When Employees Count too Much

By Craig L. Greene , CFE, CPA

Spotting Overstated Inventory

Because inventory fraud is often more difficult to prevent and detect than other asset thefts, fraud examiners need to understand the mechanics of inventory accounting and the signs of overstated inventory schemes.

The metal bands were a dead giveaway to the "Asset-Based Lender" (ABL) auditors. Computers are never shipped on pallets secured by metal bands. ABL's quick check of the boxes revealed nothing but air instead of the $4 million in inventory that helped collateralize the customer's $7 million working capital loan.

ABL's customer, a mid-size retailer of computer hardware, had attempted to dupe the auditors. Our CPA firm's job was to discover the truth and, of course, find the cash.

We discovered that the hardware company was losing money by selling its products at near break-even and the financial statements were fictitious.

Eventually, our examination would find some of the proceeds anchored off Ft. Lauderdale in the form of a 110-foot yacht, complete with a full-time crew. Yes, the company owner was enjoying the high life at the lender's expense.

Inventory fraud is a significant problem for many businesses. This fraud is often more difficult to prevent and detect than other asset thefts because of a large volume of items in inventory, the number of employees with access to assets, complicated processes involved in production, and the many entries and complex systems used to account for the inventory and the production process.

A Lesson in Inventory Accounting

The fraud examiner needs to understand how inventory is accounted for and valued in an organization before attempting to spot or investigate an overstated inventory scheme.

Generally Accepted Accounting Principles (GAAP) define inventories as:
Those items of tangible personal property, which are held for sale in the ordinary course of business, are in the process of production for such sale, or are to be currently consumed in the production of goods or services to be available for sale.

Items considered to be in inventory differ depending on the business of the company. A manufacturing firm has three classes of inventory: raw materials, work in process, and finished goods.

However, in a wholesale company environment, inventory generally consists of finished goods procured from a manufacturer or another wholesaler/distributor for sale to a retailer or distributor. Likewise, in a retail environment, inventory consists of finished goods for sale to consumers procured from wholesalers and manufacturers.

Most accounting systems account for the procurement of inventory through a charge to an account called "Purchases." The entry to record purchases is typically entered like this:

Debit Purchases $10,000
Credit Accounts payable/cash $10,000
At the end of the accounting period (monthly, quarterly, or annually) a determination of the ending inventory is made to calculate the company's cost of goods sold as follows:
Beginning inventory $ 200,000
+ Purchases 2,500,000
= Goods available for sale 2,700,000
- Ending inventory 300,000
= Cost of goods sold $2,400,000

Ending inventory is often calculated based on recordings of the number of items in a perpetual inventory system. At least annually (usually at the end of the fiscal year) a physical count of the inventory items is made and the perpetual system is adjusted to reflect the quantity physically counted. Companies may use count sheets, count cards, bar scanners, or other methods in recording the physical inventory. "Inventory Shrinkage" is often used to describe the difference between the quantity of inventory according to the physical count and that shown in the perpetual inventory system.

Since inventory differs depending on the business of the company, GAAP allows for numerous methods to value the units of the ending inventory:

Cost Method
Generally speaking, inventories are priced at cost, in which "cost" means acquisition cost plus production costs, if any.

Retail Method
The retail method of inventory pricing uses the selling price of the goods as a starting point for computing ending inventory. The price is adjusted for mark-ups and mark-downs and then a normal gross profit percentage is applied to it.

First-in, First-out (FIFO)
Since the cost of purchasing or making items may vary over time, a method is needed to determine the cost of the remaining inventory. The first-in, first-out method of determining the cost of inventories is based on the assumption that the first goods acquired are the first to be sold.

Last-in, First-out (LIFO)
Under the last-in, first-out method of determining the cost of inventories, the last merchandise purchased is assumed to be the first merchandise sold.

Lower of Cost or Market
When there is evidence that (a) the ability of inventories to produce revenue has decreased in utility to the extent that the company will dispose of them at less than cost, or (b) replacement costs of inventories are less than original cost, the company should write down the inventory to market and charge that write-down to costs of that period.

Regardless of the method of pricing the inventory, the ending inventory valuation of an inventory unit is a computation of the number of units times the valuation amount.

There is an inverse relationship between cost of goods sold and gross profit; the lower the cost of goods sold the higher the gross profit, and the net income of the business.

Reasons for Fraudsters to Overstate Inventory

Fraudsters have myriad reasons for overstating inventory values. Here are a few of many I've observed:

Financial Statement Fraud
Financial statement fraud occurs by increasing the asset value (inventory) and reducing the related expenses (cost of goods sold). Depending on the fraudster and his motive, this fraud may be done on a corporate, divisional, or branch level to meet corporate earnings goals, avoid violating debt covenants, meet internal budgets, earn profit-related bonuses, or increase the value of employee stock options.

Asset-based Lender ('ABL') Fraud
This type of fraud occurs by increasing the value of the inventory because it is used as collateral by the ABL. The borrower may steal or divert the proceeds of the loan.

Covering up Theft
An employee steals some of the company's inventory for personal use or resale. The perpetual inventory system does not show the reduction, so the difference is written off as inventory shrinkage when discovered at the next physical inventory count. Alternatively, that count may also be manipulated to conceal the theft.

Covering up Other Internal Frauds
Fraudsters can cover up other internal frauds by adding them into the company's inventory values through:

• vendor false billing schemes in which purchased items are not actually delivered by the vendor but are included in the inventory and its valuation by an employee receiving payments or other items of value from the vendor;
• personal items charged to the inventory account;
• disbursement schemes charged to inventory, such as other fictitious costs paid or stolen by the employee; and
• vendor fraud in which the customer purchases the raw materials inventory on behalf of the vendor and the vendor diverts the goods to other customers.

Methods of Overstating Inventory
The most common methods of inventory overstatement are:

• falsifying inventory on hand;
• falsifying physical inventory quantities;
• inflating inventory pricing;
• including consigned inventory in inventory values;
• misapplying bill-and-hold terms;
• recording false entries into the general ledger; and
• failing to write down slow-moving or obsolete inventory items.

Falsifying Inventory on Hand

During a physical count of the inventory, the fraudsters place boxes in the area to be counted that hold something other than the inventory item or nothing at all and hope the counters and/or auditors include the boxes in the quantity counted but do not actually open the boxes and check the contents.

Also, the dishonest employee can arrange the inventory on pallets or shelves in such a way as give the impression of a greater quantity, e.g., concealing an open space in a stack of containers. In addition, the fraudster can inflate the inventory by salting it with non-inventory materials. In The Great Salad Oil Scandal of the 1960s, the perpetrators substituted water for salad oil in the inventory.

Additionally, the fraudster can transport previously counted inventory from one count location to the next when the physical counts occur over several days.

Falsifying Physical Inventory Quantities

Since auditors perform only test counts and often do not visit all the locations where inventory is held, falsifying the quantities is an easy fraud to commit. (The fraudster can use this method whether or not the auditors are present.) The fraudster can falsify physical inventory by:

• simply entering additional quantities on count sheets, cards, scanners, etc. that do not exist or adding a digit in front of the actual count;
• falsifying shipping documents to show that inventory is in transit from one company location to another; or
• falsifying documents to show that inventory is located at a public warehouse or other location not controlled by the company.

Inflating Inventory Pricing

Since pricing the inventory can require complex tracking of historical costs and the proper application of one of the two methods described above, it may be easy for the fraudster to manipulate the pricing information. An alternative is to use current supplier costs that often exceed the historical costs of the items purchased.

Including Consigned Inventory in Inventory Values
Some vendors consign inventory to their customers. In a consignment transaction the consignee takes physical possession of the inventory, does not actually own it, and is not obligated to pay for it until the inventory is actually sold. A fraudster may improperly include this consigned inventory in his inventory valuation.

Misapplying 'Bill-and-hold' Terms
In a bill-and-hold transaction, the vendor invoices the sale but holds the inventory in its location for the convenience of the customer. If the vendor representative is also a fraudster, then he could inflate his own inventory value by including these previously billed inventory items he is holding for his customer in the inventory. Thus, the entire proceeds of the sale get added to the vendor's gross profit and falls directly to the bottom line (net income).

Recording False Entries into the General Ledger
The easiest method to inflate the inventories is simply to make false entries into the company's accounting records. This is easily accomplished if no one is properly reconciling the inventory accounts or if the auditors do not thoroughly review or understand the entries to the inventory accounts.

Years ago, I discovered such a fraud in a small business in which the general manager directed the accounting staff to make "inventory adjustment" entries to the company's general ledger, overstating the value of inventory and inflating profits.

The general manager ran the business for an absentee owner and received a bonus based on the company's results.

Failing to Write Down Slow-moving or Obsolete Inventory Items
GAAP requires inventory values to be written down to net realizable value for slow-moving or obsolete inventory. The failure to write down these values results in overstated inventory values. During the physical observation of the inventory, the fraud examiner needs to look for older items that may be rusted, soiled, dusty, etc.

Investigative Techniques to Discover Overstated Inventory
The fraud examiner can use a number of methods to discover overstated inventory:

• analytical reviews;
• physical counts;
• computer analysis and data-mining techniques;
• price testing;
• examination of accounting entries affecting inventory and purchases accounts; and
• confirmation of inventory purchases.

Analytical Reviews
A number of financial ratios have been developed to analyze a company's financial statements. The following financial ratios can reveal analytical symptoms of overstated inventories:

• Age of Inventory [365 x (average inventory divided by cost of sales)] This ratio indicates the average number of days needed to sell the inventory. An increase in the number may indicate that inventory has been overstated.
• Gross Profit Margin (gross profit divided by net sales) This ratio indicates the average percentage of gross profit generated from each sale. An increase could reflect the inflation of inventory.
• Inventory Turnover (cost of goods sold divided by average inventory) Although this ratio is normally used to analyze the effectiveness of inventory management, a low inventory turnover may indicate to the fraud examiner that there is a problem with overstated inventories.

Physical Counts of Inventories
Many companies conduct physical counts of their inventories at or near their balance sheet dates. A complete count of the inventory is often necessary in a fraud examination of overstated inventory. While it may not identify the perpetrators, it is an effective method of detecting overstated inventories. If the fraud examiner cannot conduct a surprise physical count, then he or she should consider surveilling the facility prior to and after the count.

The company may consider hiring an outside inventory firm, which would provide a wide range of services from counting the inventory to pricing and extending it. These firms provide efficient, accurate counts and increase the element of surprise (and allow less time for the fraudster to clean up the inventory) because the company employees do not typically need advance notice of the count. Using an outside inventory firm also eliminates the risk that a fraudster will be on the count team or otherwise participate in the physical count.

Computer Analysis and Data-mining Techniques
The computer can assist the fraud examiner in selecting large or unusual items for further investigation. I've used these techniques recently to investigate overstated inventory in a home improvement retailer by selecting for additional analysis the top six selling items in each of the retailer's 12 departments. After analyzing these items I discovered that the price per unit appears to be overstated for each of these items.

Other computer data-mining selections that may help the fraud examiner include:

• purchases by vendor;
• purchases by item;
• inventory levels by types and dates;
• inventory shipped by address;
• cost per item over time;
• direct labor by item;
• direct materials by item;
• overhead per inventory item; and
• overages/shortages by inventory item;

In a manufacturing environment, the fraud examiner may wish to compare the parts shown on the bill of materials to the detailed inventory records to determine if all items in inventory are used in the manufacturing process.

Price Testing
The fraud examiner should perform extensive price testing to ensure that the inventory unit costs have not been artificially overstated. A price test involves an examination of vendor invoices determining the number of units purchased and the cost per unit that is paid.
The fraud examiner may also want to inspect other documents supporting the invoices reviewed, such as receiving reports, bills of lading, purchase orders, purchase requisitions, and canceled checks.

Finally, the fraud examiner should review the entries recording the purchases in the company's accounting system.

These procedures will help determine if proper controls are in place over the inventory and purchase accounts and if the invoices support the quantities shown in the inventory records. The inventory is probably overstated if there are substantial differences.

Examination of Accounting Entries Affecting Inventory and Purchases Accounts
As part of the investigation, the fraud examiner needs to make a detailed review of accounting entries made to the inventory and purchases accounts. Unusual entries such as round amounts, general journal entries, and credits in the purchases account should be particularly examined.

Confirmation of Inventory Purchases
Independent confirmation of inventory purchases from the vendor or source also may help to identify overstated inventories. The fraud examiner needs to be cognizant that there may be collusion between the vendor and the fraudster.

Inventory fraud is often more difficult to prevent and detect than other asset thefts. When fraud examiners understand the mechanics of inventory accounting and the signs of overstated inventory schemes they have a much better chance of catching the employees who count too much.

Craig Greene, CFE, CPA, is the partner in charge of financial investigative services for McGovern & Greene LLP, Certified Public Accountants and Consultants, in Chicago, Ill. His e-mail address is: craig.greene@mcgoverngreene.com