## Auditing Inventories: Obsolete and Damaged Items

Inventory must be valued at the lower of cost and net realisable value (NRV). Obsolete, damaged, or slow-moving inventory will often have NRV below cost — requiring write-down. The auditor must identify such items and verify correct valuation.

### How to Identify Problem Inventory

During physical stock observation, the auditor should flag items noted as:

Damaged
Obsolete (discontinued models, superseded technology)
Slow-moving (sitting on shelves for extended periods)

### Audit Procedures for Valuation

Procedure	Purpose
Request inventory ageing analysis from client	Identify slow-moving/stagnant items
Compare recorded cost vs replacement cost	Check for NRV < cost
Examine vendor price lists	Confirm current market prices
Calculate inventory turnover ratio	Low ratio signals potential obsolescence
In manufacturing: test overhead allocation rates	Ensure only direct labour, direct material, and overhead included
Verify application of lower of cost or NRV principle	Confirm correct write-down where NRV < cost

### The Lower of Cost or NRV Rule

If NRV < Cost → write down to NRV (recognise loss immediately)
If NRV > Cost → carry at cost (do not write UP)
The write-down is not optional — it is mandatory per AS 2

### Inventory Turnover Ratio

```

Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

```

A significantly low ratio suggests inventory is not selling — a red flag for obsolescence.

Worked example

### Example 1

Q: CA Mukund observes during physical counting that a large quantity of electronic parts (stagnant for 2+ years, some damaged, some discontinued) is included in HST Ltd.'s inventory at cost. What should he do?

A: CA Mukund should: (1) Request an inventory ageing report from management to quantify the stagnant stock, (2) Follow up on all items flagged during physical counting as damaged or obsolete, (3) Obtain the best estimate of NRV for these items (vendor price lists, market quotes, scrap value for damaged goods), (4) Compare NRV to recorded cost — if NRV is lower, the inventory must be written down to NRV, (5) Calculate the inventory turnover ratio to assess the broader extent of slow-moving stock, (6) Ensure overhead allocation rates include only permissible costs (direct labour, direct material, overhead), (7) Verify that the write-down is reflected in the financial statements.

⚠️ Common exam mistakes

Applying lower of cost or NRV only to damaged goods — it must be applied to ALL inventory including slow-moving and obsolete items
Forgetting to calculate inventory turnover ratio as an analytical procedure — it is the most efficient way to identify broad obsolescence risk
Including abnormal wastage in cost of inventory — abnormal wastage must be excluded and expensed to P&L
Confusing replacement cost (buying price today) with NRV (estimated selling price minus completion costs) — they serve different purposes

Reference:

Now that you've read this — what's next?

Move from understanding → mastery in 3 clicks. Each option below picks up from this lesson's topic.

🔥 Drill 5 Qs on this → ✍️ Adaptive practice →

Auditing Inventories – Obsolete and Damaged Items

Worked example

⚠️ Common exam mistakes