Inventory valuation audit: FIFO, weighted average and cost testing

An inventory valuation audit tests three things: that the cost formula actually applied by the accounting system matches the one disclosed in the notes (FIFO or weighted average, not both inconsistently), that inventory is carried at the lower of cost and net realizable value with NRV genuinely tested rather than assumed, and that overhead absorbed into manufactured goods reflects normal capacity rather than distorting cost through under- or over-absorption. Each of these needs independent recomputation, not acceptance of the client's stated policy.

Cost formulas under AS 2 and Ind AS 2

Both AS 2 and Ind AS 2 permit FIFO or weighted average cost, require the same formula to be used for all inventories having a similar nature and use to the entity, and require specific identification for items that are not ordinarily interchangeable. The standards themselves are not where valuation audits go wrong — the gap is almost always between the policy stated in the notes and what the accounting system was actually configured to compute.

1. 01Confirm the disclosed policyRead the significant accounting policies note and note the stated cost formula for each category of inventory — raw material, WIP, finished goods, stores and spares often differ.
2. 02Pull the system's actual costing configurationIn Tally this is the valuation method set at the stock group or stock item level. In an ERP it is a costing method field on the item master. Get this for a sample spanning multiple item groups and locations, not just the group the client points you to.
3. 03Recompute cost for a sample of high-value itemsTake the opening quantity and cost, every receipt with its rate, and the closing quantity, and independently build the FIFO or weighted average layer to arrive at closing cost. Compare to the system's figure.
4. 04Investigate every mismatch between recomputed and system costA small rounding difference is not the same as a different formula being applied. If the system figure matches neither FIFO nor weighted average cleanly, ask what it is actually computing — sometimes it is a moving average recalculated at every transaction, which is a variant of weighted average but behaves differently with volatile purchase prices.

Net realizable value testing

The lower-of-cost-and-NRV rule is simple to state and is the step most often skipped in practice, because most items never need a write-down and it is tempting to assume none do. NRV has to be tested, item by item or by category, not assumed to exceed cost because it did last year.

• For finished goods, compare cost to actual selling prices achieved after the year end, net of estimated selling costs. Post-year-end sales invoices are the best evidence available at the time of the audit.
• For raw materials, NRV is normally assessed by reference to the NRV of the finished products they go into, not the raw material's own resale value — a material does not need a write-down just because its replacement cost has fallen, if the finished product it goes into still sells above total cost.
• For items with no post-year-end sales (slow-moving stock, by definition), NRV testing converges with the ageing and obsolescence review — handle them together rather than running two separate analyses that reach different conclusions on the same SKUs.
• Watch for a write-down applied at a blanket percentage across a category rather than assessed per item or sub-category — a round-number provision is a sign NRV was estimated, not tested.

Overhead absorption in manufacturing cost

For a manufacturer, the cost of finished goods and WIP includes an allocation of production overheads, and this is where valuation testing intersects with costing judgment. Fixed production overhead is meant to be absorbed based on normal capacity; allocating it based on actual output in a low-production year inflates unit cost and can misstate the inventory figure precisely when the business is under pressure.

1. 01Identify the absorption basis usedMachine hours, labour hours, or a percentage of direct cost. Confirm this matches what is disclosed, if disclosed, and is applied consistently across the year rather than changed mid-year to smooth a result.
2. 02Establish what 'normal capacity' means for this clientNormal capacity is the production expected to be achieved on average over a number of periods under normal circumstances, not the capacity the factory ran at this particular year, and especially not a shutdown-affected year.
3. 03Test for under- or over-absorptionCompare overhead actually incurred to overhead absorbed into production during the year. A large under-absorption that has been added back into inventory cost rather than expensed is a valuation overstatement; standards generally require unabsorbed fixed overhead arising from abnormally low production to be expensed rather than inventoried.
4. 04Recompute unit cost for a sample of finished goodsMaterial, labour and overhead per unit, built up independently, compared to the standard or actual cost the valuation sheet shows for that item.