In this guide
What CARO 2020 Says About Inventory
Inventory is dealt with in clause 3(ii) of CARO 2020, and it has two limbs that are routinely confused with each other. The first limb requires the auditor to report whether physical verification of inventory has been conducted at reasonable intervals by management, whether the coverage and procedure followed were appropriate, and whether discrepancies of ten per cent or more in the aggregate for each class of inventory were noticed and properly dealt with in the books of account. Two points inside that sentence get misread constantly: the ten per cent test is applied in the aggregate for each class of inventory rather than line by line, and the verification is management's obligation while the reporting is the auditor's. The second limb concerns companies sanctioned working capital limits in excess of five crore rupees in aggregate, at any point during the year, from banks or financial institutions on the security of current assets, and asks whether the quarterly returns or statements filed with those lenders agree with the books of account.
The Verification the Order Expects
The order expects physical verification of inventory to have been conducted at reasonable intervals by management, and the phrase carries three separate ideas that are frequently collapsed into one. Physical verification means somebody counted, weighed or measured the goods, not that a system report was printed. Reasonable intervals means a defined and documented cycle appropriate to the size and nature of the inventory rather than a fixed frequency written into the order. By management means the responsibility sits with the company. The auditor then assesses whether the coverage and the procedure followed were appropriate, which is a judgement about the design of what management did rather than a repetition of it. Coverage is examined by class of inventory, and procedure means the count controls: whether sheets were prepared and accounted for, whether cut-off was properly observed, whether differences were recounted. The division of labour is what most companies get wrong. Management performs and the auditor reports, so a company that has not verified has not shifted a problem onto its auditor; it has created one that the auditor is obliged to describe in a report that every lender and investor reading the accounts will see.
The Ten Per Cent Test, Read Correctly
The reporting threshold is whether discrepancies of ten per cent or more were noticed on verification, and the words that matter are the ones people drop. It is ten per cent or more in the aggregate for each class of inventory. Aggregate per class means the differences within a class are netted and compared against that class as a whole, not that each item is tested individually. An item short by half its quantity does not by itself trip the threshold if the class it belongs to is broadly in agreement, and a class short by a tenth trips it even though no single item within it looks dramatic. Testing item by item produces a report that flags almost everything; testing across the whole inventory in total produces one that flags almost nothing. Both are wrong for the same reason, which is that the level of aggregation is specified and neither respects it. This test does not apply to fixed assets. Clause 3(i) deals with property, plant and equipment and sets no percentage at all, using materiality instead, so importing ten per cent into that clause imports a threshold the order never put there.
Clause 3(ii)(b): Borrowings Against Current Assets
The second limb attaches to companies sanctioned working capital limits in excess of five crore rupees in aggregate, at any point during the year, from banks or financial institutions on the security of current assets. Each element narrows it: the limits are aggregated across lenders rather than tested one by one, the test is sanction rather than utilisation, and the security has to be current assets rather than any collateral. A company drawing modestly against a large sanctioned limit is inside the clause. What the auditor reports is whether the quarterly returns or statements filed with those lenders are in agreement with the books of account. The comparison is against the books, not against the audited financial statements, and it is the returns as filed rather than as they might have been. What a discrepancy signals depends on its direction and its persistence. An isolated timing difference explained by the cut-off is unremarkable. A consistent gap between what the books show and what was reported to the bank suggests the statements are being prepared outside the accounting system, which is the underlying condition this reporting requirement exists to surface.
What the Auditor Asks the Company to Produce
Three documents are requested, and they are requested together because each is incomplete without the others. The first is the verification programme and the count sheets it produced: what was to be counted, when, by whom, on what basis, and what was actually found. Count sheets prepared in advance, issued under control and accounted for afterwards carry weight; sheets compiled after the event do not. The second is the reconciliation of physical quantities to book quantities, performed at the level of each class of inventory rather than in total, since the reporting test is applied for each class. A single net reconciliation across all classes cannot answer the question that is actually asked. The third is the treatment of differences in the accounts. Identifying a discrepancy and leaving it unposted is worse than not identifying it, because the records then show that the company knew its stock figure was wrong and reported it anyway. Where the difference reaches the reporting threshold in the aggregate for a class, the auditor is required to say so, and the entry supporting its treatment is what makes the answer straightforward.
Being Ready for the Clause
A verification programme that can be tested is written down before the counting happens. It states which classes of inventory are covered, at what intervals, on what basis items are selected, who performs the count, and who reviews it. That document is what allows an auditor to conclude that verification was conducted at reasonable intervals by design, and its absence is why companies that count diligently still struggle with the clause. Document the coverage by class rather than in total, because the reporting test is applied for each class of inventory and a consolidated coverage figure cannot answer a question asked class by class. Keep the count sheets, the reconciliation and the journal entries together for each cycle, so the chain from observation to accounting entry is visible without reconstruction. An independent count is the cleanest evidence where inventory is material and held at several locations, where the internal team counting the stock also controls it, or where a previous year's reporting was modified on this point. A stock audit service engaged for the year end supplies exactly the evidence the clause is asking about.
