Stock Audit of Banks

© Rajkumar.S.Adukia 1
STOCK AUDIT IN BANKS
Presented by,
CA . Rajkumar S. Adukia
(M) 9323061049/9820061049
: rajkumarfca@gmail.com
radukia@vsnl.com
http://www.carajkumarradukia.com

Agenda
1. Meaning of stock
2. Bank lending and stock audit
3. Composition of NPA ON Public sector banks in 2005
4. Stock/receivables audit
5. Need for stock audit
6. Scope of stock audit
7. ICAI Pronouncements
8. Relevant Auditing and assurance standards
9. RBI Notifications

Agenda…
10. Conduct of stock audit
a) Pre-commencement
b) Understanding the entity
c) Audit planning
d) Substantive procedures
e) Reporting
11. Working papers
12. Analytical review
13. Internal control evaluation
14. Verification of securities
15. Deficiencies observed in cash-credit accounts
16. References

What is Stock?
Stock or Inventory means the assets:
 which are held for sale in the ordinary course of business;
 in the process of production for such sale; or
 in the form of material or supplies to be consumed in the
production of goods or services for sale
(As per AS 2)
These goods are normally stored in the warehouses, which are
generally located near the factory.

Bank lending and stock audit
A major part of working capital requirement of any unit would consist of
maintenance of inventory .Finance against such inventories by banks
is generally granted in the shape of cash credit facility where
drawings will be permitted against stocks of goods. It is a running
account facility where deposits and withdrawals are permitted
Stock audit acts as a warning signal to those accounts which are likely to
turn into NPA
Stock audit helps in prevention and early detection of frauds

Composition of NPA as on Public
sector banks in 2006
Data as on 31.03.06 Rs. in crores
Priority sector 21926
Non-priority sector 18072
Public sector 932
----------
Total 41378
----------
Source: off –site returns (domestic & Provisional ) of banks, Dept of
banking supervision, RBI

Stock or Receivables Audit
This involves:
1. verification and valuation of current assets, current liabilities and
loans and advances
2. checking for diversion of funds,
3. verifying application of funds,
4. verifying the accuracy of stock and book-debts statements,
5. arriving at the revised drawing power and
6. Any other matter connected with the credit administration

Need for stock audit
1. A stock audit is necessary to give an assurance regarding the
following:
 A suitable environment exists for preservation of stock
 A responsible person is safeguarding the stock
 Degraded stock have been written off
 Adequate safeguards exist against fire and natural calamities
 Physical stocks tally with the stock statements submitted to bank
 The pledged/hypothecated stock is realizable
 Stock is owned by the borrower
 All sanction terms have been adhered to
 Stocks are not stagnating and becoming obsolete

2. To investigate, wherever the party is not submitting periodic stock
statements regularly
3. To investigate, where the accounts have been marked as
substandard
4. To find out reasons when there are too many qualifying remarks
about stocks and receivables in the Auditor’s report on the
Balance Sheet of the borrower
5. To find out suspect dealing in lending procedure
6. Where there are too many qualifying remarks about stocks and
receivables in the auditors report on the balance sheet of a
borrower
7. reasons such as mismanagement, heavy losses, lockout, strikes
etc
8. To make the banks aware of their right of enforcement of the
security interest provided in the Securitization and
Reconstruction of Financial Assets and enforcement of Security
Interest Act, 2002.
9. to fulfill H.O requirement

Scope of stock audit
1. Physical verification of stocks.
2. Verification of condition of storage
3. Valuation of stocks and pointing out variances
4. Valuation of obsolete / non-moving stock.
5. Age-wise categorization of stocks.
6. Evaluation of the stock management by the Co.
7. Reconciliation of stock statements submitted with the accounting
records maintained by borrowers particularly, relating to
quantity, rate, value of inventories, age, marketability, etc.
8. Verification and evaluation of sundry creditors indicating
separately those relating to stock and their relationship with
bank finance

9. commenting upon the sources of the raw materials, i.e., whether
any credit is available for the material and which of the items are
available against cash payments
10. Age-wise and value-wise qualification of debtors
11. Determination of the drawing power.
12. Checking on adequacy of the insurance cover.
13. Verification of documents/ securities
14. Commenting upon the comparative Profitability and Inventory
ratio
15. Ensuring that the terms and conditions of limit sanctioned have
been complied
16. Verification of transactions with sister concerns, unsecured
Loans to Directors and others
17. Any other matters of interest to the bank.

ICAI Pronouncements
As there is no guidance note or standards prescribed for stock
audit, the auditors should conduct the audit based on the
generally accepted auditing practices and to the best of his
judgment and ability
A reference to the following pronouncements of ICAI could be
made
 Guidance note on Audit of Inventories,
 Guidance note on Audit of Debtors
 AS 2 Valuation of Inventories
 AS 9 Revenue Recognition

Relevant Auditing and Assurance
standards
These can be referred to in 5 stages
1. Pre-commencement
AAS-26-Terms of Audit Engagement
AAS 32-Engagements to perform Agreed upon
procedures regarding financial information
2. Understanding the entity
AAS 6-Risk Assessments and Internal control
AAS 20-Knowledge of the business
AAS 21-Consideration of Laws and Regulations in an
audit of financial statement
AAS 23-Related parties
AAS 24-Audit considerations relating to entities using service
organizations

AAS 29-Auditing in CIS environment
3. Audit planning
AAS 2-Objective and Scope of the audit of financial
statements
AAS 8-Audit Planning
AAS 12-Responsibility of joint auditors
AAS 15-Audit Sampling
AAS 16- Going concern
AAS17- Quality control for Audit work
4. Substantive procedures
AAS 1- Basic Principles Governing an Audit
AAS 3- Documentation
AAS 4- The Auditor’s responsibility to consider Fraud
and Error in an audit of financial statements
AAS 5-Audit Evidence
AAS 7- Relying upon the work of an Internal Auditor

AAS 9-Using the work of an expert
AAS 10-Using the work of another auditor
AAS 11-Representations by management
AAS 13- Audit materiality
AAS 14-Analytical procedures
AAS-19- Subsequent events
AAS 30-External confirmations
AAS 34- Subsequent events
5. Reporting
AAS 27-Communication of Audit matters

RBI Notifications
A reference to the following circulars could be made:
 DBOD No. BP. BC. 15 / 21.04.048 / 2006-07dated July 1, 2006-
Master Circular on Prudential norms on Income Recognition,
Asset Classification and Provisioning pertaining to Advances
 RBI/2007/234 UBD.BPD (PCB) MC. No. 13 /13.05.000/2006-
07dated January 22 , 2007-Master Circular on Management of
Advances

Conduct of stock audit
This can be discussed under
1. Pre-commencement
2. Understanding the entity
3. Audit planning
4. Substantive procedures
5. Reporting

Pre-commencement
1. Obtain the engagement letter from the bank.
2. Obtain, the relevant details of the borrower including:
a) Name of the unit and of the key persons
b) Address of both the registered office and
factory of the unit
c) Nature of business
d) Sanction terms and conditions
e) Bank Account No, banking facilities
enjoyed by the borrower

f) if the advance is a consortium lending, names of lead bank
and other banks and their participation
g)) last three months bank statements
h) last three months stock statements
i) latest inspection report of the account, Annual report or any
available audit reports
j) Insurance particulars
3. Get an appointment before visiting the borrower’s office.

Understanding the entity
This involves understanding /knowing :
1. the nature of business
2. the nature of goods, especially with regard to the storage-
whether stored at multiple locations, whether they are of
deteriorating nature etc
3. the processes involved in manufacture, production and
ascertaining whether any part of the work is to be sent out of
the entity for further processing
4. The key personnel involved in preparation and submission of
stock statements and financial statements to the bank

Audit planning
Planning should be based on:
1. Day and time of visit
2. Method of counting
3. Instructions to be given to employees
4. Provisions to be made for receipts of stock during the count,
segregation of stock not owned and physical arrangement of
stock
5. Location of stock

Substantive procedures
The procedures involved are:
1. In-house audit
2. Physical verification of stock
3. Valuation of stock
4. Verification of Debtors
5. Calculation of Drawing power
6. Checking adequacy of insurance coverage

In- house audit
 Ensure compliance to sanction terms
 Check documentation such as DPN, Agreement of hypothecation,
Letter of Acceptance, Continuity letter, etc
 Check whether prescribed particulars of charges as detailed in S
125(4) along with the instrument by which the charge is created
has been filed with the Registrar for registration within 30 days
after the date of its creation
 Check operation in account during last 6 months
 Check whether interest is being served in time and repayments are
regular
 Check whether stock statements are submitted on time
 Check whether party operates any other bank account and verify
for diversion of funds
 Check all statutory dues have been paid
 Check the sales and purchase invoices
 Scan through previous audit report, if available
 Check , if bank’s name board is prominently displayed
 The name of the official present at the time of audit

Physical Verification of stock
 Godown inspection with regard to its condition, location, rent
payments, maintenance etc
 Actual counting of stock – reconciliation with the book figures if
there is a difference,
 Check on record- keeping and verifiy purchase/ Sales
registers and Goods received note and Goods returned note.
 Check whether no-lien note has been obtained from
processors
 Confirmation of stock at public warehouse, in transit or sent on
consignment
 Check for unpaid stocks
 Age-wise analysis of stock and movement of stock
 Check for abnormal increase in stock

Valuation of stock
 Ascertain Accounting policy adopted for valuation
 Cost of inventory should not include:
 Abnormal waste
 Storage cost if not part of manufacturing process
 Administrative overheads not contributing to bringing inventory to
present location
 Selling and distribution expenses
 Check for arithmetical accuracy
 Check that the cost of obsolete and damaged items are written off
 Check for consistency in basis of valuation
 Cut-off procedures at year-end are followed

Verification of debtors
 An analysis of sundry debtors ledger and sales register
 Age-wise classification of debtors
 Bad and doubtful debts should be excluded from drawing power
calculations
 The age of book-debts should not be more than stipulated sanction
terms
 All realizations from debtors should be routed through the borrowal
account
 Sale to sister concerns/ related parties to be scrutinized
 A check on few invoices/Gate passes to ensure actual movement
of goods
 Confirmation of balances from certain parties
 Check for debit balances in debtors account

Drawing power calculation
 Ensure margin requirements as per sanction terms are
considered
 Check for arithmetical accuracy
 Check that old and obsolete stocks are excluded
 Check that debtors greater than 90 days are excluded
 Check that the statement is submitted as per bank’s format only
 Drawing power is required to be arrived at based on the stock
statement which is current.
 The outstanding in the account based on drawing power
calculated from stock statements older than three months, would
be deemed as irregular
 The account will become NPA if such irregular drawings are
permitted in the account for a continuous period of 90 days even
though the unit may be working or the borrower's financial
position is satisfactory.

Insurance coverage
 Check whether the stock hypothecated is adequately insured
 Check whether the policy is in force
 Check whether stocks with third parties are also covered
 Check whether bank clause is included in the policy
 Check whether the stock is covered against all major perils
 Check whether the collateral security is also insured adequately

Reporting
1. The report has to be submitted to the authority appointing the
auditor .
2. It should be in the prescribed format and should be exhaustive
and inclusive of all facts and summaries
3. It should include the date, time, location of visit and the name of
the officials conducting the audit and the official of the entity
present at the entity at the time of conducting the audit
4. Copies of confirmations, management representations, etc
should be submitted along with the report

Working papers
 Sanction letter
 Stock and book-debts statements for last 3 months
 Bank statements for last 3 months
 A certified copy of the constitution of entity- partnership deed,
Memorandum and Articles of Association, etc.
 Financial statements for the last 3 years
 Copy of insurance policy in force
 Comprehensive management representation letter
 Organization chart of the entity
 Flow chart for the actual manufacturing process
 A copy of agreement ownership/rent agreement of office/
godown
 In case of a company, the following copies (i) a copy of form
No.18 along with filing fees receipt for registered office address
(ii) A copy of form no 32 along with filing fees receipt for
directors. (iii) A copy of form No. 8 & 13 along with filing fees
receipt & charge registration certificate (iv) A copy of Form No.8
& 17 along with filing fees receipt & certificate for registration of
charge and balance sheet.

Analytical review
certain analytical procedures have to be carried out to review the
financial soundness of the business of the borrower including:
 Check records of opening stock, purchases, production, sales and
closing stock
 Compare closing stock with those of previous year quantity
 Compare composition of closing stock with the previous year
 Compare the current year Gross Profit with that of last year
 Compare actual stock with budgeted figures
 Compare inventory ratios with those of the industry and firms

Internal control evaluation
1. On Stock
 Whether persons involved in stock taking differ from those
responsible for store-keeping
 Whether store procedures provide for the use of pre-numbered
forms
 Whether a system of cross-checking exists for checking data
generated by different departments
 Whether controls exists for receipts and issues of stores
2. On Debtors
 Whether basis for fixing credit limits are clearly laid down
 Whether debts and realizations are recorded promptly and
receipts are linked with outstanding

Verification of securities
SCOPE OF AUDIT:
1. To verify physically the certificates of the securities held by the
Branch.
2. To see that the registers for the securities held physically are
maintained properly.
3. To verify that securities held by the branch are tallying with
Security Holding Register.
4. To obtain the statement showing the securities sent for demat and
cross tally with the records maintained in the register.
5. To check Vault and other registers with the Stock Holding Register
to see the reconciliation between physically verified scrips and
total investments made by the Bank. This scrutiny will reveal
major queries relating to demat, redemption, withdrawals, re-
deposits, call/put options

Deficiencies generally
observed in cash-credits
1. Stock / Book Debts / QIS statements not furnished in time.
2. Stock Statement received from Borrower filed in a routine way
without scrutiny. Non moving stock not identified.
3. Age wise analysis of Debtors not done. Debtors more than 90
days considered for D.P.
4. D.P. not correctly calculated.
5. Inadequate insurance, insurance not available, Policy without
Bank Clause/coverage of all risk.
6. Operations in the accounts not scrutinized with reference to
projections, QIS statements, audited accounts etc.
7. In case of consortium advances account is not monitored in
close coordination with the member bank

8. Physical verification of assets and stock not done as per
stipulation. Defects pointed out by the Inspectors are
neglected..
9. Valuation of stock not verified.
10. Confirmation for stock with third party not obtained or physical
verification of Stock not done.
11. Material received from third parties for job work not excluded
while calculating D.P.
12. Diversion of funds and inter account transfers are not properly
monitored.
13. Accounts not reviewed/renewed at regular interval.
14. Monitoring of account where sub-limit is transferred to
branches.
15. Borrower having operations with other bank.
16. To cover the valuation of security, revaluation of assets done
which may not be genuine.

References
www.rbi.org.in

Thank you

Stock Audit of Banks

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