## Audit of Inventory – Valuation

Inventory valuation is audited separately for three categories, each with distinct cost elements and AS 2 requirements.

### AS 2 Rule

Inventory must be valued at lower of cost or NRV (Net Realisable Value).

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### A. Raw Materials

Step	What to Do
1	Identify which elements of cost are included
2	Test-check cost prices against purchase invoices received during the month
3	Follow up valuation of damaged / obsolete items by establishing NRV

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### B. Work-in-Progress (WIP)

Step	What to Do
1	Ensure correct cost elements are included
2	Material cost should exclude abnormal wastage
3	Ascertain how various stages of production are measured

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### C. Finished Goods

Step	What to Do
1	Verify AS 2 valuation – lower of cost or NRV
2	Enquire what costs are included in finished goods value
3	Examine valuation of obsolete and damaged inventory

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### Additional Procedures (All Categories)

Obtain Inventory Ageing Report and follow up on damaged / obsolete items observed during physical counting.
Calculate replacement cost and examine vendor price lists to determine current market price; if recorded cost > current market price → verify AS 2 compliance.
Goods on Consignment: Segregate consignment goods from own inventory.
Tagged Inventory: Perform tests for omitted transactions.
Verify clerical and arithmetical accuracy of inventory listings.
Calculate Inventory Turnover Ratio – a very low ratio indicates possible obsolete inventory.
For WIP: AS 2 guideline – only Direct Material, Direct Labour, and Direct Overheads are included.

Worked example

### Example 1

Example – Obsolete Raw Material: Company A holds raw material with recorded cost ₹500/unit. Current market price (from vendor price list) is ₹350/unit. Auditor step: recorded cost (₹500) > current market price (₹350) → verify NRV, check AS 2 compliance, ensure inventory is written down to ₹350/unit.

Journal Entry to record write-down:

Dr. Loss on Inventory Write-down ₹150/unit

Cr. Inventory ₹150/unit

### Example 2

Example – WIP with Abnormal Wastage: A manufacturing company includes ₹2,00,000 of abnormal wastage in WIP cost. Auditor procedure: AS 2 requires abnormal wastage to be excluded from cost and expensed immediately. Auditor flags this as a misstatement and recommends adjustment:

Dr. Abnormal Loss A/c ₹2,00,000

Cr. WIP A/c ₹2,00,000

### Example 3

Example – Inventory Turnover Ratio Analysis: Finished goods balance = ₹50 lakhs; Cost of goods sold = ₹60 lakhs. Inventory Turnover = 60/50 = 1.2 times. Industry average = 6 times. Very low ratio → strong indicator of obsolete inventory → auditor must obtain ageing report and assess NRV.

⚠️ Common exam mistakes

Including abnormal wastage in WIP cost – this violates AS 2 which requires abnormal costs to be expensed in the period they arise.
Valuing finished goods at cost alone without checking if NRV is lower – AS 2 mandates lower of cost or NRV.
Failing to segregate goods held on consignment from the entity's own inventory – consignment goods should NOT appear in the entity's inventory.
Not following up on tagged or physically identified damaged items during counting – these require NRV testing.
Including selling and distribution overheads in inventory cost – only production-related costs qualify under AS 2.

Bare-Act text Para 9 · AS 2 – Valuation of Inventories (ICAI) · click to expand

Inventories shall be measured at the lower of cost and net realisable value.

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