Capital Work In Progress (CWIP) Stock In Process (SIP) and Stock

– not seeing the light of day 

Topics covered in this article are as follows:

  1. Why is it Important?
    • Capital Work in Progress
    • Stock in Process
    • Similarities in CWIP and SIP
    • Stock of Raw Material and Finished Goods
    • Similarities in SIP and Stock
    • Inventory Fraud
    • Inventory Fraud Example
    • What Makes Inventory Vulnerable to Fraud?
    • WIP Inventories
    • Types of Inventory Fraud
    • How to Prevent Inventory Fraud
  2. Fast Facts – Before Decoding | Presentation of Details
    • Capital Work-in-Progress
    • Inventories
    • Meaning of Inventories
    • Inventories Held for Sale in the Ordinary Course of Business
  3. How to Decode?
  1. Why is it Important?

The capital work in progress (CWIP), stock in process (SIP) and stock of raw materials, finished goods etc. – are the 3 important items of balance sheet of any entity. Considering the similarities in CWIP & SIP and SIP & Stock, all 3 items are covered in this chapter for the purpose of better understanding and unlocking the secrets hidden for forensic audit.

1.1 Capital Work in Progress

The Capital Work in Progress, also known in short as CWIP, is one of the important part of the non-current asset of an entity. CWIP includes building under construction, machinery under assembly etc., at the time of preparation of balance sheet. CWIP is the work that is not yet complete but amount has already been paid. These payment, these funds which is claimed to have been paid for the said construction, which is not yet complete or machinery or plant which is under installation is sometime found to have been used as route to divert or siphon the funds – and thus, a cause for forensic audit.

Purchases of item of assets at an inflated price especially from a related party or making payment for some assets being shown as CWIP, for which no assets has been received of economic value or even expenditure for repairs and maintenance recorded as CWIP are some of the areas of forensic audit. Similarly, recording of an assets purchased as CWIP, which in effect has not actually been received by the entity at all, are important aspect of forensic audit of CWIP.

As the name suggest that CWIP, is the work of putting plant & machinery and constructing building which is not yet completed, the same being continued from one balance sheet date to another. Therefore, used as tool to either inflate the same or to divert the funds.

It is also relevant to know that so long as an asset is CWIP, the same is not required to be considered as fixed assets and therefore, not required to be recorded in the fixed assets register and also not required to be depreciated.

The benefit of spillover from one balance sheet to another balance sheet – which sometimes continues in several balance sheet, is taken by the management, as for stakeholders, it is difficult to immediately identify any early warning sign due to such spillover.

Therefore, the forensic audit of CWIP requires looking into genuineness of the same, is it inflated and correctly shown.

The understanding of the CWIP and how to look and analyse the same, is important in forensic audit. In this chapter how to decode the CWIP is explained, to find out how genuine the same is or there are some issues which requires further investigation or it is used as a means/mode to divert or siphon the funds.

It is also important to understand and analyse the CWIP in forensic audit, as CWIP forms part of the tangible net worth (TNW) of an entity. Therefore, to know actual TNW and real position of the TNW, the CWIP requires to be looked into.

1.2 Stock in Process

Stock-in-Process known in short as SIP (also known as Work-in-Progress – WIP) is one of the important part of the current assets of an entity. Like CWIP, WIP includes entity’s partially finished goods waiting for completion. Since, it is one of the items for the purpose of calculation of Current Ratio, SIP plays an important role, in any loan proposals by borrowers to the Banks and/or Financial Institutions. Since stock in process, is considered as part of the current assets, and overall amount of current assets is one of the shining star to any financial statements, its importance is shining as the sun rays.

In each and every financial statements, while looking at the Balance Sheet, lenders investors, stakeholders etc., whoever has interest in the entity, always look upon the amount of current assets and particularly the amount of Inventories, which forms integral part of the current assets. Stock-in-Process is one of the important item of inventories in any entity. Since Stock-in-Process indicates that manufacturing process is undergoing and the raw materials is being processed or being manufactured, and the process is continuing, as the stage of finished goods or final products has not yet been reached. Therefore, higher amount of stock in process, as compared to raw materials and finished goods is always viewed positively.

Huge inventory level of raw materials indicate that the materials have been procured but not processed and similarly higher level of finished goods indicate that an entity has manufactured the goods but not able to sell. As against this, higher level of SIP, provides comfort to the lenders and investors that since it is SIP, naturally the same cannot be sold and thus, not viewed adversely or not as negative as huge inventories of raw materials and finished goods. Therefore, benefits of this situation (considered as mind game) is sometime taken by entities in showing huge inventory level of SIP.

Apart from above mind game, the other most important reason, for showing huge level of inventory of SIP is that, manufacturing process of each industry is different, manufacturing cycle being different in each industry and sometime even in the same industry, it may be different, because of management or for any reasons, it is easy to provide reasons and logic for higher level of SIP. Such reasons are difficult for a layman to understand the same, as it is a technical subject and thus, reasons advanced by the company’s management is accepted on the face value.

It is also found that even in physical verification[1] of Inventories, it is easy to physically verify the raw materials and finished goods as compared to SIP, as depending upon the types of products and industry, there may be several stages of SIP, which makes it difficult to physically verify the quantity and value thereof.

It is also not possible to maintain process records of SIP, as in the case of other inventories. It is also difficult to maintain the itemwise, stagewise, productwise, processwise details of quantity and amount of each and every items of SIP.

Therefore, the benefit of all such situations or some of such situations are found to be taken by those entities, who wants to either window dress the financial or mis-represent the facts about good financial positions of the entity, by showing higher level of SIP than the actual.

And that is why wherever the amount and quantity or overall value of SIP is found higher, as compared to overall inventory level, overall business volume and/or overall sales, the detailed analysis of SIP is very important and desirable too, in forensic audit, to find out is there anything serious or wrong in the level of SIP, as SIP normally forms part of the primary security for the Working Capital Loan or a Cash Credit Facility provided by the banks or financial institutions to the entity.

1.3 Similarities in CWIP and SIP

As explained in details hereinabove, both CWIP and SIP are undergoing items of balance sheet date. Though, CWIP is part of non-current assets but SIP is part of current assets. Due to the fact that both have not attained the final shape and therefore, difficult to verify as compared to finished assets.

This peculiar stage – stage of under progress/process, which sometime unnecessarily extended and after long progress and process, which keeps on progressing and progressing but never end and as a result these CWIP and SIP are unable to see the lights of the day!

1.4 Stock of Raw Material and Finished Goods

Apart from stock in process (SIP), the other inventories – such as raw materials, finished goods, stores and spares, packing materials etc., which are intended for consumption or sale in the normal course of operating cycle, also forms part of the inventory.

For the purpose of forensic audit of an entity for genuineness of inventories, these items of inventories are also requires to be examined.

No doubt, the major concern of forensic auditor is for SIP (as explained in details above) but the other inventories cannot be ignored and in some cases, it may be the other inventories – which pose more seriousness, as compared to SIP.

In the case of a trading entity, the stock-in-trade i.e. the goods acquired for the purpose of trading, which remained as stock at the balance sheet date, is also relevant in forensic audit of such trading.

1.5 Similarities in SIP and Stock

Both forms part of inventories and both are current assets. Stock in process and stock of other inventories – requires to be examined by a forensic auditor, on same parameters, except some additional verification with respect to SIP.

1.6 Inventory Fraud

Inventory is one of the biggest assets on a manufacturing entity. It’s also one of the hardest assets to measure and track.

Thousands of transactions flow through the inventory account each year — and many of these journal entries require subjective estimates, such as overhead allocations, write-offs, and valuation adjustments. In addition, many employees have direct daily access to inventory or inventory accounting records, providing an ongoing temptation to steal or cook the books.

1.7 Inventory Fraud Example

Consider ABC Manufacturing, a fictitious company that fell victim to a $300,000 inventory fraud scheme involving three trusted employees. Their scam was simple: The shipping clerk sent most finished goods to legitimate customers or company-owned retail outlets. But a few shipments to retail outlets were redirected to the home of the payables clerk. Later, the controller picked up the stolen goods to resell them on the Internet.

ABC’s retail outlets weren’t invoiced for shipments at the time of delivery. So there was no paper trail identifying what had happened to the redirected shipments. Without physical inventory counts, the perps were able to pull the wool over the owner’s eyes for more than 18 months. Eventually, the shipping clerk became overwhelmed with guilt and confessed the scheme to the owner. With stronger internal controls, the scheme might have been detected sooner — or prevented from ever occurring.

(Source – www.lbmc.com)

1.8 What Makes Inventory Vulnerable to Fraud?

Inventory is vulnerable to fraud because it’s eventually closed out to cost of goods sold (COGS). This is an expense account that winds up as part of retained earnings at the end of the accounting period.

The formulas for computing COGS are:

Beginning inventory + purchases during the year = goods available for sale

Goods available for sale – ending inventory = COGS

These formulas make sense for retailers or distributors that don’t add value to the goods they sold and, therefore, handle only finished goods. But they’re oversimplified for manufacturers that process raw materials into finished goods.

Manufacturers typically possess three types of inventories:

    • finished goods
    • work-in-progress (WIP)
    • raw materials

1.9 WIP Inventories

WIP inventories include charges for raw materials, direct labour, and overhead. Sometimes there are additional charges when the production of components is outsourced to a third party.

In addition, manufacturers can use a variety of techniques to account for finished goods inventories under Generally Accepted Accounting Principles. These include the lower of cost or market; first-in, first-out (FIFO); and last-in, first-out (LIFO).

The more complicated a company’s inventory reporting process, the more opportunities employees have to commit fraud.

1.10 Types of Inventory Fraud

Small manufacturers often operate like families. Owners can’t fathom that a trusted “family member” would ever steal inventory. But it happens more often than thought. When faced with financial pressure and given an opportunity to steal, an employee may rationalize the theft of inventory.

Inventory fraud may also occur within the accounting department. For example, the controller or CFO may try to overstate inventory by artificially inflating inventory counts or values, recording false entries into the general ledger, or failing to write off old, obsolete or damaged items.

Moreover, the inventory account may become a “slush fund” for other internal fraud schemes. Inventory overstatements might be used to manage earnings or to meet financial covenants.

1.11 How to Prevent Inventory Fraud

Unearthing financial misstatements involving inventory overstatements is less straightforward than catching people who directly steal physical assets. A forensic auditor help by benchmarking financial statement trends, verifying source documents and building a case that will help to find out person involved.

  1. Fast Facts – Before Decoding | Presentation of Details

2.1 Capital Work-in-Progress

The amount of CWIP is requires to be shown separately on the face of balance sheet, as part of fixed assets under non-current assets.

2.2 Inventories

The inventories are required to be classified as:

  1. Raw materials;
  2. Work-in-progress;
  3. Finished goods;
  4. Stock-in-trade (in respect of goods acquired for trading);
  5. Stores and spares;
  6. Loose tools;
  7. Others (nature to be specified).

Further, goods-in-transit is required to be disclosed under the relevant sub-head of inventories and mode of valuation of inventories, is also required to be stated.

2.3 Meaning of Inventories

As per Ind AS 2, “Inventories” – the inventory has been defined as assets:

    1. Held for sale in the ordinary course of business;
    2. In the process of production for such sale; or
    3. In the form of materials or supplies to be consumed in the production or in the rendering of services.

2.4 Inventories Held for Sale in the Ordinary Course of Business

Inventories held for sale in the ordinary course of business are finished goods of a manufacturing entity or trading goods of a trading units. Standard products available with software developers or data base provider or e-learning developers for example CD of study material, anti-virus software etc. are also treated as inventories under Ind AS 2, as these items are held for sales in the ordinary course of business. Similarly, when a data base provider or e-education provider gives access to subscribers, while the data base is an intangible asset, the cost of creating access points, if material, is treated as service inventories. Any unsold access points will be accounted for applying Ind AS 2.

Supplies, loose tools, stores and spare are example of ‘material or supplies to consume in the production process or in the rendering of services’.

Inventories encompass goods purchased and held for resale including merchandise purchased by a retailer and held for resale, or land and other property held for resale.

Inventories also encompass finished goods produced, or work in progress being produced, by the entity and include materials and supplies awaiting use in the production process.

  1. How to Decode?

The decoding of CWIP, SIP and Stock for the purpose of forensic audit requires examination of several critical issues. In the following table, the important critical parameters on which CWIP, SIP and Stock, requires to be verified for the purpose of forensic audit are given:-

Sr. No. Verify/ Examine CWIP SIP Stock
1 Use usable in the business usable as finished goods raw materials usable in manufacturing and finished goods for sale
2 Period of use more than one year Immediately in finished goods during operating cycle
3 Examine the details what constitute of CWIP what constitute of SIP Item-wise details of raw materials and finished goods
4 Business of entity are CWIP in line with business of entity are SIP in line with manufacturing process are the stock of inventories related to business
5 Details of acquisition details of the parties to whom paid details of relevant raw materials and manufacturing cost details of the major suppliers of raw materials and details of manufacturing cost
6 Internal control over acquisition of items of CWIP over purchases of relevant items of raw materials over sale of finished goods
7 Verification of existence  of CWIP items of SIP items of stock
8 Verification of agreement, purchase deeds, delivery challans etc. to know genuineness to know genuineness to know genuineness
9 Complete records to establish actual amount to establish actual amount to establish actual amount
10 Verification of cut off to know proper capitalization to know proper SIP to know stock
11 Rights of ownership to find out diversion, if any to find out diversion, if any to find out diversion, if any
12 Valuation to know inflated CWIP to know inflated SIP to know inflated valuation
13 Verification of existence to find out siphon of funds to find out siphon of funds to find out siphon of funds
14 Presentation and disclosure in financial statement to find out any mis-statement to find out any mis- statement to find out any misstatement
15 Purchases from related or connected party to find out genuineness to find out genuineness to find out genuineness
16 Reconciliation to know correctness and diversion, if any to know correctness and diversion, if any to know correctness and diversion, if any
17 Auditor’s Report is there any qualification or discussion about CWIP is there any qualification or discussion about SIP is there any qualification or discussion about Stock
18 CARO Report SIP has been physically verified by the management all the inventories has been physically verified by the management
19 Any disclaimer by auditor any disclaimer with respect to CWIP, indicate early warning signs any disclaimer with respect to valuation and quantity indicate early warning sign Any disclaimer for inventory indicate early warning sign
20 And the most important

After the above process is carried out, the most important part of forensic audit of CWIP, SIP and stock is to determine, since how long the same has been shown as CWIP or SIP or stock. The period of construction of building or assembling plant and machinery, if found to be substantially longer (say more than 2 years) then genuineness of the same need to be critically examined, depending upon the size of capitalization and industry. Similarly in the case of SIP, the process of manufacturing in the terms of time to be kept in mind while decoding about the genuineness of SIP. In case of stock also, huge inventory level need to be critically examined by forensic auditor.

The longer and longer the period of CWIP or SIP, is an area of doubt and the same requires more detailed verification in forensic audit, to find out is it inflated or there are reasonable reasons for the same.

[1]     Physical Verification of the inventories (which includes all inventories of raw material, SIP, finished goods etc.) are of the area always undertaken by the lenders in each and every cash credit facility provided by the banks in India. Such verification is carried out by the bank staff or by outside CA or Cost Accountants on behalf of banks/financial institutions.

Forensic

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