Inventory Fraud
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Over the last decade corporate America has seen a significant increase in white-collar crimes and corporate scandals. This lead to the enactment of the Sarbanes-Oxley Act by the United States Congress in 2002 which required transparency in financial reporting, enhancement of penalty for white-collar crimes and more accountability for corporate executives. But despite the enforcement of the Sarbanes-Oxley Act there has been a steady increase in incidents of inventory and other corporate frauds which have internal auditors and anti-fraud professional scurrying to develop strategies to prevent and detect fraud, or simply to manage the risk of fraud. Among the many different types of fraud, inventory fraud is probably the most common. This is because inventory has a significant impact on the financial statement and managers can easily manipulate inventory count as in the Phar-Mor case. In this case, managers overstated inventory count so that the cost of goods sold would appear lower, thus overstating income. Because inventory fraud is on the rise it is the responsibility of management to implement anti-fraud strategies to mitigate and manage the risk of inventory fraud.
Since inventory fraud is rising it is very important that auditors develop auditing procedures that will help with the detection of fraud within their organizations. Although it is one of the easiest types of frauds to commit it is also one of the hardest frauds to detect. According to forensic accountant Craig Greene, “it is more difficult to detect inventory fraud compared to other asset thefts due to large volume of 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 production process”. This is because many companies avoid maintaining accurate inventory records, while other companies will overstate the inventory on purpose by manipulating the cost of overhead since it is based on a set of assumptions. Also companies will alter the cost of repairs orders in process which can either overstate or understate an inventory. These various situations can make fraud detection very difficult for auditors to catch.
Planning an audit to detect fraud must be carefully planned and executed. Generally accepted Auditing Standards (GAAS) can help detect fraud. GAAS requires auditors to “plan for the audit by assessing the risk of errors and irregularities including fraud”. First the Auditor will list inventory fraud exposures. An example of an inventory fraud scheme is double counting which is what Phar-mor company executed They moved inventory from other stores into the five stores the auditors planned to audit. This is considered double counting because the company moved inventory from one store were inventory was already counted to another that was still counting.
The second step is to look for unusual circumstances. The auditor should look for reasons that will cause management to make fraudulent inventory reports. A great example is when a companys inventory is larger than its assets, and is not making profit. This is a great reason that can push managers to make false inventory. In addition to analyzing Inventory fraud related symptom auditors should look to see whether balances in inventory, purchase returns, and discounts are rapidly increasing or too high. Also they should focus on end of the period inventory changes, because a change in that can cause a drastic overstatement or understatement in the inventory and that will cause a change in the cost of goods sold, then which in turn will make the gross profit increase. Finding symptoms does not always mean that fraud has occurred, but it can help lead to findings of a fraudulent activity.
Using experienced Auditors and speaking with those that directly handle the inventory is also very beneficial in detecting fraud. A well experienced investigator can speak with the individuals that handle the inventory and get information whether the items work, and also in what condition the merchandise in hand are in. using some of these techniques, auditors should be able to detect more inventory fraud.
Though inventory fraud is one of the hardest to detect, it is preventable. The first step to preventing fraudulent activity is to conduct fraud risk assessment which helps identify the opportunities for fraud to exist, and measures the risks. The second step is to apply the prudent preventative controls that will mitigate the risks. Also carrying out a comprehensive monitoring by employees and having internal an
Creating an overall inventory policy and verifying that inventory records are accurate are great ways to prevent inventory fraud. In setting an inventory policy, management will need to stress the issue of keeping a low enough level of inventory, which will reduce storage cost. Also keeping a low enough level of inventory will reduce the companys investment in working capital therefore leaving the company