The Four Pillars Of Inventory Fraud

There are a lot of ways a company can illegally boost its financial performance. I will provide a brief explanation and a list of example cases in which a company may participate in dishonest activities regarding inventories. Generally, four main techniques are used by fraudulent companies to boost ending inventories and financial performance: Fictitious inventory, manipulation of inventory counts, non-recording of purchases, and fraudulent inventory capitalization.

The auditors need to familiarize themselves with the procedures in detecting these types of inventory fraud. By following the trend in inventory and analyzing the data, auditors are expected to be able to implement professional skepticism in dealing with inventory accounts. Among the procedures are: investigating whether the ending inventory amount is increasing faster than the sales trend or total assets, checking if shipping expenses are decreasing as a percentage of inventory, and verifying the appropriate disclosure for the reduction in inventory turnover.

The Four Techniques That Companies Use To Commit Inventory Fraud

● Fictitious Inventory

To fraudulently boost inventory levels, one of the easiest ways for companies is to record inventories when they do not actually exist. This usually goes along well with the fabrication of the journal entries, forgery of the purchase orders, and inventory counts sheet numbers which help avoid the auditors from uncovering the fraud.

The fictitious inventory process can come in various creative ways. For example, stacking and counting empty boxes as inventories. Another example would be moving the inventories around multiple locations and double-counting them. These practices will increase inventory level and are violations of the existence assertion under U.S. GAAP.

● Manipulation of Inventory Counts

Another easy way to commit inventory fraud is to manipulate the inventory counts. Auditors may not have the time and resources to scrutinize every inventory in each of the locations a company has, especially if the company is a global company with multiple locations in many countries. Oftentimes, what happens is the auditor will take samples or observe the locations where there are significant amounts of inventories. This gives an opportunity for fraudulent companies to alter the inventory counts for the items the auditors did not count or for the locations not visited by the auditors. This practice also violates the existence assertion and usually is tricky for auditors to detect.

● Non-Recording of Purchases

When purchasing inventories, companies are required to record inventories going into the company and record expenses as cash flowing out of the company. This is intended to keep the books balanced and reflect the company’s actual inventory amount.

By not recording the purchases properly, the company can fraudulently increase the inventory level while keeping the expenses low. This example shows a violation of the completeness assertion.

● Fraudulent Inventory Capitalization

Another way of fraudulent inventory practice is by capitalizing inventories that are not actually owned by the company. The easiest way to do this is through the capitalization of consigned goods. Under U.S. GAAP, companies are required to disclose the consignment information. An omission of this information and a capitalization of a consigned good will be a violation of the rights and obligations assertion. The auditors need to be able to answer the question of whether a particular inventory really belongs to the company or is owned by another company.

How To Detect An Inventory Fraud?

Inventory fraud can be complicated to detect. However, there are several measures that the auditors can take into account when analyzing and detecting these practices. Auditors need to be able to compare the current performance with the one from previous years and note the change in trend.

One of the analytical procedures an auditor can take is to see if the ending inventory is increasing faster than the sales trend. This may be a signal that a company was not capable of selling the inventories as much as what was initially believed. As a result, a company would stock up on inventories that are vulnerable to the risks of becoming obsolete.

Other than the write-downs due to obsolete inventories, an auditor should be aware and professionally skeptical if they had found a reduction in inventory turnover without a proper disclosure over it. Any unexplained decrease in inventory turnover can indicate long-term problems in sales of the company.

Auditors can also check if the Cost of Goods Sold numbers in the books matches the Cost of Goods Sold numbers for tax purposes. A mismatch in this number would hint that there has been a misstatement in the financial reporting.

Common Perpetrators Of Inventory Fraud

Source: “Report to the Nation,” 2018. Association of Certified Fraud Examiners (ACFE) - ACFE is the world-leading anti-fraud organization and fraud examiners. Its activities include providing anti-fraud training and education.

The chart on the left shows the likelihood of inventory fraud committed by either employee, management, or owners. Based on the graph, employees are the most likely perpetrator of inventory fraud. This might be due to the reason that the low-level employees, especially warehouse employees are the ones who work in close proximity with inventories. This makes it easy for them to make slight frauds of inventories, and also cover them up. Employees make almost half of the inventory fraud proportion with 44%. Managers have a slightly less percentage (34%) followed by the owners with 19%.

However, if we take the median loss into the consideration, inventory fraud perpetrated by owners is more likely to be costly, shown by the graph on the right. This might be due to the fact that the people who are in higher positions have a higher power to alter the financial statement and influence the people who are below them.

Indicators Of Heightened Risk For Inventory Fraud

The auditors have the responsibility to remain professionally skeptical when performing an audit in inventory. The auditors need to check and investigate:

- If the company is attempting to obtain financing secured by inventory

- If the inventory is listed as a significant item in the balance sheet

- Whether the percentage of inventory to total assets is increasing over time.

- If the ratio of cost of sales to total sales decreased over time

- If the shipping cost decreasing over time

- If the inventory turnover has slowed down

- If there is any significant adjusting entry that increases the inventory balance recently

- If the company is involved in a rapidly changing industry

- If the company uses a complicated system to value inventory. The auditors need to check the inventory valuation practice of the company and determine if it complies with the U.S. GAAP