CARO 2020 clause 3 explained: this guide covers what it means, who it applies to, the step-by-step process, documents required, fees, due dates and penalties in India — so you can stay compliant with confidence and avoid costly mistakes.
Clause 3(ii) has two parts. The first asks whether management verified inventory at reasonable intervals, whether the coverage and procedure were appropriate, and whether any discrepancy of 10 per cent or more by class was found. The second asks, for companies with large working capital limits secured on current assets, whether the quarterly statements given to banks agree with the books.
It is explained from the ICAI Guidance Note on the Companies (Auditor's Report) Order, 2020 (Revised 2022 Edition, July 2022). CARO 2020 applies to audits of financial years commencing on or after 1 April 2021. Later amendments to the Order, Schedule III and the laws named should be checked.
Management counts the stock; the auditor judges whether the count was appropriate and reports any discrepancy of 10 per cent or more in value for any class of inventory, on a net basis. For the second part, the auditor looks at the sanctioned limit, not the utilisation, on any day of the year, and compares the quarter-end statements filed with lenders against the books.
The Order's own wording is in the live clause i and ii explainer. Preparing the statements that go to lenders is the subject of bank compliance and stock statement work. The fixed asset side is in our clause 3(i) article.
Clause 3(ii)(a): verification of inventory (paragraph 47)
What counts as inventory. The GN uses the accounting standard meaning: goods held for sale, work in progress, and materials or supplies used in production or services. Spares and standby equipment that meet the definition of PPE are not inventory.
Interval and method. Management should verify all material items at least once a year and more often where appropriate. The two methods are periodic (one point in time, usually near year end) and continuous (different items at different times through the year, which works well with a perpetual inventory system). Frequency may follow an A-B-C classification, with A items checked more often than B and B more often than C. The auditor examines documents of verification in the year and at year end, and may attend the count. If present, he observes that the instructions are followed and does test counts. For the full counting procedures, see our SA 501 explainer.
Is the coverage and procedure appropriate? That is a matter of professional judgement, tested against the size and nature of the business. The GN lists documents to examine: written instructions to counting staff, authenticated inventory sheets, authenticated summary sheets, internal memos on issues found, and the extent of coverage by value. It also expects the auditor to look at cut-off by sampling stock movement documents shortly before and after the cut-off date, and to confirm that procedures for identifying damaged and obsolete stock are well designed. For stock held by third parties, obtain confirmations (see SA 505). If coverage or procedure is not appropriate, the auditor says so and points to the specific areas.
The 10 per cent test. The GN is detailed on this point:
| Feature | How the GN reads it |
|---|---|
| Measured by | Value, for each class of inventory |
| Basis | Net, after setting off excesses and shortages within the class |
| Net excess | A net excess of 10 per cent or more must also be reported |
| Materiality | The company's materiality threshold is not relevant; 10 per cent or more must be reported even if immaterial |
| Goods in transit | Form part of the class to which the goods belong |
| Classes | Those used in the accounting standard (raw materials, work in progress, finished goods, stock-in-trade, stores and spares and so on) |
| Timing | Calculated when the physical verification was made; with perpetual records, aggregate book stock, physical stock and the discrepancy |
If a discrepancy of that size was found, the auditor also says whether it was properly dealt with in the books. If it was not, the extent and impact on the financial statements are reported. Where day-to-day records are missing, the auditor can use an annual reconciliation of opening stock, purchases and consumption, if consumption can be linked to production; if no reconciliation is possible, the report says the discrepancy cannot be determined.
Clause 3(ii)(b): working capital limits and quarterly statements (paragraph 48)
The clause applies only if, at any point of time during the year, the company was sanctioned working capital limits above Rs 5 crore in aggregate from banks or financial institutions on the security of current assets. The GN draws these lines:
- It is the sanctioned limit, read from sanction letters and agreements, not the amount used. A limit above Rs 5 crore that is only partly used is covered. A limit below Rs 5 crore that is temporarily overdrawn beyond that figure is outside the clause.
- Fresh sanctions, renewals and limits due for renewal in the year count.
- Fund based and non-fund based facilities (cash credit, overdraft, bills discounting, letters of credit, guarantees) both count, aggregated across all lenders.
- Limits not secured on current assets are excluded.
- The Rs 5 crore test is for any day of the year, not the year-end.
Once the clause applies, the auditor obtains a list of the statements and returns given to lenders and compares each quarterly one with the books. Stock statements, book debt statements, debtor ageing and other quarterly information are covered. Monthly returns are not: if a company files monthly, only the quarter-end month is checked. The auditor does not audit the returns, nor the books behind them, but only compares them and reports disagreement. Typical differences are in stock value, debtors or creditors totals and ageing. Materiality and relevance to users are matters of judgement. The auditor also reads sanction letters, charge documents and the register of charges, and considers any reconciliation the company prepared.
The Schedule III link
Schedule III asks management to disclose borrowings secured on current assets and whether the quarterly returns agree with the books, with a reconciliation summary and reasons for material differences if not. It has no monetary threshold and covers all borrowings, so it is wider than the clause. The auditor reviews that disclosure before commenting.
A worked example
Harbor Tools Private Limited has a cash credit limit of Rs 4 crore and a bill discounting limit of Rs 2 crore with one bank, both secured on stock and debtors. Aggregate sanctioned limits are Rs 6 crore, so clause 3(ii)(b) applies even though utilisation never passed Rs 3.5 crore. For the quarter ended 31 December, the stock statement given to the bank shows raw material of Rs 1.8 crore against Rs 1.5 crore in the books. The auditor reports the difference with the reasons given by management.
Separately, at the year-end count raw materials show a net shortage of 12 per cent by value against book stock. The auditor reports it and states whether the shortage was written off in the books.
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Key takeaways
- Inventory should be verified at least once a year for material items; coverage and procedure are judged for appropriateness.
- The 10 per cent test is by value, per class, net, and applies whether or not it is material.
- Clause 3(ii)(b) is triggered by sanctioned limits above Rs 5 crore on any day, secured on current assets.
- Only quarter-end statements are compared; the auditor does not audit them.
- Schedule III disclosure is wider than the clause and is reviewed first.
Read next
- CARO 2020 clauses 3(iii) and 3(iv) in practice: loans, guarantees and sections 185 and 186
- CARO 2020 Guidance Note: general approach and Schedule III link
- SA 501: inventory count and litigation
- SA 520: analytical procedures
Disclaimer: Based on the Companies (Auditor's Report) Order, 2020 as explained in the ICAI Guidance Note on CARO 2020 (Revised 2022 Edition), as consulted on 3 October 2026. CARO applies to financial years commencing on or after 1 April 2021; later amendments to the Order, Schedule III and the laws referred to should be checked. This article is general information, not legal advice; check the official text before acting.