Stock audit of bank borrowers: Process and Required Documentation

Stock Audit for Bank Borrowers: Utilizing working capital finance through cash credit or overdraft, secured by the hypothecation of stock and debtors, is a prevalent form of financing among various banks. In such scenarios, borrowers are required to furnish monthly details of their stock and debtors. Based on this information, banks calculate the Drawing Power, deducting the prescribed margin.

Given that stock and debtors serve as primary security, banks ensure the authenticity and accuracy of these statements by regularly engaging chartered accountant firms for stock audits. This practice is especially prevalent when the exposure exceeds a predetermined threshold limit, typically set at over Rs. 100 Lakhs.

Stock audit of bank borrowers

The stock audit encompasses the examination of the borrower’s most recent stock and debtor information, with the report ideally reflecting the stock and debtor positions as of the visit date. Additionally, it involves scrutinizing the borrower’s historical data submitted to the bank and recorded in their books of accounts, aiming to verify the reliability of the information provided by the borrower.

Objectives of Stock Audit

The primary objective of the banker appointing a CA firm for stock audit is to verify the safety and correct valuation of the security, which includes the borrower’s stock and debtors against which financing has been provided. The various purposes of stock audit can be summarized as follows:

1. Ensure proper preservation, storage, and handling of stock.
2. Identify and assess the presence of obsolete stock and determine if it has been appropriately segregated and written off.
3. Verify whether the stock is adequately insured against fire and other natural calamities, and in specific cases, against risks such as theft, burglary, marine incidents, riots, etc., as per the sanction terms.
4. Ascertain the reconciliation between physical stock and the stock statement submitted to the banker.
5. Check for any diversion of funds.
6. Investigate reasons for numerous qualifying remarks about stocks and receivables in the Auditor’s report on the borrower’s Balance Sheet.
7. Ensure compliance with the terms and conditions of the sanctioned limit.
8. Ascertain the realizability of hypothecated stock.
9. Confirm that the stock is owned by the borrower, and financing is provided against the value of paid stock only.
10. Examine the age-wise outstanding debtors as per books and as per the statement submitted by the bank, including steps taken for the recovery of long-pending debtors and potential instances of debtors turning bad.
11. Address any other matters of interest to the bank.

Steps involved in stock audit

Conducting a stock audit is essential at the borrower’s location for evident reasons. However, before visiting the borrower, a thorough understanding of the entity, its banking operations, and financial affairs is imperative.

Hence, it is recommended to visit the respective branch where the borrower holds an account to gather information related to the sanction, account operations, nature of business, borrower’s performance, and other fundamental details. This visit includes reviewing comments and observations noted by other auditors, such as Internal Auditors, Concurrent Auditors, etc. It provides a brief understanding of the borrower and their financial situation. It is advisable to schedule an appointment before visiting both the branch and the borrower’s office.

Visit to Borrower’s Branch

Banks typically have a system of maintaining two folders for each borrower, although in some cases, only one folder is used. One folder is dedicated to holding original documents executed by the borrower, such as the Demand Promissory Note, Hypothecation Deed, Guarantee Bond, etc. The other folder contains the Application form, project report, Sanction Letter, Audited Financial Statements, and the previous stock audit report.

Stock statements submitted monthly by the borrower are filed with the correspondence file or may be kept in a single file designated for storing stock statements of all borrowers. Scrutinizing both folders, along with reviewing account operations and the DP Register in relation to the terms of Sanction, allows stock auditors to gain insight into the borrower’s affairs and conduct a comprehensive audit of the account.

Important note: If the borrower operates any other bank account, such as a Term loan, verification for the diversion of funds is necessary.

Documents Required From the Bank Branch Officials

1. Sanction Letter and the most recent renewal letter.
2. Stock Statements (latest 6).
3. Bank Statement for the last 6 months.
4. Turnover report for the last financial year and the current financial year (up to the present date).
5. For a company, a copy of Form No. 8 & 32 for the creation/modification of Charge or ROC search report. OR CERSAI copy in the case of entities other than a company.
6. Balance Outstanding in All Accounts with the bank.
7. DP register.
8. QMR/QMS/QIS/QPR for the last 2 quarters.
9. Branch inspection report (for the last 2 quarters).
10. The latest 3 GST/excise returns (which could be obtained from the borrower as well).
11. Valuation report for collateral securities.
12. Audited Financial Statements for the last financial year ended (which could be obtained from the borrower as well).
13. Half-yearly/Quarterly book debt CA certified book debt statement.
14. Insurance policy copies for both primary and collateral securities (which could be obtained from the borrower as well).
15. If major transactions with the same party are reflected in the account statement, then the relationship with such a party and the genuineness of such transactions should be verified at the party’s place.
16. Any other documents related to stock audit to conduct a more effective audit or reporting.

Visit to borrower and verification of stock

After obtaining fundamental information from the bank branch, the next step involves visiting the borrower. It is recommended to bring an audit questionnaire during the visit to ensure that no crucial points or areas are overlooked (a detailed questionnaire should be drafted with the help of an audit format). The visit to the borrower includes the verification of stock and debtors, inquiries about internal control, and an analysis of past results and bank operations. Although the audit focuses on stock and debtors, a comprehensive understanding of the overall financial scenario and inquiries into sister concerns and their businesses may assist the stock auditor in preparing a more comprehensive report.

Before initiating stock verification, it is essential to comprehend the nature of goods, especially regarding storage conditions—whether stored at multiple locations, whether they are prone to deterioration, and so forth.

The auditing process involves understanding the manufacturing and production processes and determining whether any part of the work is outsourced to other entities for further processing.

Physical verification of stock

1. Conduct a warehouse inspection, considering its location, condition, rent payments (if the warehouse is rented), and maintenance.
2. Physically count the stock and compare it with the recorded figures, reconciling any differences.
3. Examine records, including opening stock, purchases, production, sales, and closing stock.
4. Perform an age-wise analysis of stock and assess the movement of stock.
5. Investigate abnormal increases or decreases in stock.

You have to verify all major creditors and debtors.

Required Documentation from the Borrower:

1. Stock position as of the Verification date.
2. Trial balance or Provisional Balance Sheet as of the Verification date.
3. Copy of the latest audited balance sheet.
4. Insurance Policy (including Bank Hypothecation Clause for primary and secondary Collateral Security).
5. Figures of Purchases and Sales for the last 6 months and the current month until the date of Verification.
6. Invoices of Purchases and Sales, Stock Register, and other supporting documents for verifying internal controls.
7. Method of valuation followed for Inventory with detailed working.
8. Copy of the latest Excise/GST Returns filed.
9. Breakup of Sales into export and domestic.
10. Details of non-moving and obsolete stock and stock held for more than 6 months.
11. ABC analysis of stocks based on the value of annual consumption of major items (if available).
12. Products manufactured with details of licensed capacity, installed capacity, and actual utilized capacity.
13. Month-wise details of purchases and sales, stock, debtors, and creditors for the last 6 months.
14. Verification of major operational creditors and debtors with their transactions on a random basis.

Common Irregularities/Observations in Stock Audit:

The CA firm conducting the stock audit may observe common irregularities, including:

1. Stock Book Debts statements not submitted or not submitted within the specified time.
2. Inadequate details in statements, such as rate, quantity, and amount of different types of stock items.
3. DP Register not updated.
4. Age-wise analysis of debtors not provided.
5. Incorrect calculation of drawing power.
6. Absence of the latest visit report by branch officials.
7. Operations in the accounts not scrutinized with reference to projections, QIS statements, audited accounts, etc.
8. Non-compliance with defects pointed out by Internal Auditors/Concurrent Auditors.
9. Account not renewed or belated review.

Observations about Statement Submission & Scrutiny:

1. Stock Book Debts statements not submitted or submitted but not within the specified time.
2. Inadequate details, such as rate, quantity, and amount of different types of stock items, not stated in the statement.
3. DP Register not updated.
4. Age-wise analysis of Debtors not provided or done.
5. Debtors over 90 days (or as per sanction) considered for drawing power.
6. Drawing power not correctly calculated.
7. Latest visit report by branch official not on record.
8. Operations in the accounts not scrutinized with reference to projections, QIS statements, audited accounts, etc.
9. Defects pointed out by the Internal Auditors/Concurrent Auditors are not complied.
10. Account not renewed/belated review.

Observations about Account Operations:

1. All sales as per financial statements not routed through the account.
2. Account not operated actively.
3. Abnormal cash withdrawal during the current period.
4. Frequent overdrawing in the account.
5. Balance over drawing power, although within the Sanctioned Limit.

Observations about Insurance Coverage:

1. Under insurance of stock.
2. Insurance expired and not renewed.
3. Premium for the renewal policy paid but policy not on record.
4. Insurance Policy without Bank Clause.
5. No coverage of all risks as per sanction.
6. Wrong items/description of goods on the insurance policy.
7. Location of goods wrongly stated.
8. All locations of stock not covered.

General Observations:

1. Stock book not maintained/not updated.
2. Obsolete stock not excluded from stock figures submitted to the bank.
3. Deteriorating stock turnover ratio.
4. Stock, debtors, and creditors figures submitted at the year-end in the stock statement and as per financial statement not matching.
5. Confirmation for inventory with a third party not obtained or physical verification of Inventory not done.
6. Material received from third parties for job work not excluded while calculating drawing power.

Findings of Stock Audit and its uses

Stock audits conducted by external CA firms serve as crucial tools for credit monitoring within banks. Beyond ensuring the safety of realizable security, these audits play a vital role in guiding the bank’s efforts to maintain borrower discipline and act as an early warning system for potential future Non-Performing Assets (NPAs). The findings from these audits empower the bank to implement timely remedial measures, preventing substantial future losses. Additionally, stock audits shed light on any weaknesses in the existing monitoring system of a branch, offering insights through comments on the maintenance of the DP register, scrutiny of statements, and review of accounts, ensuring compliance with audit findings.

Furthermore, stock audits provide valuable utility for borrowers. Comments addressing insurance inadequacies, incorrect product descriptions, and discrepancies in stated locations within policies, if rectified promptly, can shield the borrower from avoidable future losses.

In my view, unlike statutory audits that primarily focus on compliance with respective statutes, stock audits represent a knowledge value addition exercise for both bankers and borrowers.

Stock audit of bank borrowers FAQ