Following on my previous post about How To Perpetrate and Prevent Inventory Fraud [17 Techniques]. Here we are going to start with the techniques:
Tecnique-1: Change Labor Routing Assumptions
Although labor usually makes up a relatively small proportion of the total cost of a product, this cost can be artificially expanded to result in a much larger proportion, which then drives up the cost of inventory, reduces the cost of goods sold, and results in a higher level of reported profitability.
The way to increase the labor costs charged to a product is to alter the labor routings so they spread the cost of equipment setups over a smaller number of parts produced—this means that the assumed length of production runs is shortened. For example, if a metal stamping machine requires 10 hours of setup before it can stamp a particular part, then the cost of that setup can be charged to the resulting manufactured parts. If the setup cost is $1,000 and the number of parts produced during the production run is 1,000, then the cost of the operation per part will be $1. However, if the labor routing is altered so that the assumed length of the production run is much shorter, such as 100, then the cost allocated to each unit goes up to $10.
Obviously, a small change in the assumption leads to a large change in cost, which makes this a worthwhile endeavor for a fraudulent manager to undertake. The approach can be further disguised by making a series of small, incremental reductions in the assumed production run lengths in the labor routings over several years, so that auditors do not see any sudden changes in costs at one time. I noted one situation where a shaped metal part suddenly jumped in cost from $2 to $6,000, which was so excessive that auditors spotted it at once, quickly uncovered the entire plot, and forced the company in question to restate its inventory based on prior-year labor routing information.
The best way to detect labor routing alterations is to review a selection of labor routings with the industrial engineering staff to obtain their opinions regarding the proper production run lengths. If there is some chance that the engineers are involved in the labor routing changes, then bringing in an outside consultant who can review the data and observe actual production runs may be the best alternative.
Another detection technique is to turn on the tracking log option in the computer system, which notes who makes all changes to the labor routings file. The best prevention method is to restrict access to the computerized labor routings file.
Technique-2: Change Bill of Material (BOM) Components
The bill of materials (BOM) is the most sacrosanct document used by the engineering and purchasing departments, and it is considered absolutely inviolable by both of those departments. However, there is a way for a fraud-minded manager to not only alter bills of material in order to skew financial results, but to even make both departments go along with and even initiate the change. A manager who wants to improve financial results wants to include every conceivable product component in a bill of materials, because this will create a higher per-unit cost for each item in inventory (including those already in inventory), which yields a higher inventory valuation. An easy way to do this is to put all fittings, fasteners, and shop supplies into the bills that are even remotely connected to a specific product. The engineering staff, whose job it is to do this, will think they have a micromanager on their hands and will make the changes just to humor him.
Consequently, a fraudulent manager can quickly engineer a reduction in the cost of goods sold in the 1% to 2% range without raising any suspicions by anyone. The change is small enough that most cost accountants and auditors will probably not notice it. The best way to monitor this situation is to keep tabs on the amount of monthly expense in the manufacturing supplies area; this expense should drop precipitously, because the expense is being capitalized into the inventory. Another detection technique is to turn on the tracking log option in the computer system, which notes who makes all changes to the labor routings file.
This practice is difficult to stop, because of its limited nature and theoretical justification. The best approach is to adopt a company-wide policy regarding the treatment of supplies, fittings, and fasteners, so that a fraudulent manager cannot alter the bills of material without breaking company policy. A good prevention method is to restrict access to the computerized labor routings file. Of course, one can also make major changes to a bill of materials in order to effect immediate major changes in product costs. However, a major change will immediately flow through to excessively large picking tickets and the automated purchasing of considerable excess quantities of goods, so changes of this scope are much more easily detected.
Technique-3: Change Normal Scrap Assumptions
Most bills of material contain a list of each part or assembly that is used to manufacture a product, as well as the unit of measure for each part, the standard quantity used, and the standard scrap percentage that is assumed to arise in the course of production. This last item can be manipulated for short-term gains in reported levels of profitability. If the scrap percentage is altered, then a product’s cost will increase in a standard costing environment, because we multiply the cost of each inventory item by the standard scrap percentage associated with it to arrive at a total cost. As a result, both the cost of goods sold and the value of all work-in-process and finished goods inventory will increase, which does little to assist a fraudulent manager in the long run. However, if a company operates in a seasonal industry where there is a continuous inventory build-up for most of the year and then a short selling season, a fraudulent manager who is working toward a short-term profitability bonus can alter the scrap percentage upward, which can increase the inventory valuation by several percent, while the small proportion of sales during most months will have a minor impact on profitability. The result is a boost in the short-term reported level of profitability. However, the fraudulent manager will see these “paper profits” reversed as soon as the inventory is sold off, which should occur during the primary selling season. Consequently, this approach only works if the manager causing this activity will be rewarded for a short-term run-up in profits. It also requires a standard costing system, which relies heavily on accurate bills of material.
This is one of the most short-term approaches to fraud, but a clever manager can combine it with another method, which is a massive expansion in the level of inventory. By doing so, the manager can apply the extra scrap percentage to more inventory, irrespective of the level of sales. This is a particularly rewarding method if a manager is about to receive a performance bonus and then leave the company, because he or she will not care that the inventory levels and scrap percentages will have to be reduced at some point in the future, causing all “paper profits” to be reversed. This type of fraud is most easily guarded against if the manufacturing software is designed so that a single change to a scrap percentage field in one screen will result in an automatic and cascading ripple effect that changes all of a company’s bills of material. This is an easy field for a fraudulent manager to personally access and change, but it is equally easy to install password protection to it, thereby denying access to all but a few authorized employees. Given the critical nature of the information in a bill of materials, it is always a good idea to use password protection of this information, irrespective of the likelihood of fraud. At a minimum, be sure to turn on the track changes feature in the software, so an historical record is kept of all changes made.
Technique-4: Alter Unit Costs
A good accounting computer system will record the exact unit cost of any item purchased, so that the per-unit cost passes into a LIFO, FIFO, or some similar database that carefully tracks the costs of all parts kept in stock. When done properly, the system should represent an extremely accurate picture of all inventory costs, which can then be traced back through the accounting system to the exact supplier invoice that provides evidence of each cost. However, this system can be skewed in two ways.
One approach is to gain access to the costing data and directly alter the per-unit costs of all or selected inventory items. If the changes made are extremely small, such as tenths of a cent, the differences may appear so insignificant that an auditor will not bother to trace why there is such a tiny difference in the computer’s recorded cost and the cost on the supplier’s invoice. However, when there are many units of a particular item in stock, that small incremental change in the cost can result in a significant alteration in the value of the inventory, and so it is worth the effort for a fraudulent manager to undertake.
The best way to spot this problem is to use an accounting system that records and reports on all transactions in the system. Then a periodic trace of transactions relating to costing records will provide abundant evidence that someone has altered records. Another approach is to lock down all access to the costing records to all but high-level personnel. Under normal circumstances, there is no valid reason for anyone to access these records, so limiting access should not be an issue.
The other way to alter costing records is to change the assumptions under which costs are recorded from that of noting just the actual per-unit cost of each item to adding on the freight cost of each delivery from a supplier. This is perfectly acceptable under generally accepted accounting principles (GAAP), but it will result in a higher unit cost for each item in inventory, which will result in a lower cost of goods sold and a higher level of profitability. If a company is using LIFO or FIFO costing, the change will be gradual, because the new and higher costs will only gradually take over as older layers of inventory costs are used up. However, under a standard costing system where all inventory costs are replaced at once with the new cost, there will be a marked one-time jump in the inventory value that is sufficiently large to attract the attention of a fraudulent manager.
Technique-5: Increase Value-Added Inventory
One of the most commonly cited forms of cost accounting fraud noted in business schools is when a manager deliberately increases the amount of value-added inventory on hand, which results in a much larger allocation of overhead costs to inventory, thereby keeping the overhead from being charged to expense. To do this, the fraudulent manager first obtains a copy of the inventory that breaks down the amount of direct labor charged to each product at either the work-in-process or finished goods stages of production (or something besides direct labor, if something else is used to allocated overhead costs to the inventory). He then sorts the list to determine which inventory items have the highest labor content, and then issues orders for exceptionally large quantities of those inventory items to be produced, usually far beyond what will actually be needed in the normal course of business. The accounting staff then allocates overhead to the inventory in its usual manner, which is probably by summarizing the direct labor content of the inventory and charging the monthly pool of overhead costs to the inventory by multiplying a standard cost of overhead to each direct labor dollar. For example, if the preset overhead allocation rate is $2.50 to be applied to each $1 of direct labor, then Inventory Fraud / 55 the overhead cost applied to inventory for $20,000 of direct labor will be $50,000.
By shifting so much additional overhead cost to the inventory, there will be less left over to charge to the cost of goods sold, which results in a higher profit. The fraudulent manager then collects his performance bonus before anyone realizes just how much larger the inventories have become, and leaves the company.
This is a dangerous practice to pursue from the perspective of overall company health, because there must be a considerable additional investment in inventory before there is a noticeable increase in profits. The cash invested in this inventory may not be recovered for some time, because the inventory may have been expanded to one or more years’ worth of inventory; and the larger the inventory, the greater the chance that some of it will be written off due to obsolescence or be sold at a discount.
The best way to avoid this type of fraud is to reward managers based on not only bottom-line profitability but also the amount of working capital invested in the business. Under this approach, an increase in inventory would result in an increase in working capital, so the manager would receive no bonus, and therefore would not have an incentive to perpetrate this type of fraud.
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