Ghost Goods: How to Spot Phantom Inventory

What auditors have to know to uncover phony figures. Just 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. FICTITIOUS INVENTORY 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. …