The Hindu Business Line : Valuation of stocks

What are proper books of account regarding inventories is not spelt out anywhere. The I-T Act also has cast a responsibility upon the tax auditor in respect of stocks-in-trade.

The degree of the auditor's risk depends on the extent of checks he has subjected the certificate issued by the management

Valuation of closing stocks has always been a dicey proposition. General accounting principles state that closing stock should be valued at cost or market value, whichever is lower. Accounting Standard 2, on valuation of inventories, explains the concept of net realisable value. It is defined as market value minus any additional expenditure necessarily to be incurred to sell the goods. What is cost and how it is determined is dealt with at length in AS-2. Similarly, the Income-Tax Act has also issued AS IT, on valuation of closing stocks. This AS, issued by the I-T Department, is at variance with that issued by the ICAI.

Significantly, while AS-2 of the ICAI requires that duty drawbacks, Cenvat credit, etc., be excluded from the value of closing stock, AS IT requires closing stocks to be valued inclusive of these items and to mention the VAT credits as a separate item. Non-compliance with AS-2 would vitiate the true and fair view of the financial statements. The same values cannot be adapted for income-tax purposes since it would amount to non-compliance with the AS issued by the income tax department. Necessarily, adjustments have to be made to the value of closing stocks as shown in the balance sheet to make them acceptable to the tax authorities.

AS-2 vs AS-16

A study of AS-2 and AS-16 together makes interesting reading. Paragraph 12 of AS-2 states interests and other borrowing costs are not to be related for bringing the inventories to their present location and condition and, therefore, are usually excluded from the cost of inventories. AS-16, on borrowing costs, requires such costs to be capitalised in the case of qualifying assets. In paragraph 5 of AS-16, inventories that require a substantial period of time to bringing them to a saleable condition has been included in examples of qualifying assets. These two provisions do not seem to be in sync with each other.

A question arises whether a builder enjoying credit facilities can include the interest on borrowings as a part of the cost of the flat. Apartment blocks, being stock-in-trade, qualify to be inventories for the builder. It takes a long time for him to bring the inventories to a saleable condition. Based on this, the inventories become a qualifying asset as per AS-16.

But AS-2 (paragraph 12) gives a different version and prohibits inclusion of interests in the cost of inventories. As on the balance-sheet date, if a few of the flats in an apartment block remain unsold, whether to include the interest in the value of the flat or not becomes an interesting situation. Top up the situation with the pronouncements in AS-7, and the circle is complete. Valuation of stock of a trading concern is a lesser problem compared to that of a manufacturing concern.

Auditor's responsibility for stock-in-trade

An auditor is an expert in accounting and auditing. He cannot be expected to be a specialist in the field of valuation of stocks. He is entitled to secure the services of an expert in the matter (AAS 9). It was held in the well-known Kingston Cotton Mills case that the auditor is responsible for verification of stocks. But depending upon the nature of business and its size, often the auditors obtain a management representation regarding valuation of stocks. While relying upon the certificate issued by the management, the auditor should consider the basis upon which such a certificate was issued by the management. Such a certificate should be subjected to such further checks as the auditor may deem fit.

If the auditor is satisfied about the valuation after exercising due care and diligence, he is justified in accepting the values as certified by the management. While accepting such a certificate, the auditor should satisfy himself that the requirements of AS-2 have been complied with. He should consider whether the entity has a good costing system. If there are good internal controls and costing systems, the auditor can rely on the certificate issued by the management.

In such circumstances, where the auditor relies upon a certificate of the management, it is advisable that he issues a disclaimer in the audit report. The degree of the auditor's risk depends on the extent of further checks he has subjected the certificate issued by the management. The auditor cannot be absolved of his responsibility merely by saying that he has relied upon a certificate issued by the management.

The Kingston case is a landmark judgement on the liability of an auditor for verification of assets, including stock-in-trade. Though it is a judgement in a British case, its applicability in India is not in doubt. Many of such judgments are adapted in our company law, as in the Lubbock case in the matter of payments of dividends out of capital profits.

Considering the responsibility of auditors regarding inventories, the Auditing and Assurance Standards and the Accounting Standards issued by the ICAI, the matter is set to rest and the auditor cannot escape responsibility. In fact, the responsibility of the auditor regarding stocks is wider in Indian circumstances than what was stated in the Kingston case of 1896, which is over a century old. Therefore, it can be said that the decision in the Kingston case is not applicable in India not because it is a British case but because the pronouncements of the ICAI are far wider than the judgment.

Legal compulsions

Considerable exercise is to be done in respect of stock-in-trade to comply with law. Company law requires the board of directors to state quantitative details of stocks being opening stocks, purchases, sales/issues to production, closing stock, etc. CARO requires the auditor to state in his report:

Whether physical verification is done at reasonable intervals by the management.

Are the procedures followed for physical verification adequate and commensurate with the size of the business, if not, the inadequacies are to be reported.

Whether the company is maintaining proper books of accounts regarding inventories and are the discrepancies noticed during physical verification properly dealt with in the books of accounts.

Whether the method of valuation of stock has been the same as in the earlier year.

This casts a responsibility upon the auditor to ensure that stocks have been properly stated in the financial statements. The auditor should document the verification procedures followed by the company. He would do well to obtain a management representation to that effect, supported by factual evidence to ensure that there has been actual verification of stocks carried out.

The auditor is caught in a fix where he has to state whether, in his opinion, the procedures followed for such physical verification are adequate and commensurate with the nature and size of business. Any inadequacies noticed should also be reported by the auditor. Company law prescribed fixed assets register to be one of the statutory books but not stock registers. There is no legal requirement for a company to maintain a stock register, unless maintenance of cost records is prescribed for the industry. But CARO seems to suggest that stock registers shall be maintained by a company.

What are the consequences if an auditor reports that the company is not maintaining proper books of account regarding inventories is anybody's guess. What are proper books of account regarding inventories is not spelt out anywhere. The I-T Act also has cast a responsibility upon the tax auditor in respect of stocks-in-trade.

Form 3 CD, the annexure to tax audit report, also requires considerable details to be given in respect of stock-in-trade.

All the information cannot be obtained unless stock records are properly maintained. Compliance with the Accounting Standards of ICAI, AS of I-T Department, compliance with the requirements of CARO are all of material importance and the auditor has to do a tightrope walk.

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