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Home » » Companies (Auditor's Report)(Amendment) Order, 2004 - Clause 4(ii)(b)

Companies (Auditor's Report)(Amendment) Order, 2004 - Clause 4(ii)(b)

Written By Admin on Sunday, 1 April 2012 | Sunday, April 01, 2012

Clause 4(ii)(b)

are the procedures of physical verification of inventory followed by the management reasonable and adequate in relation to the size of the company and the nature of its business. If not, the inadequacies in such procedures should be reported.

1) This clause 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. The term “inventory” should be construed to have the same meaning as assigned to it in Accounting Standard (AS) 2, “Valuation of Inventories”.

2) 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. 

3) 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. 

4) Normally, before commencement of verification, the management should issue appropriate instructions to stock-taking 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 in forming 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. 

5) 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 stock-taking. 

6) 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. 

7) 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:

(i) maintains adequate stock records that are kept up-to-date;

(ii)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

(iii) investigates and corrects all material differences between the book records and the physical counts.

8) The auditor should determine whether the procedures for identifying damaged and obsolete items of inventory operate properly.

9) 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:  

(i) written instructions given by the management to the concerned staff engaged in the verification process;

(ii) physical verification inventory sheets duly authenticated by the field staff and responsible officials of the company;

(iii) summary sheets/consolidation sheets duly authenticated by the responsible officials;
(iv) internal memos etc., with respect to the issues arising out of physical verification of inventory;
(v) any other relevant documents evidencing physical verification of inventory.

10) 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.

11) 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. 

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