Other Manipulations to Consider
“Ghost Goods: How to Spot Phantom Inventory” ( JofA, June01, page 33) raised some excellent points about how companies can commit fraud by manipulating inventory costs and/or quantities.
The article had one drawback, however. It failed to point out there are a number of ways a company can use inventory valuation methods to manipulate profits in various economic environments.
For example: Under inflationary conditions, a company electing to use the Fifo method would be considered highly aggressive. This is because the inventoried items sold would have been carried at their lower manufacturing costs, understated relative to current conditions, to produce higher profits.
Conversely, a company which operates in a high-tech area, such as computer equipment manufacturing, would be seen to be taking an aggressive stance if it chose the Lifo method, because cost trends in this area have tended to decline—items produced earlier may have higher costs than current production. Once again, the inventory valuation method will lead to increased profits.
Similarly, the methods can be used to influence cash flows. If a company used the Lifo method in an inflationary period, a lower reported profit and lower taxes would result, thereby increasing cash flows.
Because there are ways to influence profits without committing outright fraud, auditors need to be aware of these kinds of choices, since they go directly to corporate management’s state of mind. If management is willing to push the rules to the limit, and use unorthodox methods, the question then becomes, How far will it go?
Mark S. Glochowsky
Gerber Plumbing Fixtures Corp.