## CARO 2020 – Clause 2: Inventory

Clause 2 covers two separate aspects of inventory.

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### Part A: Physical Verification

Report on:

1. Whether physical verification of inventories has been conducted at reasonable intervals

2. Whether any discrepancies of 10% or more in aggregate for each class of inventory were noticed

3. If discrepancies found — whether they have been properly dealt with in the books of accounts

> 10% threshold is per class of inventory (not overall). Even if the total discrepancy is small, a 10%+ discrepancy in any single class must be reported.

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### Part B: Working Capital Loans ≥ ₹5 Crore

Triggered when: the company has been sanctioned working capital (WC) loans of more than ₹5 crore from banks or financial institutions in aggregate.

Report on:

Whether the quarterly returns/statements filed with the bank/FI are in agreement with the books of accounts
If not in agreement — give details of the differences

> This part addresses loan fraud — companies sometimes inflate inventory/debtors in statements submitted to lenders. The auditor must cross-check.

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### Summary Table

Aspect	Trigger	What to Report
Physical verification	Always	Reasonableness of intervals, 10%+ discrepancies, treatment
WC loan statements	Sanctioned WC loans > ₹5 crore	Agreement of quarterly returns with books

Worked example

### Example 1

Apex Ltd verified its three inventory categories at year-end. Results: Raw materials (book: ₹40L, actual: ₹37L — shortfall 7.5%); WIP (book: ₹20L, actual: ₹18L — shortfall 10%); Finished goods (book: ₹60L, actual: ₹59L — shortfall 1.7%). How should you report under CARO Clause 2?

Answer: The discrepancy in WIP is exactly 10% — this meets the reporting threshold. The WIP discrepancy of ₹2 lakh must be reported under Clause 2 along with how it was dealt with in the books. The raw materials shortfall (7.5%) and finished goods (1.7%) are below 10% per class and do not trigger the threshold. Also report whether physical verification was at reasonable intervals.

### Example 2

Beta Ltd has working capital loans of ₹7 crore sanctioned from State Bank. During the audit, you find that the quarterly stock statement submitted to the bank for Q2 showed inventory of ₹12 crore, but the books reflected ₹9.5 crore for the same period. How do you report this?

Answer: Since WC loans exceed ₹5 crore, Clause 2(Part B) is triggered. The quarterly return (₹12 crore) is not in agreement with the books (₹9.5 crore) — a difference of ₹2.5 crore. This must be reported with details. This is a serious red flag for inflated collateral and may also trigger reporting under Clause 11 (Fraud).

⚠️ Common exam mistakes

Applying the 10% discrepancy test to total inventory instead of per class — the test is per class of inventory.
Forgetting the WC loan sub-clause entirely — many students answer Clause 2 covering only physical verification.
Confusing the WC loan threshold (₹5 crore) with the borrowing threshold in the applicability exemption (₹1 crore).
Stating 'no material discrepancy' without specifying whether discrepancies below 10% exist — the question is whether 10%+ discrepancy was noticed, and the answer should be clear.
Not linking a mismatch between bank statements and books to potential fraud under Clause 11.

Reference: Clause 3(ii) – Inventory — Companies (Auditor's Report) Order, 2020

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