Below are another techniques set you can apply to detect and prevent inventory fraud by management override:

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Technique-6: Ignore Obsolete Inventory

In even the best-run companies, some obsolete inventory will always be written off each year. The largest amount of write-offs will occur in those situations where there are poor inventory tracking systems, because employees will tend to ignore or repurchase components that are already in stock if those parts cannot be found.

Obsolescence also arises when the purchasing staff buys excessive quantities of parts under the misguided notion that it is reducing per-unit costs by buying in bulk. Finally, obsolete inventories will arise when the engineering staff switches over to new parts for an existing design without first drawing down existing stocks of old parts. If all three of these issues are present in a company, then the annual write-off due to obsolescence can be remarkably high—well in excess of 10% of the total inventory balance.

Given the potential size of the write-off each year, it is no surprise that many managers will vigorously deny the existence of such large quantities of unusable inventory. Their method for eliminating this expense can cover several actions. One is to sharply reduce the obsolete inventory allowance, which is a reserve that the accounting staff accrues in each reporting period in anticipation of a future writeoff of inventory. They can also pressure the warehouse and accounting staffs to stop or sharply reduce the amount of actual write-offs taken against this reserve, thereby leaving so much of the reserve in place that they successfully argue in favor of no further expense accruals to add to the reserve. They can also clean up or reshuffle the inventory, so that a casual or inexperienced observer will not notice any inventory that is covered with dust or has otherwise clearly been unused for a long period.

I am aware of one company that even hired a maid to dust off the inventory! Finally, a manager can disable the reports that itemize those inventory components or products that have not been used recently, and which are the principle and most accurate tools for identifying obsolete inventory. The combination of all of these activities can severely reduce or eliminate obsolescence write-offs.

The truly clever manager will not implement all of these changes at once, but rather will either gradually increase the usage of each technique or implement each one in a staggered fashion. By doing so, the external auditors will not see a sudden and highly suspicious drop in obsolescence write-offs, but rather a gradual decline, which the manager will have a much easier time explaining away as being caused by a gradual improvement in the company’s ability to control its inventory. This is a difficult activity to stop, especially if a manager is only reducing the obsolescence write-offs in small increments. One action is to respond promptly and in detail to any special request by the outside auditors for reports that show the age of selected inventory items, while another possibility is to ensure that the auditors have discussions with those members of the warehouse staff who can identify old inventory items; however, in this case, the severity of possible retribution by the responsible manager may keep anyone from talking. A final possibility is to suggest that the auditors run a trend line of inventory write-offs in relation to inventory turnover, because this ratio should be relatively steady from year to year. The auditors can then calculate a probable obsolescence expense based on this calculation and force the manager to accept the extra expense as part of the audit.

 

Technique-7: Change the Components of the Overhead Cost Pool

One of the areas that always seems to attract the attention of the fraudulent manager is the overhead cost pool. This pool of costs includes all overhead costs that will be allocated to inventory, rather than be directly expensed within the reporting period. If the number of expenses listed here can be increased, then the proportion of costs charged to the current period will drop, resulting in an increase in profits for the period.

The types of costs charged to the overhead cost pool are relatively standard and are as follows:

  1. Depreciation of factory equipment and facilities
  2. Factory administration expenses
  3. Indirect labor associated with production activities
  4. Indirect materials expended in support of production activities
  5. Factory maintenance
  6. Officers’ salaries related to production
  7. Benefits of production employees
  8. Quality control costs
  9. Rent of any production equipment or facilities
  10. Rework labor
  11. Taxes related to production assets
  12. Utilities related to production activities

 

Although the specific types of costs that can be allocated are clear-cut, there are two ways to still commit fraud in this area. The first approach is to dump unrelated costs into approved accounts that will be summarized into the overhead cost pool.

For example: the manager may require the accounts payable staff to code all office supply billings into the production supplies account, rather than a separate “office expenses” account. Another variation is to record all fixed-asset purchases into the production equipment asset account, so that the resulting depreciation and personal property taxes will all be loaded into the overhead cost pool. The second and more common approach is to increase the proportion of costs allocated between the production cost pool and period expenses. This is particularly likely when allocating the cost of officer salaries to production, because this is a highly subjective measure that cannot be precisely proven without a time-consuming study of the activities of each company officer.

A combination of the activities noted here will result in a larger overhead cost pool, which will increase profits as long as the amount of inventory (to which all of these additional costs are being directed) does not fall, which would result in the expensing of some portion of these previously capitalized costs. Prevention is primarily in the hands of either internal or external auditors, who can run historical trend lines on the size of individual line items within each cost pool, as well as question the reasons for changes in allocated amounts.

 

Technique-8: Change the Basis for Overhead Allocation

When allocating overhead costs to products, the most common approach is to charge a predetermined amount of overhead to each dollar of direct labor that is used in each product. The direct labor component of the equation has been used for decades and is still the most common one used, despite the incursions of the much more sophisticated and accurate activity-based costing (ABC) allocation system. When a manager wants to inflate the value of inventory, thereby driving down the cost of goods sold, one possible approach is to cast around for a different allocation system that results in more overhead dollars being allocated to the inventory. It does not really matter to the manager which system is more accurate; he just wants the one that allocates the most overhead dollars to inventory. The way in which this type of fraud begins is that a manager piously proclaims that it is time to throw out the outdated direct labor allocation system (which may be a valid claim), and so commissions a study by the accounting staff to find several allocation systems that are “more accurate.” The accountants go off in a corner, chuckling to themselves that they finally have a manager who cares about cost accounting, and come back with several possible allocation systems. The manager expresses deep interest in all of the new systems, and asks that the accountants revalue the inventory based on each system, just to see what happens. When the study is completed, the manager runs through the list of inventory valuations and picks the one that yields the highest possible valuation; he does not care about the theoretical underpinnings of the system selected, he just wants a higher valuation.

Because this type of cost accounting change appears to be perfectly valid, and cannot even be considered fraud (because the new system may actually allocate costs better than the old one), there is not a great deal to be done about it. However, one should consider this a warning sign that if a manager is fiddling with the allocation system, he may have designs on other alterations to the costing system that will arise later.

 

Technique-9: Over-allocate Overhead Costs

The normal approach for allocating overhead to inventory is to either compile all overhead costs for each reporting period and then allocate the actual amounts based on some allocation methodology or enter in the computer system a standard overhead cost for each item, and then adjust the total standard amount at the end of the reporting period so that it matches the total cost actually accumulated during the period. The first method is difficult for a fraudulent manager to alter, but the second one is subject to some manipulation, with the assistance of the accounting staff.

If the standard overhead system is used (the second method just noted), then the amount automatically allocated to each item in inventory will stay the same in every period, until someone goes into the computer records and manually alters them.

A fraudulent manager can take advantage of this system by convincing the controller that there is no need to adjust this standard amount to match actual overhead costs in each period; making an adjustment at the end of the reporting year is sufficient. The manager can then raise the standard overhead rates charged, which has a dramatic upward impact on the value of inventory, thereby showing excellent reported profits until the end of the year. Even then, knowing that auditors are sure to review the adequacy of the overhead allocation, a manager who is working in concert with the accounting staff can shift actual costs from other accounts into the overhead cost accounts to make it appear as though actual overhead costs have risen, thereby validating the increased standard overhead costs charged to each product. The greatest failing of this type of fraud is that it requires collusion between the fraudulent manager and the accounting staff—and the more people involved in the farce, the greater the chance that the secret will leak out. Also, a thorough auditing staff has a good chance of finding this type of fraud by carefully examining year to year changes in the various accounts that are used to compile overhead costs, and then closely investigating those accounts in which large year-to-year cost increases have occurred.

 

Technique-10: Shift Cost Allocations Away from Non-production Departments

If a company uses the traditional method of cost allocation, then all overhead costs are assigned to production activities, which means that some of the costs will be charged to inventory, and some will go into the cost of goods sold. This is the ideal situation for the fraudulent manager, because he can then concentrate on altering the system so that as much of the cost as possible is allocated to inventory, thereby driving down the cost of goods sold. However, if the cost allocation system is a more sophisticated one that also allocates costs to other departments, then those costs will probably be charged directly to expense, which leaves fewer costs to be allocated to inventory. For example: if a company has one or more service departments that provide services to other departments within the company (such as the computer services department), a reasonable allocation approach is to determine the usage of those services by all departments and allocate the costs accordingly; by doing so, some costs will be charged to general and administrative departments, whose costs are always charged directly to expense in the current reporting period. If a fraudulent manager is looking for costs to capitalize into overhead, then such a sophisticated overhead allocation system will be a target for modification. The easiest approach is for this manager to order a reversion to the traditional allocation system that dumps all costs into production activities. If this direct conversion is not possible, then the manager will attempt to alter the allocation system so that a higher proportion of service costs are allocated to production.

The best response is to prepare a report that clearly shows the impact on reported profits that result from the manager’s changes, as well as how the new allocation system is clearly skewing costs. This information should be sent up the chain of command to the controller or chief financial officer, who should use it to deal with the manager causing the changes.

 

Technique-11: Change Inventory Valuation Methods

Every inventory is valued using some underlying valuation method, such as LIFO or FIFO. These valuation methods are based on the assumed flow of inventory through a facility. For example: if you stock a shelf with inventory, the first inventory you load onto the shelf is positioned at the rear, where it will stay until all other inventory in front of it has been used. Under this assumption, the last inventory in (i.e., at the front of the shelf) is the first inventory to be used (i.e., a shopper or picker always takes the inventory at the front of the shelf first). This assumption is called the last-in, first-out (LIFO) method. The reverse assumption applies to the first-in, first-out (FIFO) method.

Whichever valuation method is used (and there are several other valid ones), there is a different impact on the inventory’s valuation. For example: when there is a great deal of inflation over several years, the inventory stored at the back of the shelf will be the oldest, and so also has a lower cost than the more recent, and therefore more expensive, items near the front of the shelf. If a company currently uses the LIFO valuation methodology, and a manager wants to increase the value of the inventory, he can switch to the FIFO method; in our example, this will assign the latest, inflated, costs to inventory, while using up the oldest and least expensive inventory items first. Therefore, by altering the valuation method, one can either increase or decrease the value of the inventory, even though the inventory has never moved.

Altering the inventory valuation method is legitimate and may in fact better reflect the actual movement of costs through the inventory. However, such a change is discouraged under GAAP and requires a disclosure in the financial statements, which makes the impact of the change clear to readers of those statements. Nonetheless, if making such a change will improve the level of reported results, a manager may try it. If the accounting staff is unhappy about the switch, it can present its case to the outside auditors, who can determine if actual cost flows accurately reflect the proposed change, and who can refuse to render an opinion on the statements if they feel the change will result in misleading financial statements.

 

Technique-12: Record Sales Through Bill-and-Hold Transactions

When a manager is having difficulty selling products, a clever alternative is to enter into arrangements with customers whereby they can purchase additional quantities of product, frequently at a significant discount, but they do not have to take delivery or pay for the items until they are shipped, which may be some months in the future. Because the products do not meet the basic accounting test of having been shipped, auditors will examine these transactions in great detail and will request written confirmation from customers that these are legal and nonreversible sales. Although this “bill and hold” transaction is not technically illegal, the end result is that a company has stuffed an excessive quantity of product into its distribution pipeline, and to such an extent that some of it has backed up into the company’s facilities. At some point in the near future, there will have been so many sales recorded through bill and hold transactions that customers will no longer need to purchase additional products until they have flushed out the bulk of their bill and hold inventories. When that time arrives, sales will plunge, resulting in major losses.

The fraudulent manager will try to build up bill and hold transactions to the greatest possible extent, collect his or her performance-based bonus, and leave the company just before sales suddenly dive.

This is not a difficult transaction to detect, because there must be a reasonable amount of accompanying documentation to satisfy the outside auditors. Also, it is visually apparent, because the warehouse will be overloaded with finished product that is being held for customers. The best way to stop this practice is to point out to senior management that working capital requirements have greatly expanded, because the company has now invested in inventory that is technically owned by its customers, but for which they do not have to make any payments until after they accept delivery.