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.
ASSESSING THE RISK OF INVENTORY FRAUD
Statement on Auditing Standards no. 82, Consideration of Fraud in a Financial Statement Audit, lists many factors at play in cases of financial statement manipulation. In evaluating risks of inventory overstatements, the auditor should answer the following questions. The more “yes” answers, the higher the risk for inventory fraud
Is the company attempting to obtain financing secured by inventory?
Is inventory a significant balance sheet item?
Has the percentage of inventory to total assets increased over time?
Has the ratio of cost of sales to total sales decreased over time?
Have shipping costs fallen compared with total inventory?
Has inventory turnover slowed over time?
Have there been significant adjusting entries that have increased the inventory balance?
After the close of an accounting period, have material reversing entries been made to the inventory account?
Is the company a manufacturer, or does it have a complex system to determine the value of inventory?
Is the company involved in technology or another volatile or rapidly changing industry?
CASE STUDY: FAR MORE GHOSTS
Since he was a kid, Mickey Monus loved all sports—especially basketball. But with limited talents and height (five foot nine on a good day) he would never play on a professional team. Monus did have one trait, however, shared by top athletes: an unquenchable thirst for winning.
Monus transferred his boundless energy from the court to the board room. He acquired a single drugstore in Youngstown, Ohio, and within 10 years he had bought 299 more stores and formed the national chain Phar-Mor. Unfortunately, it was all built on ghost goods—undetected inventory overstatements—and phony profits that eventually would be the downfall of Monus and his company, and would cost the company’s Big 5 auditors million of dollars. Here is how it happened.
After acquiring the first drugstore, Monus dreamt of building his modest holdings into a large pharmaceutical empire using power buying, that is, offering products at deep discounts. But first he took his one unprofitable, unaudited store and increased the profits with the stroke of a pen by adding phony inventory figures.
Armed only with his gift of gab and a set of inflated financials, Monus bilked money from investors, bought eight stores within a year and began the mini-empire that grew to 300 stores. Monus became a financial icon and his organization gained near-cult status in Youngstown. He decided to fulfill a sports fantasy by starting the World Basketball League (WBL) in which no players would be over six feet tall. He pumped $10 million of Phar-Mor’s money into the league.
However, the public did not like short basketball players and were not buying tickets. So Monus poured more Phar-Mor money into the WBL. One day, a travel agent who booked flights for league players received a $75,000 check for WBL expenses, but it was disbursed on a Phar-Mor bank account. The employee thought it odd that Phar-Mor would be paying the team’s expenses. Since she was an acquaintance of one of Phar-Mor’s major investors, she showed him the check. Alarmed, the investor began conducting his own investigation into Monus’s illicit activities, and helped expose an intricate financial fraud that caused losses of at least half a billion dollars.
THE GAME IS OVER
Generating phony profits over an entire decade was no easy feat. Phar-Mor’s CFO said the company was losing serious money because it was selling goods for less than it had paid for them. But Monus argued that through Phar-Mor’s power buying it would get so large that it could sell its way out of trouble. Eventually, the CFO caved in—under extreme pressure from Monus—and for the next several years, he and some of his staff kept two sets of books—the ones they showed the auditors and the ones that reflected the awful truth.
They dumped the losses into the “bucket account” and then reallocated the sums to one of the company’s hundreds of stores in the form of increases in inventory costs. They issued fake invoices for merchandise purchases, made phony journal entries to increase inventory and decrease cost of sales, recognized inventory purchases but failed to accrue a liability and over-counted and double-counted merchandise. The finance department was able to conceal the inventory shortages because the auditors observed inventory in only four stores out of 300, and they informed Phar-Mor, months in advance, which stores they would visit. Phar-Mor executives fully stocked the four selected stores but allocated the phony inventory increases to the other 296 stores. Regardless of the accounting tricks, Phar-Mor was heading for collapse. During the last audit, cash was so tight suppliers threatened to cut the company off for nonpayment of bills.
The auditors never uncovered the fraud, for which they paid dearly. This failure cost the audit firm over $300 million in civil judgments. The CFO, who did not profit personally, was sentenced to 33 months in prison. Monus went to jail for 5 years.
Why didn’t the auditors see signs of fraud at Phar-Mor? Perhaps, they just believed in their client—they read the newspaper articles and watched the television spots on the hard-driving Monus and bought the hype. They might have conducted the audit under a faulty assumption: Their client would not be motivated to commit financial statement fraud because it was making money hand over fist. Looking back, the auditors might have been able to spot the ghosts if anyone had asked a fundamental question: How can a company make money by selling goods below cost?
JOSEPH T. WELLS, CPA, CFE, is founder and chairman of the Association of Certified Fraud Examiners, Austin, Texas. He can be reached at email@example.com .