STOCK AUDIT IN BANKS

Presented by,
CA . Rajkumar S. Adukia (M) 9323061049/9820061049 : rajkumarfca@gmail.com radukia@vsnl.com http://www.carajkumarradukia.com

Rajkumar.S.Adukia

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

Rajkumar.S.Adukia

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
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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.

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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

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Composition of NPA as on Public sector banks in 2006

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

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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

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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

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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 Auditors 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
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Scope of stock audit

1. 2. 3. 4. 5. 6. 7. Physical verification of stocks. Verification of condition of storage Valuation of stocks and pointing out variances Valuation of obsolete / non-moving stock. Age-wise categorization of stocks. Evaluation of the stock management by the Co. 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

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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.

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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

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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

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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 Auditors 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
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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

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RBI Notifications
A reference to the following circulars could be made: DBOD No. BP. BC. 15 / 21.04.048 / 2006-07dated July 1, 2006Master Circular on Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances RBI/2007/234 UBD.BPD (PCB) MC. No. 13 /13.05.000/200607dated January 22 , 2007-Master Circular on Management of Advances

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Conduct of stock audit

This can be discussed under
1.
2. 3. 4. 5.

Pre-commencement Understanding the entity Audit planning Substantive procedures Reporting

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Pre-commencement
1. 2. Obtain the engagement letter from the bank. 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

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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 borrowers office.

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Understanding the entity

This involves understanding /knowing : 1. the nature of business 2. the nature of goods, especially with regard to the storagewhether 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

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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

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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

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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 banks name board is prominently displayed The name of the official present at the time of audit
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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

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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

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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

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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 banks 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.

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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

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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

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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.
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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

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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

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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, redeposits, call/put options

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Deficiencies generally observed in cash-credits

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

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8. 9. 10. 11.

12.
13. 14.

15. 16.

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

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References

www.rbi.org.in

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Thank you

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