Accounting, Financial, Taxation

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

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.

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.

An unfortunate fact of the business world is that some companies use their inventory systems to commit fraud. Although this can involve the deliberate theft of inventory, it is even easier to artificially inflate or deflate a company’s reported profits without laying a hand on the inventory. This can be done through the alteration of costing records, bills of material, the item master file, and the contents of overhead cost pools, as well as by changing the costing methodology used. In this post, we explore who usually commits inventory fraud, the various types of inventory-related fraud that can be perpetrated, and how it can be prevented (This post can be combined with the inventory control systems I have posted for better picture of how fraud is caused and can be prevented).

Warning!:

1. This post is not going to talk about inventory theft, you know how and what to do with inventory theft. It is rather about inventory fraud in many ways and form that clever (yet, naughty and bad management people) may override to cheat the other board member or stakeholders.
2. This is not about some law speeches, it is not about fraud concept and theories. It is about real techniques for real problem on real inventory cases that you can copy and duplicate for your own cases.

Next, we are going to discuss these inventory common fraudulences and each techniques you can apply for each. But, you know, due to the traffic increase. I will breakdown this topic to become some post series maybe three or four post. There shouldn’t be a problem. You only need to follow the link (I am going to provide it on every bottom of the post) will lead you to the related topic may worth reading for you. So read on…………

Who Commits Inventory Fraud?

Inventory-related fraud is usually instigated at the management level. The reason is that when managers are compensated based on the profitability of the company as a whole or of their individual business units, they have an incentive to stretch reported results. The problem is exacerbated when a disproportionately large part of a manager’s potential income is based on “stretch” profitability goals that can only be achieved through inordinately great efforts. The reverse situation may also be true for privately held companies that are more concerned with the avoidance of taxes; these organizations may reward their managers based on their ability to improve cash flow while holding down the amount of reported profitability. In either situation, the level of fraud initially committed is relatively minor—perhaps a slight adjustment to income that results in a small change in income, but enough to reach a performance goal. However, that small step into the realm of fraudulent behavior makes it easier to make a larger adjustment in the next reporting period, and so on.

Soon, a manager is incorporating fraudulent actions into his or her daily activities and develops a range of activities that will result in skewed financial results. The simplest detection approach is to create a trend line of all major cost categories, inventory levels, and cost allocation pools, and simply trace the levels of the items from as far back as possible, right up to the present day. Because these costs rarely change, either in total or in proportion to each other, variations will reveal the presence of a tampering manager. The level of work required to keep track of this information is minimal, so even a reduced accounting staff or one whose activities are being deliberately forced in other directions should still be able to find the time for such rudimentary analysis. The real problem is that, once detected, the very people who should be acting on the information to prevent fraud may be the ones creating it. If so, consider forwarding the information to the corporate audit committee for further action.