The balance sheet looked strong. Closing stock was growing, gross margins were healthy and the stock statement matched the books. Yet the finance team was always short of cash and the bank limit was fully drawn. The question that changed the review was simple: why is working capital always under pressure if the business is profitable? The answer sat in the warehouse: slow-moving and obsolete stock that was valued correctly on paper but could not be sold at that value. This article explains how internal audit should review inventory, what controls to test, how to spot dead stock and how to release the cash locked inside it.
An inventory internal audit checks that stock exists, is recorded accurately and is valued at the lower of cost and net realisable value. The key test is an ageing analysis by item, compared with recent consumption or sales, to identify slow-moving and obsolete stock. Controls to test include physical verification, provisioning policy, purchase planning and periodic management review of non-moving items.
Why inventory can look profitable while cash goes missing
Inventory is valued at cost unless there is evidence that it cannot be recovered. If nobody looks for that evidence, old stock stays in the books at full cost year after year. Profit looks healthy because the loss of value has not been recognised, and the balance sheet looks strong because inventory is an asset.
The cash tells a different story. Money spent on stock that does not move is money that cannot pay suppliers, salaries or loan instalments. The business borrows more against inventory, interest cost rises and management wonders why profits do not convert into cash. Our article on cash flow versus profit explains this gap from a buyer's perspective.
Inventory is valued at the lower of cost and net realisable value (NRV) under Ind AS 2 and AS 2. NRV is the estimated selling price less the costs to complete and sell. Stock that is damaged, out of fashion, near expiry or simply not selling usually has an NRV below cost, and the difference should be written down.
What can go wrong in inventory controls
How to run an inventory ageing and slow-moving analysis
- Extract item-level data. Closing quantity and value by item, batch and location, with the date of last receipt and last issue or sale.
- Bucket by age. For example 0 to 90 days, 91 to 180, 181 to 365 and above 365 days, based on receipt date (or batch date where FIFO or batch tracking is used).
- Compare with movement. Calculate months of cover: closing quantity divided by average monthly consumption or sales over the last 6 to 12 months. Items with no issue in 12 months are non-moving.
- Test NRV. For slow and non-moving items, compare carrying cost with recent selling prices, scrap value or quotes, less selling costs.
- Discuss with operations. Ask sales, production and stores which items are genuinely usable, and record their reasoning.
- Propose provision and action. Recommend a write-down where NRV is below cost, and an action plan (liquidate, rework, return to vendor, scrap) for each block of dead stock.
Age buckets alone can mislead. A spare part held for three years for a critical machine may be perfectly sensible; a fashion product held for six months may already be worthless. Combine age with movement and the nature of the item before deciding.
CARO 2020, IFC and tax points on inventory
Inventory is one of the areas where statutory reporting overlaps with internal audit, so a good internal audit review also prepares the company for its statutory audit.
| Requirement | What it covers | Internal audit relevance |
|---|---|---|
| CARO 2020, clause 3(ii)(a) | Whether physical verification was conducted at reasonable intervals, whether coverage and procedure were appropriate, and whether discrepancies of 10% or more in the aggregate for each class of inventory were noticed and properly dealt with | Review count plans, coverage, independence of counters and how differences were investigated and accounted for |
| CARO 2020, clause 3(ii)(b) | Where working capital limits above ₹5 crore in aggregate are sanctioned on the security of current assets, whether quarterly returns or statements filed with banks agree with the books | Reconcile stock statements given to banks with the books and investigate differences, including ageing and valuation |
| Section 143(3)(i), Companies Act, 2013 | Auditor's report on adequacy and operating effectiveness of internal financial controls with reference to financial statements, where applicable | Inventory existence and valuation controls are usually key controls in that assessment |
| GST, Section 17(5)(h) CGST Act | Input tax credit is not available on goods lost, stolen, destroyed, written off or disposed of as gift or free samples | When dead stock is written off or scrapped, check whether input tax credit needs to be reversed |
For income tax, inventory valuation follows the lower of cost and NRV under the applicable income computation and disclosure standard, and write-downs should be supported by evidence such as quotes, sale prices or technical reports so that they stand up in assessment.
Red flags in inventory
- Inventory growing faster than sales, or inventory days rising for several quarters.
- No write-down or provision for several years despite product changes.
- Large year-end adjustments after physical verification, with no root-cause note.
- Items with zero issues in 12 months still valued at full cost.
- Stock statements to the bank that differ from the books or include rejected goods.
- Store staff counting their own stock without independent observation.
- Repeated purchase of items already held in large quantities.
Inflated inventory flatters both profit and drawing power. If stock statements to lenders include unsaleable items, the issue moves beyond accounting into lender reporting, which the Audit Committee should see promptly.
Illustrative example: releasing blocked working capital
A manufacturer carries closing inventory of ₹40 crore against annual cost of goods sold of ₹146 crore, about 100 inventory days. An ageing review shows:
- ₹30 crore moving normally (under 180 days).
- ₹6 crore slow-moving (181 to 365 days), estimated NRV ₹5 crore.
- ₹4 crore non-moving (over 365 days), estimated NRV ₹1.5 crore.
Write-down required: (₹6 crore minus ₹5 crore) plus (₹4 crore minus ₹1.5 crore) = ₹3.5 crore. If management liquidates the non-moving block and half of the slow-moving block over six months, it realises ₹1.5 crore + ₹2.5 crore = ₹4 crore of cash, and inventory falls to ₹32.5 crore after the write-down and sales (assuming normal stock is unchanged), or roughly 81 days.
The write-down hurts reported profit once. The release of cash, lower interest and more accurate drawing power usually more than compensate, and the books now tell the truth.
Controls to put in place after the audit
- Monthly ageing report by item and location, reviewed by the CFO and operations head.
- Written provisioning policy linking provision percentages to age and movement, with exceptions documented and approved.
- Purchase controls that check stock in hand and months of cover before a purchase order is approved.
- Independent physical verification on a cycle-count basis, with differences above a threshold investigated before adjustment.
- Separate location codes for rejected, returned and damaged goods.
- Disposal committee to approve scrap, discounted sales or returns, with GST and accounting effects checked.
- Bank stock statement reconciliation every quarter before submission.
Inventory levels also matter in transactions; our article on the working capital peg in due diligence shows how buyers treat excess and obsolete stock.
Inventory internal audit checklist
- Inventory ageing by item, batch and location obtained and reconciled to the ledger.
- Slow-moving and non-moving items identified using age and consumption.
- NRV tested for slow and non-moving items with evidence of selling prices or scrap value.
- Provisioning policy documented, approved and applied consistently.
- Physical verification plan, coverage and independence reviewed; discrepancies of 10% or more per class checked for CARO purposes.
- Adjustments after counts approved and root causes recorded.
- Stock statements to banks agreed with books each quarter.
- Purchase approvals check existing stock and months of cover.
- Rejected, returned and damaged goods held under separate codes.
- Input tax credit reversal considered on write-offs and scrapping.
- Action plan for dead stock with owners and dates, tracked to closure.
See our internal audit and corporate governance guide for how these findings flow to the Audit Committee.
Frequently asked questions
What is slow-moving inventory?
Slow-moving inventory is stock that is selling or being consumed much more slowly than normal, often measured by months of cover or by age buckets. Items with no movement for a long period, commonly 12 months, are treated as non-moving.
How is obsolete stock valued?
Under Ind AS 2 and AS 2, inventory is carried at the lower of cost and net realisable value. If obsolete stock can only be sold at a discount or as scrap, it is written down to that realisable value less selling costs.
What does CARO 2020 require on inventory?
The statutory auditor reports whether physical verification was done at reasonable intervals with appropriate coverage, whether discrepancies of 10% or more in aggregate for each class were noticed and properly dealt with, and, where working capital limits above ₹5 crore are sanctioned against current assets, whether quarterly bank returns agree with the books.
Is there a fixed percentage for provisioning on old stock?
No law prescribes a fixed percentage. Companies set a policy based on age, movement and the nature of the item, and should support it with evidence of realisable value. The policy should be applied consistently and reviewed periodically.
Does writing off stock affect GST?
Yes. Under Section 17(5)(h) of the CGST Act, input tax credit is not available on goods written off, destroyed, lost or stolen, so credit already claimed on such goods may need to be reversed.
How often should inventory ageing be reviewed?
Monthly review by management is good practice for most businesses with material inventory. Internal audit can test the controls quarterly or half-yearly, depending on risk.
Conclusion
Inventory is only an asset if it can be turned into cash at or above its carrying value. A disciplined ageing analysis, a clear provisioning policy, independent physical verification and purchase controls that look at stock in hand make inventory visible. Visibility leads to better decisions, honest numbers and working capital that is available for the business rather than locked in the warehouse.
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Talk to usThis article is for general information only and does not constitute professional advice or solicitation. Examples are illustrative. Provisions are summarised as of October 2026. Please refer to the relevant provisions and seek advice on your specific facts.