Auditing a trading or service company in Nepal is often a matter of verifying invoices, bank balances, and receivables. Auditing a manufacturing company is a different exercise altogether. Inventory sits at three different stages of transformation at any given moment — raw material, work-in-progress, and finished goods — each with its own valuation questions, and the costing method applied to move value between those stages can materially change reported profit. It is no surprise that inventory and costing are consistently where manufacturing audits in Nepal get complicated, and where the most significant findings tend to surface.
Raw Material, WIP, and Finished Goods Valuation Under NFRS
Under Nepal Financial Reporting Standards (aligned with NAS 2 / IAS 2 — Inventories), all categories of inventory must be measured at the lower of cost and net realizable value. For a manufacturer, "cost" is not a single number — it changes depending on which stage the inventory is at:
- Raw material is valued at purchase cost, including freight and import duties where applicable, but excluding recoverable taxes such as input VAT.
- Work-in-progress (WIP) is valued at raw material cost plus an appropriate allocation of direct labour and production overheads incurred up to that stage of completion — which requires a reasonably reliable costing system to estimate accurately.
- Finished goods carry the full cost of conversion: raw material, direct labour, and a systematic allocation of both variable and fixed production overheads, but explicitly excluding selling and administrative expenses, which must be expensed as incurred rather than capitalized into inventory value.
Auditors spend considerable time verifying that overhead allocation to WIP and finished goods is done on a rational and consistent basis — typically based on normal production capacity — rather than being adjusted period to period to manage reported margins.
Physical Stock Count Procedures and Auditor Attendance
Because inventory is often one of the largest and most judgment-heavy line items on a manufacturer's balance sheet, auditing standards require the auditor to attend the physical stock count wherever inventory is material — not merely review a stock listing prepared by management after the fact. During attendance, the auditor observes whether the company's own counting procedures are being followed correctly, performs independent test counts on a sample of items, and traces those test counts both to the final inventory listing and back from the listing to the physical shelf, to check for both overstatement and understatement. Where the year-end count happens on a date other than the balance sheet date, the auditor also reviews the roll-forward or roll-back calculation used to adjust quantities to the actual reporting date, along with the movement records supporting it.
Costing Methods (FIFO, Weighted Average) and Consistency Checks
Manufacturers in Nepal most commonly use either the First-In-First-Out (FIFO) method or the weighted average cost method to assign value to inventory as it moves through production and sale. Both are acceptable under NFRS, but the standard requires the same costing formula to be applied consistently to all inventories of a similar nature and use from one period to the next. A common audit finding is a company switching between costing methods across periods — sometimes unintentionally, through inconsistent application in the accounting system — without disclosing the change or explaining its impact on reported figures. Auditors also check that the costing method actually implemented in the company's inventory records matches the method disclosed in the accounting policy note, since these two can drift apart over time, particularly when inventory systems are updated or new staff take over cost accounting responsibilities.
Scrap, Wastage, and Byproduct Accounting
Production processes rarely convert 100% of raw material input into saleable finished goods. Scrap, normal process wastage, and byproducts are a routine part of manufacturing, but they need to be accounted for deliberately rather than simply disappearing from the inventory trail. Auditors expect to see a documented basis for normal wastage rates by product line, with any variance beyond the expected norm investigated and explained. Byproducts with resale value should be recognized and valued rather than ignored, and scrap sales should be reconciled against recorded scrap generation. Where wastage or scrap figures cannot be explained by the company's own production data, it raises the possibility of unrecorded sales, pilferage, or inventory record inaccuracies — all of which auditors are required to consider as part of their risk assessment.
Fixed Asset and Depreciation Issues Specific to Plant and Machinery
Manufacturing audits also involve closer scrutiny of plant and machinery than a typical service-company audit. Key areas include verifying that major machinery components with materially different useful lives are depreciated separately rather than as one blended asset, confirming that idle or fully depreciated machinery still in use is appropriately disclosed, and checking that capital expenditure on machinery upgrades or overhauls is correctly distinguished from repair and maintenance expense. Auditors will also review whether depreciation rates applied are consistent with the actual expected useful life and production capacity of the machinery, rather than simply following a standard rate without reassessment, particularly for machinery that has been in use for many years or is nearing the end of its productive life.
Common Findings: Obsolete Stock and Costing Inconsistencies
A few recurring issues account for the majority of inventory-related findings in manufacturing audits across Nepal:
- Obsolete or slow-moving stock carried at full cost. Raw material or finished goods that have not moved for an extended period, or relate to a discontinued product line, continuing to be valued at original cost rather than written down to net realizable value.
- Inconsistent costing application. Different costing methods applied across product lines or periods without a documented rationale or disclosure.
- Overhead absorption errors. Fixed production overheads allocated based on actual (rather than normal) production levels, distorting inventory value in periods of unusually low output.
- Unreconciled physical counts. Differences between the physical stock count and book records that are adjusted directly to the books without investigating the underlying cause.
- Missing WIP valuation basis. Work-in-progress estimated using a rough percentage-of-completion assumption rather than a documented, verifiable costing calculation.
Conclusion
Inventory is rarely where a manufacturing audit begins, but it is very often where it gets held up. A manufacturer that maintains a disciplined, consistently applied costing system, conducts regular (not just year-end) stock reconciliations, and proactively identifies and writes down obsolete stock before the auditor asks about it will move through this section of the audit far more smoothly than one that treats inventory valuation as a year-end exercise. Given how directly inventory valuation affects reported profit, tax liability, and loan covenant calculations, it is well worth investing in a proper costing system rather than reconstructing it under audit pressure each year.
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