Inventory Manipulation – Major Consideration for Accounting Frauds

Accounting fraud is the intentional manipulation of financial statements to create a false appearance of corporate financial health. Furthermore, it involves misleading investors and shareholders. A company can falsify its financial statements by overstating its revenue, not recording expenses, capitalizing expenses, manipulating inventories and other assets & liabilities.

Inventory:

Inventory are assets that are held for sale in the ordinary course of business, in the process of production for such sale; or in the form of materials or supplies to be consumed in the production process or in the rendering of services. Inventory accounting is very crucial as revenue is recognised when inventory is sold and at the same time it appears on the income statement under the cost of goods sold (COGS). Any under or over reporting of COGS will impact the profits for the year. 

Inventory consists of raw materials, unfinished and finished goods that are generally stored in warehouse. Ind AS 2 provides various methods for inventory valuation, there is a scope for gap in interpretation of the standard while accounting for inventories i.e. the amount of cost to be recognised as an asset and carried forward until the related revenues are recognised. Also there are issues relating to interpretation for writing off of inventory etc. This leaves room for interpretation by corporations and leaves wiggle room for manipulation of inventory if a company is so inclined.

Inventory Manipulation:

Manipulation of inventory, comprised the majority of asset valuation frauds. Some companies are more at risk for inventory fraud than others. Obviously, service companies with minimal inventory on hand bear little risk of inventory embezzlement; instead, it is more common among retailers, manufacturers, and contractors. 

The inventory account is just a convenient place to hide financial misstatement ploys, such as skimming or bogus sales. Thousands of journal entries are typically made to the inventory account, and it is closed out to cost of sales each year. So, manipulators with access to the accounting systems may bury their scams in the inventory account. Then, victim-organizations may write off discrepancies between the computerized perpetual inventory records and physical inventory counts as external pilferage, obsolescence, or errors. When, in fact, it is due to intentional manipulation of the accounting systems.

Inventory Manipulation will generally fall under following three categories:

1] Artificially inflating the quantity of inventory on hand:

It is mandatory for companies to conduct physical verification of inventory at reasonable interval. Accordingly value of inventory is recorded on the basis of these counts. The management can manipulate accounting records by simply falsifying the inventory count figure. Also they can add fictitious items to inventory by journal entries, shipping and receiving reports or purchase orders.

Warning signs for identifying inflation of inventory quantity: 

• Investors should pay attention to Clause 2 of CARO report which forms part of Annual report, where if any discrepancies observed will be highlighted by the auditor;
• Observe for large quantities of high cost items in summarized inventory;
• In the related party schedule check for excessive inter-company and interplant movement of inventory with little or no related controls or documentation.

2] Inflating Inventory Value:

Inventory can be manipulated by adjusting the price of goods in the company’s accounting system for a variety of reasons other than to boost earnings. For instance, a common reason to inflate the value of inventory is to obtain higher finance from banks using the inventory as a security or to cover inventory shortages. This can be accomplished by creating false journal entries designed to increase the balance in the inventory account. Another common way to inflate inventory value is to delay the write-down of obsolete or slow moving inventory also by capitalizing certain expenditures which should have been expensed out. 

Warning signs for identifying inflation in value of inventory: 

• Few or no write-downs to market or no provisions for obsolescence in industries where there have been changes in product lines or technology or rapid declines in sales or markets warrant for further investigation;
• Industries where products have short shelf life or are being updated frequently in those companies specific attention needs to be given for provision of obsolete inventory which should be verified with the industry standards;
• Check for shipping costs that decrease as a percentage of inventory.

3] False Sales of Inventory:

The false sale is never recorded as a sale in the sales records, which are usually kept independently from the inventory records. The false credit sale may be recorded (probably under a false name) but the amount never collected and eventually written off. A variation of the scheme is for the perpetrator to skim the proceeds of a valid sale to a real purchaser and not record the sale and the payment for the sale that is misappropriated.

Warning signs for identifying fake inventory sales:

• Analyze the trend of provisions for writing off of debtors.

Common hygiene checks that needs to be carried out:

• Check for irregular uptrend gross profit margin;
• Observe inventory that increases faster than sales;
• Take note of inventory turnover that decreases from one period to the other;
• Observe inventory as a percentage of total assets that rise faster than expected; and
• Notice decreasing cost of sales as a percentage of sales.

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