 2013 requires all auditors to submit a statement in addition to the financial statements, comprising of various clauses mentioned in it.
Latest in line is CARO 2016 comprising of 16 clauses which can be applicable to a company. In relation to Inventory, the following clause is applicable
Inventory, Clause 3(ii):
Following matters should be included in the Auditor’s report relating to the Inventory of the company:
Whether physical verification of the inventory has been made at regular intervals by the management, and during such verification if any material discrepancies were noticed whether the same have been properly accounted for.
  •  Companies Act, 2013
Section 133 of Companies Act, 2103 prescribes the requirement for all companies to adhere to Accounting Standards as prescribed by ICAI (Institute of Chartered Accountants of India).
Accounting Standard 2 - Valuation of Inventory
This AS provides provides accounting treatment for various inventory of the company. After following this treatment, the valuation of inventory is done and the same is recorded and shared in Financial statements of the company. As the Financial statements are required to be audited, inventory valuations and actual existence is also required to be audited by the company's auditor.
Due to constrains of time, the company auditor is not generally able to get into the details of inventory, and more often than not relies on the certification of inventory verification conducted by an independent chartered accountant (C.A.) firm.
  • Auditing Standards
SA 501 (Revised)  - Audit Evidence - Specific considerations for selected Items
All the auditors are required by law to audit the Financial statements of a company in accordance with the prescribed Standards of Auditing. In relation to inventory, SA 501 is prescribed-
SA 501 requires auditor to verify the Existence and condition of Inventory. The standard requires that whenever the inventory is material to financial statements, auditor will obtain sufficient and appropriate audit evidence regarding existence and condition of inventory by :
- Attend physical counting of inventory and if impracticable, evaluate managements instruction and procedure for recording and controlling the results of entitys physical inventory counting or observe managements count procedures.
If attendence of inventory counting is impracticable, the auditor shall perform alternative audit procedures to obtain sufficient appropriate audit evidence regarding existance and condition of inventory and if it is not possible to do so, auditor shall modify the opinion in auditors report according the SA 705.
Thus in above given scenario, either the companies get their inventories counted and verified by third party inventory verification service providers or the auditory of the company outsources or hires them to verify the inventory claimed on their behalf. The third party service provider verifies the entire inventory of the organization on some cut-off date and provides a report and certificate of the correctness of the information or any variances there in. The certificate provided from a C.A. firm can be used by the management to satisfy the companies auditor or also by the auditor to use the certificate as audit evidence.
  •  Guidance Note on Audit of Inventories
ICAI (Institute of Chartered  Accountants of India) has provided a guidance note for audit of Inventories. It outlines the peculiar features of inventories, which impact the audit procedures. The following is a gist of the important aspects of audit of inventories covered by the Guidance Note:
-Internal Control Evaluation:segregation of incompatible functions, standard form for recording movement of inventory, cross checking of data generated by different departments.
-Verification: management’s responsibility for physical verification, sufficient appropriate audit evidence for existence, ownership and valuation, procedures for verification by auditor.
-Examination of Records: type of records, extent of auditor’s examination, auditor’s procedures in case of absence or insufficiency of records.
-Attendance at Stock Taking: need for auditor’s attendance at stock taking, methods and procedures for stock taking, factors to be considered and procedures to be adopted in assessing the adequacy of stock taking, movement of stocks during stock taking, cut off procedures.
-Confirmation from Third Parties: factors to be seen, confirmations from third parties.
-Examination of Valuation and Disclosures: basis for valuation of inventories and methods of applying the basis, compliance with Accounting Standard (AS) 2, “Valuation of Inventories”, use of standard costing, examination of the disclosure in financial statements.
-Analytical Review Procedures: illustrative analytical procedures, comprising mainly of comparison of various elements.
-Work in Progress: assessing appropriateness of its valuation etc.
-Management Representations
-Documentation by the auditor
As can be seen from the above given guidelines and laws and regulations, inventory audit becomes a very important aspect of finanical statements and thus an important and a must do exercise for any entity for internal as well as external reasons.
Entity policy formulation and considerations -
All entities, be it manufacturing, trading, marketing, resellers etc., are required to conduct a periodic physical verification and count of the entire inventory to compare the actual inventories with those being indicated by the company's financial records.

1. What comprises of inventory to be verified - Raw materials, WIP (work in progress), finished goods, service parts, consumables, feature kits, etc. 

2.Inventory verification areas - includes different areas of the entity, including but not pertaining to  store and stock rooms, distrubution and production areas, demonstration, receiving, repair, engineering depots, goods returned stores, etc. Also if the inventory is being stored at a client facility, then the verification needs to be conducted there too. The companys management should arrange for necessary permissions for the same.

3.Cut-off date - When the Physical verification of Inventory is being conducted, generally the complete count is undertaken for all items. Large entities having huge geographical spread having inventory locations at multiple locations, and inter movement of the same is usual. In such cases a cut off date must be decided when all the movement of inventory is curtailed as much as possible. Our large network of operatives leads to minimum stoppage time for the movement of goods as we generally conduct pan india exercise simultaneously thus causing minimum inconvenience to our clients operations and employees.
The auditor must examine the inward and outward movement of stocks from the cut-off date till the date of physical count to establish the validity of the data as on the year-end date.
Also receiving activities must be paused, if possible, while the count is being conducted.
4. Timing of inventory count - Peiodic verification of inventoris should generally be conducted so as to sync with closing of an accounting period. This is done so that a verifiable and updated ledger balance is available. Usually all areas are covered at a given time simultaneously to ensure holistic coverage.
5. Physical inventory Verification Plan - Every division must make a plan for conducting physical count of inventory. The given plan should include the following parameters -
                Scope of exercise - This step describes the methodology being used for the count (eg: cyclical count, divisional count or wall-to-wall count), time-lines for the verification exercise, major objections or comments and guidelines, types of inventories to be included in the assignment. Also specific management concerns, such as any specific area of the entity where managements suspects any wrong doings must be indicated so as to the service provider can take due care about the same.
                Prior verifications - This is to provide an overview of previous few years results of verification exercise executed. This outlines the service provider about the general level of variances observed in previous exercises, major reasons for the same, and the corrective actions taken if any.
               Physical inventory verification exercise details - This step provides for the various operational details such as counting and processing methods that will be used, how carrying amounts will be determined, reporting and reconciliation approach, manpower requirements as well as including any special training instructions for employees participating in the counting.
6.  Reconciliation - This is the most important part of the entire exercise where in the physical count is reconciled with the inventory ledger. The resulting differences of this exercise should be enquired into and the same should be reflected in the records. The reason for such variance is determined and corrective actions are taken if needed so that the same issue is not faced in future.
7. Big value write-offs - must be signed off and approved by the designated authority, which can be decided prior to the starting of the verification exercise. Adjustment reports and a summary statement must be presented to either CFO, VP Finance or Board.
8. Reporting - An "Inventory Verification Report" summarizing the completer exercise including physical count and reconciliation activities is submitted to the Head office or designated authority of the entity or the auditor who has availed the required service. The same should be submitted as soon as the reconciliation  part of the exercise is over. Reporting also consists and discusses the following points:
- A brief outline of the actual exercise conducted, and any problems faced during the same.
- Reconciliation Summary including the adjustments made to the general ledgers, general ledger accounts reconciled, the adjustments made as a percentage of gross inventory, auditor comments.
- Summary of errors resulting in the physical inventory adjustments and corrective actions taken.
   This marks the ending of the entire Physical verification of Inventory cycle.
9. Granting specific exemptions - Some specific exemptions can be granted if the specific inventory is having the nature which cannot be readily counted or verified. Permission for such specific exemption must be taken from the designated head. Reasons for same and a disclosure of the items exempted must be given in the final report. The granting of specific exemptions is also to be reviewed and approved by the statutory Auditor.
Inventory Verification Checklist
The following areas must be kept in mind while conducting a Physical verification of Inventory audit. These are the various pre-conditions which are required in an inventory counting cycle, right up from physical counting and verification to reconciliation and reporting-
- Has the entity shared inventory ledger against which the actual findings will be compared?
- Has the agreement drawn up between the entity and Physical verification service provider detailing the entire scope of exercise, timelines and other details?
- Is any training schedule for employees of the entity required, who will be participating in the exercise?
- Is there any other acitivity planned during the time when inventory count will be taken up, so as to conflict with it?
- Has the management informed the divisional heads, branch managers on the verification exercise being taken up?
- Are there any guidelines provided for handling of dangerous inventory/ obsolete items?
- Is the cut-off date decided upon?
- Written procedure regarding conduction of verification.
- A designated person from the entity and from the service provider to smoothen out any issues arising during the exercise. Same should be a relatively senior executive.
- Counting methods to be used, any special considerations if any.
- Has the management indicated or procedures provide for any emergency movement of stock while the verificaiton exercise is being conducted?
- Is the handling of receivables/payables clear?
- Are the items not to be counted, such as leased items - clearly mentioned beforehand.
- Format of the inventory tags are pre decided, contain the requisite necessary information as desired by the entity management.
-  What are previous tag removal procedure, if any already stuck on the assets of the entity.
-  What are the procedures for turning in unused inventory tags? Is transferring of tags from one division/area/CGU to another permitted? If so, how is it controlled?
- How are all inventory tag numbers accounted for?
- If sampling test being done, then what are the parameters of deciding the smaple size and content.   
- How is the various inventory be valued?
- What should be the valuation procedure of Joint products & By products?
- What process is to be followed regarding scrap?
- Do the reconciliation procedures clearly indicate which inventory accounts are to be reconciled?
- What is the process of reporting variances?
- Ratios to be used to provide a better picture of reconciliation.
- Analytical comments to be given in reporting.
- Is it ensured that report submitted is presented to designated officials/ targetted management level and not obscured in between?
- Are the materiality levels predetermined?



Back to Top