Audit objective
Verify that inventory recorded in the books exists, is owned by the entity, is valued at the lower of cost and net realisable value per IND AS 2, and is presented and disclosed per Schedule III. Inventory audits combine three distinct skills: physical observation, costing methodology review, and obsolescence judgement, each with its own risk profile and procedure set.
Relevant framework
- IND AS 2 · Inventories · cost determination (FIFO / weighted average, never LIFO), net realisable value, write-down and reversal
- AS 2 · Valuation of Inventories for non-IND AS entities, broadly aligned
- IND AS 36 · Impairment, where inventory write-downs interact with broader asset impairment assessments
- IND AS 16 · Borrowing costs not capitalised to inventory unless it qualifies as a qualifying asset (long production period)
- Section 129 · True and fair view requirement
- Schedule III Div I & II · Inventory classified into raw material, WIP, finished goods, stock-in-trade, stores and spares, loose tools, goods-in-transit
- Mode of valuation to be stated as an accounting policy disclosure
- 3(ii)(a) · Whether physical verification of inventory has been conducted at reasonable intervals by the management; whether discrepancies of 10% or more in aggregate for each class of inventory were noticed, and if so, whether properly dealt with in the books
- 3(ii)(b) · Whether the Company has been sanctioned working capital limits in excess of Rs. 5 crore from banks/financial institutions on the basis of security of current assets; whether quarterly returns/statements filed with such banks are in agreement with the books of account; if not, give details
- SA 230 · Audit Documentation
- SA 315 · Identifying and Assessing Risks of Material Misstatement
- SA 330 · Auditor's Responses to Assessed Risks
- SA 500 · Audit Evidence
- SA 501 · Audit Evidence, Specific Considerations · attendance at physical inventory counting is an explicit requirement where inventory is material, including alternative procedures if attendance is impracticable
- SA 520 · Analytical Procedures · inventory turnover, gross margin analysis
- SA 530 · Audit Sampling, for test counts during physical verification
- SA 540 · Auditing Accounting Estimates · NRV, obsolescence provisioning, standard cost variances
- Section 145A · Inventory valuation for tax purposes to include the amount of tax, duty, cess, or fee actually paid or incurred (inclusive method), may create a book-tax difference from IND AS 2 exclusive method
- ICDS II · Valuation of Inventories for computation of business income, cost formulas largely aligned with IND AS 2 but with specific carve-outs (e.g. no LIFO, dissolution of partnership treatment)
- Section 17(5)(h) · Blocked credit on goods lost, stolen, destroyed, written off, or disposed of by way of gift or free samples; ITC originally availed must be reversed
- Rule 42 / 43 · ITC reversal mechanics for inputs and capital goods used partly for exempt supplies
- Stock write-off in books should trigger a GST ITC reversal working, frequently missed in practice
- Guidance Note on Audit of Inventories · ICAI AASB
- Technical Guide on Physical Verification of Inventory
Cost vs NRV
IND AS 2 requires inventory to be carried at the lower of cost and net realisable value, item-by-item or by group of similar items, not on an aggregate portfolio basis. This single rule generates a large share of inventory audit findings when applied at too high a level of aggregation.
What goes into cost
- Purchase price, net of trade discounts and rebates
- Import duties and non-recoverable taxes
- Freight inwards and handling directly attributable to acquisition
- Conversion costs: direct labour, fixed and variable production overheads allocated on normal capacity
- Other costs to bring inventory to present location and condition
What NRV actually means
- Estimated selling price in the ordinary course of business
- Less estimated costs of completion (for WIP/raw material)
- Less estimated costs necessary to make the sale (selling, distribution)
- Assessed at each item or group level, not on a blended/average basis
- Raw material NRV write-down only triggered if finished product NRV is below cost
Slow-moving & obsolescence
This is the single most-missed estimate in inventory audits, because it requires judgement rather than a mechanical recompute. Build the working from an inventory ageing report, not from management's narrative alone.
The four inputs that should support every provision number
System-generated ageing by SKU: 0-6 months, 6-12 months, 1-2 years, 2+ years since last movement
Consumption/sales velocity for each SKU over the last 12-24 months, not just the closing snapshot
Engineering or product team input on discontinued models, superseded specifications, regulatory changes
Recent sale prices of similar slow-moving stock, scrap quotations, or management's realistic disposal estimate
A provision computed purely as "X% of stock older than Y months" without items 2-4 above is a red flag, not an audit-ready estimate. Push for the underlying ageing-by-SKU report every time.
Risk areas by assertion
Risks below are mapped to financial statement assertions per SA 315. Valuation is typically the dominant risk for inventory, driven by costing judgement and obsolescence estimation rather than simple arithmetic error.
Existence
- Stock recorded in books not physically present at the verification date
- Goods at third-party locations (job-work, consignment) not confirmed
- Stock-in-transit recorded without supporting transport documentation
- Phantom inventory created to inflate current assets / working capital limits
Completeness
- Goods received but not yet recorded in stock ledger (GRN lag)
- Goods sent for job-work not tracked back into inventory records
- Returned goods from customers not recorded back into stock
Valuation / Accuracy Dominant
- Costing method inconsistent with policy or applied inconsistently across periods
- Overhead absorption based on less-than-normal capacity, inflating unit cost
- NRV assessed at portfolio level rather than item/group level
- Obsolescence provision computed mechanically without ageing-by-SKU support
- Standard cost variances not allocated between inventory and COGS
- By-products / scrap not valued or valued inconsistently
Rights & Obligations
- Consignment stock held on behalf of others included in own inventory
- Goods sold but not yet dispatched (bill-and-hold) still counted as own stock when control has passed
- Inventory pledged as security for borrowings not disclosed
Cut-off
- Purchases recorded before goods physically received (or vice versa)
- Sales recorded with inventory not removed from stock records at year-end
- Goods-in-transit at year-end inconsistently included/excluded between purchase and inventory records
Presentation & Disclosure
- Inventory categories (raw material, WIP, finished goods) not separately disclosed
- Mode of valuation policy not disclosed or inconsistent with actual practice
- Pledged inventory (against working capital limits) not disclosed
- CARO 3(ii)(b) quarterly return reconciliation not performed or not disclosed where material variance exists
Documents to request
Hand this to the client at the start of the engagement, and request item 13 (bank quarterly returns) early since reconciling it takes time.
- Stock ledger / inventory register, SKU-wise with quantity and value
- Physical verification plan and management's count instructions
- Physical verification report with reconciliation to book stock, discrepancies noted
- Costing policy document, with overhead absorption basis and normal capacity assumption
- Standard cost card / Bill of Materials for sample products
- Standard cost variance report (material, labour, overhead) for the year
- Inventory ageing report, SKU-wise, by last movement date
- Obsolescence / slow-moving provision working with basis of estimation
- Scrap and by-product valuation and sales record
- Stock lying with third parties (job-workers, consignees) confirmation
- Goods-in-transit listing at year-end, with purchase/sales invoice cross-reference
- Stock pledged / hypothecated against borrowings, with lender confirmation
- Quarterly stock statements / returns filed with banks under working capital facility (CARO 3(ii)(b))
- Bank sanction letter for working capital limits, to verify the Rs. 5 crore CARO threshold
- GST stock write-off and ITC reversal working for the year
- Insurance policy covering inventory, with insured value
- Stock audit report (if conducted by bank-appointed stock auditor)
- Production and consumption statement (raw material to finished goods reconciliation)
Fieldwork procedures
Procedures are grouped by assertion. Attendance at physical verification per SA 501 should be planned well before year-end, not treated as an afterthought.
- Attend physical inventory count (year-end or cyclical, per the Company's verification policy); observe management's count procedures and perform independent test counts on a sample basis
- Trace test counts both ways: floor-to-sheet (completeness of count) and sheet-to-floor (existence)
- Where attendance is impracticable, perform alternative procedures: review of subsequent sales of items counted, or roll-forward/roll-back from an interim count
- For stock held with third parties, obtain confirmations and consider attending their physical count where material
- For goods-in-transit, verify against transporter documents and subsequent receipt records
- Reconcile GRN register to stock ledger; investigate goods received but not recorded
- Verify goods sent for job-work are tracked in a separate ledger and reconciled periodically
- Trace sales returns to stock ledger to confirm reinstatement
- Vouch a sample of purchase costs to invoices; verify freight, duty, and directly attributable costs are included per IND AS 2
- Recompute overhead absorption rate; verify it is based on normal production capacity, not actual (which may be abnormally low or high)
- Test NRV at item/group level: compare cost to estimated selling price less costs to complete and sell, for a sample including slow-moving items
- Obtain and challenge the obsolescence provision working: verify it is based on ageing-by-SKU, movement history, and technical input, not a flat percentage
- Recompute standard cost variances and verify appropriate allocation between inventory and cost of goods sold (not all variance should hit P&L if inventory levels are significant)
- Verify by-products and scrap are valued consistently with policy and NRV principles
- Verify consignment stock held on behalf of others is excluded from owned inventory
- For bill-and-hold sales, verify transfer-of-control criteria are met before excluding from inventory
- Verify pledged/hypothecated inventory against working capital borrowings is correctly disclosed
- For a sample of purchases around year-end, verify GRN date determines the correct period for both inventory and payables
- For a sample of sales around year-end, verify stock is removed from records only when control has transferred to the customer
- Verify goods-in-transit at year-end are consistently treated between the buyer's and seller's books (where information available)
- Verify inventory categories are separately disclosed per Schedule III
- Verify the valuation policy disclosed matches actual costing practice observed during fieldwork
- For CARO 3(ii)(a), verify management's physical verification intervals are reasonable and the 10% discrepancy threshold is correctly assessed per class of inventory
- For CARO 3(ii)(b), where working capital limits exceed Rs. 5 crore, reconcile quarterly stock statements filed with the bank to the books; document and report variances
- Verify pledged inventory is disclosed as security against borrowings in the relevant note
Common findings and red flags
The most common observations encountered in Inventory fieldwork. Each line is a working-paper trigger.
Sample conclusion language
Use these as starting drafts. Adapt to engagement-specific facts and your firm's house style. All language is illustrative.
"Based on our procedures, which included attendance at physical inventory counting, independent test counts on a sample basis, recomputation of net realisable value at the item level, review of the obsolescence provision methodology, and reconciliation of quarterly stock statements filed with the Company's bankers to the books of account, the inventory as at 31 Mar XXXX is stated at the lower of cost and net realisable value in accordance with IND AS 2 and presented in accordance with Schedule III to the Companies Act, 2013. No material misstatement was noted."
"As reported under CARO 2020 Clause 3(ii)(b), the quarterly statements of current assets filed by the Company with [Bank Name] in support of the working capital limits sanctioned were not in agreement with the books of account, with a variance of Rs. XX lakhs in inventory value reported for the quarter ended [date]. This is a CARO reporting matter."
"We noted that inventory items aggregating to Rs. XX lakhs have shown no consumption or sales movement for a period exceeding 24 months. Management's obsolescence provision of Rs. YY lakhs does not appear to adequately reflect the realisable value of these items based on our review of recent disposal transactions for similar stock. We have recommended management revisit the provision methodology. [Assess materiality for opinion impact.]"
"During our review, we noted that the Company's perpetual inventory system reflects negative stock balances for [N] SKUs as at the year-end, indicating that goods issues are being recorded ahead of corresponding goods receipts in certain instances. We have recommended that the Company strengthen sequencing controls between the GRN and issue processes to prevent negative stock positions."
Linked AuditAIKit tools
Three-Way Match
Vouch inventory purchases where PO, GRN, and Invoice can be reconciled, supports the costing and completeness procedures above.
Live · SA 530 CompliantAudit Sampling Engine
Select test count samples for physical verification attendance and NRV testing samples.
PlannedInventory Ageing & NRV Analyzer
SKU-level ageing buckets, automated NRV flagging, obsolescence provision adequacy testing against movement history.
Sources & references
Every reference in this playbook traces to an official source. Open the link to verify the exact wording in force as at the last review date.
| Reference | Source | Link |
|---|---|---|
| Companies Act, 2013 · Sec 129, Sch III | MCA | mca.gov.in |
| IND AS 2 / 36 / 16 | ICAI / MCA notification | icai.org |
| CARO 2020 Order · 25 Feb 2020 | MCA | mca.gov.in |
| SA 230, 315, 330, 500, 501, 520, 530, 540 | ICAI AASB | icai.org |
| Guidance Note on Audit of Inventories | ICAI AASB | icai.org |
| Income Tax Act · Sec 145A; ICDS II | Income Tax Dept | incometax.gov.in |
| CGST Act · Sec 17(5)(h); Rule 42, 43 | CBIC | cbic.gov.in |