ust a hint of inventory fraud can be a frightening experience for an auditor of financial statements. Indeed, the list of freakish inventory manipulations companies have committed over the last 50 years reads like a rogue’s gallery: McKesson and Robbins, the Salad Oil Swindle, Equity Funding, ZZZZ Best, Phar-Mor. The tried-and-true schemes these and other companies pulled have always given auditors nightmares. A CPA who recognizes how these fraudulent manipulations work will be in a much better position to identify them.
FRAUDULENT ASSET VALUATIONS
Companies use five techniques to illegally boost assets and profits: fictitious revenues (see “So That’s Why They Call It a Pyramid Scheme,” JofA Oct.00, page 91 ), fraudulent timing differences, concealed liabilities and expenses (see “Follow Fraud to the Likely Perp,” JofA. Mar.01, page 91 ), fraudulent disclosures and fraudulent asset valuations.
In a 1999 study, the Committee of Sponsoring Organizations of the Treadway Commission found misstated asset valuations accounted for nearly half the cases of fraudulent financial statements. Inventory overstatements made up the majority of asset valuation frauds and are the focus of this article.
The valuation of inventory involves two separate elements: quantity and price. Determining the quantity of inventory on hand is often difficult. Goods are constantly being bought and sold, transferred among locations and added during a manufacturing process. Figuring the unit cost of inventory can be problematic, too; Fifo, Lifo, average cost and other valuation methods can routinely make a material difference in what the final inventory is worth. As a result, the complex inventory account is an attractive target for fraud.
Dishonest organizations usually use a combination of several methods to commit inventory fraud: fictitious inventory, manipulation of inventory counts, nonrecording of purchases and fraudulent inventory capitalization. All these elaborate schemes have the same goal of illegally boosting inventory values.
The obvious way to increase inventory asset value is to create various records for items that do not exist: unsupported journal entries, inflated inventory count sheets, bogus shipping and receiving reports and fake purchase orders. Since it can be difficult for the auditor to spot such phony documents, he or she normally uses other means to substantiate the existence and value of inventory.
Observation of physical inventory. The most reliable way to validate inventory quantity is to count it in its entirety. Even when this is done, little mistakes can allow inventory fraud to go undetected:
Management representatives follow the auditor and record the test counts. Thereafter, the client can add phony inventory to the items not tested. This will falsely increase the total inventory values.
Auditors announce when and where they will conduct their test counts. For companies with multiple inventory locations, this advance warning permits management to conceal shortages at locations which auditors will not visit.
Sometimes auditors do not take the extra step of examining packed boxes. To inflate inventory, management stacks empty boxes in the warehouse.
Analytical procedures. Ghost goods throw a company’s books
out of kilter. Compared with previous periods, the cost of sales will be too low; inventory and profits will be too high. There will be other signs, too. When analyzing a company’s financial statements over time, the auditor should look for the following trends:
Inventory increasing faster than sales.
Decreasing inventory turnover.
Shipping costs decreasing as a percentage of inventory.
Inventory rising faster than total assets move up.
Falling cost of sales as a percentage of sales.
Cost of goods sold on the books not agreeing with tax returns.
MANIPULATION OF INVENTORY COUNTS
The auditor relies heavily on observing the client’s inventory. Therefore, it’s quite important for the auditor to take and document test counts. Regrettably, some cases of inventory fraud occur when the client alters the auditor’s working papers after hours (see JofA. Oct.00, page 94 ). Auditors must maintain adequate security over audit evidence.
For instance, say the client receives a large shipment of merchandise five days before the end of the accounting period and picks up all copies of the receiving reports and invoices and secretes them during the audit. Then, during the physical inventory count, employees count the merchandise, which the auditor then tests.
Obviously, physical inventory will be overstated by the amount of the unrecorded liability. The client’s advantage with this method is that the amount of the overstatement is buried in the overall cost of sales calculation. An alert auditor can detect these schemes by any one of the analytical methods described above and also can examine the cash disbursements subsequent to the end of the period. If the auditor finds payments made directly to vendors that were not recorded in the purchase journal, he or she should investigate further.
Although any inventory item can be improperly capitalized, manufactured goods present a particular problem. Common items capitalized are selling expenses and general and administrative overhead. To detect these problems, auditors should interview manufacturing process personnel to gain an understanding of appropriate charges to inventory. Although there may be many good faith reasons to boost income by capitalizing inventory items, there also may be fraudulent ones. Usually the auditor will find that the CFO, typically at the CEO’s direction, carries out material illegal schemes. Therefore, during normal interviews with key personnel, the auditor always should ask—in a straightforward but nonaccusatory way—if anyone in the company has instructed them to inflate inventory information.
There are many ways a dishonest client can attempt to manipulate inventory. An auditor must look at the data with a different mindset, surmising not only how inventory fraud works, but why the client would resort to such improprieties in the first place. The answer is almost always because upper management feels extreme pressure to meet financial projections. The auditor who assesses both motive and opportunity to commit material inventory fraud will end up spotting the ghosts.
Perpetrators of Fraud in an Organization