Tag Archives: Inventory Fraud

Inventory of Fraud

One of the first frauds I worked on early in my career was a scheme by management to overstate the periodic inventory of the Prison Industries system of a state Department of Corrections.   In that case the manipulation was carried out by creating false inventory counts and altering records after the physical count.

What made this an especially interesting case of management fraud were the various reasons that the audit report subsequently revealed why accounting management had decided to overstate the inventory:

  • To overstate the income of Prison Industries.
  • To achieve internally projected goals.
  • To increase Prison Industry’s perceived value in the eyes of State government administration.
  • To meet Department of Corrections stiff goals for Prison Industry management.
  • To hide poor operational performance.
  • To enhance the perceived performance of individual members of Prison Industries management.
  • To hide the theft of some inventory.

These reasons are in contrast to fraudster goals if a fraud scheme’s overall objective is to show reduced inventory:

  • To reduce income.
  • The entity has achieved its goals and wants to show reduced results.
  • To reduce the overall value of the business or enterprise.
  • A new management team is in place and wants to defer reporting additional performance to the future.

Such inventory counting related schemes are likely to occur with inventory components perceived to be less likely of being counted or in conjunction with a planned reason for the false count. The hope is that any examiner/auditor will view the false count as an error versus an intentional plan to misstate the inventory. Therefore, the examiner needs to ensure that management has no record of the test counts. Certain types of inventory counts are more susceptible to being false, such as:

  • Periodic Inventory. This particular inventory is susceptible to false counting because the auditor has no inventory reports to determine what the inventory should have been prior to the count.
  • Perpetual Inventory. Variances or in-transit items are often used as an explanation for any deviations.
  • Multiple Inventory locations. The non-tested sites are susceptible to false counts because the auditor is not performing procedures at those locations. Management may also use other scams in conjunction with the false-count fraud schemes.

As every accounting student knows, inventory is tangible property that either (1) is held for sale in the ordinary course of business (finished goods); (2) is in the process of production for such sale (work in process); or (3) is currently consumed either directly or indirectly in the production of goods or services available for sale (raw materials). The primary basis of accounting for inventory is cost. By definition, inventory excludes long-term assets subject to depreciation accounting.

The inventory records at Prison Industries were complex. Inventory was constantly being transferred between manufacturing processes, was often dispensed in several locations across the state’s correctional system, and normally comprised a significantly large amount of items. For these reasons, as well as the variety of decisions made about direct valuations, inventory was an appealing place for management to decide to commit financial statement fraud, in this case by manipulating and altering the physical inventory count.

Inventory falsification occurred at Prison Industries when the entity showed inventory on its financial statements that both did not exist and was improperly valued;  the two methods were  used simultaneously.  Techniques used to inflate the value of inventory included the creation of false documents, such as inventory count sheets, receiving reports, and manipulation of the actual physical inventory. During the fraud, it was common for management to insert phony inventory count sheets during the inventory observation or to alter the quantities on the count sheets. There where instances where management created the illusion that inventory existed with the help of phony inventory items. Simply put, some items of inventory that appeared real on paper were actually fake.

The fraud examination was originated as a result of predication provided by a Hot Line tip and featured the application of a number of procedures.

Interviews were conducted with management and personnel. Questions asked included the following to determine whether the inventory represented by management actually existed and whether it was properly valued:

– Do the inventories included in the Prison Industries balance sheet physically exist?
– Does the inventory represent items held for use in the ordinary course of production?
– Do inventory quantities include all items on hand or in transit?
– Are inventory listings accurately compiled and are they properly included in the inventory accounts?
– Does the State have legal title or ownership rights to the inventory items?
– Does the inventory exclude items billed to customers or owned by others?
– Are inventory costs the result of an acceptable method consistently applied?
– Are inventories properly classified in the balance sheet and are the related disclosures adequate?

The examiners calculated the inventory turnover ratio. The inventory turnover ratio measures how fast inventory was moving through the entity. If the inventory is inflated, then the average inventory balance will be overstated, causing the inventory turnover ratio to decline. The  inventory turnover ratio was compared with the results from prior years and with industry averages for reasonableness.

Price tests were performed. A fraud examiner must determine whether the pricing of the inventory is reasonable. Price testing employs vouching, tracing, and re-computation procedures to test the auditee’s  pricing of its inventory. An examiner should test the application of prices by vouching items to vendors’ invoices and to cost accounting records to verify that the inventory is properly priced. For example, an examiner selects from the inventory detail item L243, classified as a raw material. According to the company’s records as of the balance sheet date, there are twenty L243s at $120 apiece. The examiner reviews the last invoice representing the purchase of L243s and discovers that the company purchased the L243s at $60 apiece. This price discrepancy is a sign that management might be trying to inflate the value of its inventory. Vendors’ invoices should also be traced to the books to confirm proper price recording. Examiners should recompute the quantities indicated on-hand by the observation with vendor prices to determine that the inventory, balances on the balance sheet are correct.

Following the fraud examination inventory was re-performed. The physical inventory was re-performed to ensure that the enterprise’s application of corrective action to methods for counting inventory would result in an accurate and reliable count in future. The re-examination of physical inventory included observation, as well as inquiries and physical examination (i.e., test counts). It is important to remember that management is responsible for the propriety of the inventory. The examiner observed the re-taking of the inventory to satisfy his/her reliance on management’s representations of the quantities and prices.

Cut off tests were performed. A cut-off test is a procedure to control the shipping and receiving activities at the physical inventory date. For the time of the physical inventory, the examiner  noted the numbers of the last pre-numbered shipping and receiving documents because purchases of inventory often are recorded when received and sales recorded when shipped. Identifying the document numbers helped the examiner determine whether the inventory was properly or improperly included or excluded from the inventory counts. For instance, if management indicated that the last shipping document for 1991 was #2500, then the examiner would assume that #2501 was shipped in January 1992. If, upon review of shipping document #2501, the examiner notices that the inventory was shipped in 1991, then there is the possibility that management is inflating the quantity and value of the company’s inventory at year-end. Therefore, inquiry and further testing are warranted. These cut-off numbers are often used in conjunction with the cut-off test used in accounts receivable and accounts payable testing. If cut-off procedures appear unclear or indicate possible inclusions in inventory of goods sold, then cut-off tests should be expanded.

There are several other audit procedures that can be used in detecting inventory fraud scenarios. These include:

  • Reviewing the statement of cash flows and asking whether the increases and decreases in cash make sense in relation to the inventory account balances and changes.
  • Computing the inventory turnover ratio and days-to-sell ratio. Do these ratios make sense in relation to what the auditor has verified regarding the physical aspects of the inventory?
  • Computing the percentage of gross profit and the related percentage of the cost of goods sold, and then the trend to look for understatement of the cost of goods sold percentage.
  • Ensuring there is a consistent use of the inventory cost flow assumption. For example, the use of first-in-first out (FIFO) gives a higher net income in an inflationary environment.

It was the large number of items comprising the inventory that made it an attractive target for fraudulent manipulation at Prison Industries. Theft and misuse are the actions of choice when it comes to inventory fraud. The rationale typically Is: “Who is going to miss a few hundred widgets in an inventory of thousands, perhaps millions?” The size of inventory as a percentage of the amount of total assets also makes it an easy target for management-initiated financial reporting misstatement. Having the possibility of two types of fraudulent acts ganging up on inventories at the same time, the CFE doesn’t want to waste time going down the wrong path, so it’s very important to determine which fraudulent act is likely occurring.

Any discussion of fraud likelihood involves the concepts of concealment, conversion, and opportunity. So, in addition to “how” the Inventory fraud took place, other questions need to be addressed, such as: How sophisticated is the concealment strategy? Who has the most benefit to gain by the theft, misuse, or misstatement of the inventories? Who has and where are the opportunities to divert/misstate inventories? These are the questions that need to be answered by the CFE/auditor, and fortunately, the tools and guidance are available from the ACFE to achieve the right answers when faced with almost any pattern of inventory fraud.