Question

a: Research a company who used inventory and cost of sales to fraudulently overstate net income. Provide details of your findings.

b: Explain how an auditor can use data analytical tools to identify potentially obsolete inventory.

Answer 1

Answer i(a)

The iAssociation iof iCertified iFraud iExaminers i(ACFE) idefines iaccounting ifraud ias i"deception ior imisrepresentation ithat ian iindividual ior ientity imakes iknowing ithat ithe imisrepresentation icould iresult iin isome iunauthorized ibenefit ito ithe iindividual ior ito ithe ientity ior isome iother iparty." iFinancial istatement ifraud ican itake imultiple iforms, iincluding:

1. Overstating irevenues iby irecording ifuture iexpected isales

2. Inflating ian iasset's inet iworth iby iknowingly ifailing ito iapply ian iappropriate idepreciation ischedule

3. Hiding iobligations/liabilities ifrom ia icompany's ibalance isheet

4. Incorrectly idisclosing irelated-party itransactions iand istructured ifinance ideals.

Inventory iManipulation

Inventory irepresents ithe ivalue iof igoods ithat iwere imanufactured ibut inot iyet isold. iInventory iis iusually ivalued iat iwholesale ibut isold iwith ia imarkup. iWhen iinventory iis isold, ithe iwholesale ivalue iis itransferred iover ito ithe iincome istatement ias icost iof igoods isold iand ithe itotal ivalue iis irecognized ias irevenue. iAs ia iresult, ioverstating iany iinventory ivalues icould ilead ito ian ioverstated icost iof igoods isold, iwhich ican ireduce ithe irevenue iearned iper iunit. iSome icompanies imay ilook ito ioverstate iinventory ito iinflate itheir ibalance isheet iassets ifor ithe ipotential iuse iof icollateral iif ithey iare iin ineed iof idebt ifinancing. iTypically, iit iis ia ibest ipractice ito ibuy iinventory iat ithe ilowest ipossible icost iin iorder ito ireap ithe igreatest iprofit ifrom ia isale.

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iWhen iending iinventory iis ioverstated, ithis ireduces ithe iamount iof iinventory ithat iwould iotherwise ihave ibeen icharged ito ithe icost iof igoods isold iduring ithe iperiod. iThe iresult iis ithat ithe icost iof igoods isold iexpense ideclines iin ithe icurrent ireporting iperiod. iYou ican isee ithis iwith ithe ifollowing iformula ito iderive ithe icost iof igoods isold:

Beginning iinventory i+ ipurchases i- iending iinventory i= iCost iof igoods isold

Thus, iif iABC iCompany ihas ibeginning iinventory iof i$1,000, ipurchases iof i$5,000, iand ia icorrectly icounted iending iinventory iof i$2,000, ithen iits icost iof igoods isold iis:

$1,000 iBeginning iinventory i+ i$5,000 iPurchases

- i$2,000 iEnding iinventory i= i$4,000 iCost iof igoods isold

But iif ithe iending iinventory iis iincorrectly istated itoo ihigh, iat i$2,500, ithe icalculation ibecomes:

$1,000 iBeginning iinventory i+ i$5,000 iPurchases

- i$2,500 iEnding iinventory i= i$3,500 iCost iof igoods isold

In ishort, ithe i$500 iending iinventory ioverstatement iis idirectly itranslated iinto ia ireduction iof ithe icost iof igoods isold iin ithe isame iamount.

If ithe iending iinventory ioverstatement iis icorrected iin ia ifuture iperiod, ithis iproblem iwill ireverse iitself iwhen ithe iinventory ifigure iis idropped, ithereby ishifting ithe ioverstatement iback iinto ithe icost iof igoods isold, iwhich iincreases ithe icost iof igoods isold iin iwhichever ifuture iperiod ithe ichange ioccurs.

When ian iending iinventory ioverstatement ioccurs, ithe icost iof igoods isold iis istated itoo ilow, iwhich imeans ithat inet iincome ibefore itaxes iis ioverstated iby ithe iamount iof ithe iinventory ioverstatement. iHowever, iincome itaxes imust ithen ibe ipaid ion ithe iamount iof ithe ioverstatement. iThus, ithe iimpact iof ithe ioverstatement ion inet iincome iafter itaxes iis ithe iamount iof ithe ioverstatement, iless ithe iapplicable iamount iof iincome itaxes.

To igo iback ito ithe ipreceding iexample, iif iABC iCompany iwould iotherwise ihave ihad ia inet iprofit ibefore itax iof i$3,500, ithe ioverstatement iof iending iinventory iof i$500 inow ireduces ithe icost iof igoods isold iby i$500, iwhich iincreases iABC's inet iprofit ibefore itax ito i$4,000. iIf iABC ihas ia imarginal iincome itax irate iof i30%, ithis imeans ithat iABC imust inow ipay ian iadditional i$150 i($500 iextra iincome ix i30% itax irate) iin iincome itaxes.

Ending iincome imay ibe ioverstated ideliberately, iwhen imanagement iwants ito ireport iunusually ihigh iprofits, ipossibly ito imeet iinvestor iexpectations, imeet ia ibonus itarget, ior iexceed ia iloan irequirement. iIn ithese icases, ithere iare ia ivariety iof itools ifor ifraudulent iinventory ioverstatement, isuch ias ireducing iany iinventory iloss ireserves, ioverstating ithe ivalue iof iinventory icomponents, iover icounting iinventory iitems, iover iallocating ioverhead, iand iso iforth.

Answer i(b)

The isimplest iway ito iidentify iobsolete iinventory iwithout ia icomputer isystem iis ito ileave ithe iphysical iinventory icount itags ion iall iinventory iitems ifollowing icompletion iof ithe iannual iphysical icount. i iThe itags itaped ito iany iitems iused iduring ithe isubsequent iyear iwill ibe ithrown iaway iat ithe itime iof iuse, ileaving ionly ithe ioldest iunused iitems istill itagged iby ithe iend iof ithe iyear. i iYou ican ithen itour ithe iwarehouse ito isee iif ian iobsolescence ireserve ishould ibe icreated ifor ithem. i iHowever, itags ican ifall ioff ior ibe iripped ioff iinventory iitems, iespecially iif ithere iis ia ihigh ilevel iof itraffic iin inearby ibins. i iThough iextra itaping iwill ireduce ithis iissue, iit iis ilikely ithat isome itag iloss iwill ioccur iover itime.

Even ia irudimentary icomputerized iinventory itracking isystem iis ilikely ito irecord ithe ilast idate ion iwhich ia ispecific ipart inumber iwas iremoved ifrom ithe iwarehouse ifor iproduction ior isale. i iIf iso, iit iis ian ieasy imatter ito iuse ia ireport iwriter ito iextract iand isort ithis iinformation, iresulting iin ia ireport ilisting iall iinventory, istarting iwith ithose iproducts iwith ithe ioldest i“last iused” idate. i iBy isorting ithe ireport iwith ithe ioldest ilast iusage idate ilisted ifirst, iyou ican ireadily iarrive iat ia isort ilist iof iitems irequiring ifurther iinvestigation ifor ipotential iobsolescence. i iHowever, ithis iapproach idoes inot iyield isufficient iproof ithat ian iitem iwill inever ibe iused iagain, isince iit imay ibe ian iessential icomponent iof ian iitem ithat ihas inot ibeen ischeduled ifor iproduction iin isome itime, ior ia iservice ipart ifor iwhich idemand iis ilow.

An iadvanced iversion iof ithe i“last iused” ireport icompares itotal iinventory iwithdrawals ito ithe iamount ion ihand, iwhich iby iitself imay ibe isufficient iinformation ito iconduct ian iobsolescence ireview. i iIt ialso ilists iplanned iusage, iwhich icalls ifor iinformation ifrom ia imaterial irequirements iplanning isystem, iand iwhich iinforms iyou iof iany iupcoming iusage irequirements. i iAn iextended icost ifor ieach iitem iis ialso ilisted, iin iorder ito igive ireport iusers isome iidea iof ithe iwrite-off ithat imight ioccur iif ian iitem iis ideclared iobsolete.

If ia icomputer isystem iincludes ia ibill iof imaterials, ithere iis ia istrong ilikelihood ithat iit ialso igenerates ia i“where iused” ireport, ilisting iall ithe ibills iof imaterial ifor iwhich ian iinventory iitem iis iused. i iIf ithere iis ino i“where iused” ilisted ion ithe ireport ifor ian iitem, iit iis ilikely ithat ia ipart iis ino ilonger ineeded. i iThis ireport iis imost ieffective iif ibills iof imaterial iare iremoved ifrom ithe icomputer isystem ior ideactivated ias isoon ias iproducts iare iwithdrawn ifrom ithe imarket; ithis imore iclearly ireveals ithose iinventory iitems ithat iare ino ilonger ineeded.

An iadditional iapproach ifor idetermining iwhether ia ipart iis iobsolete iis ireviewing iengineering ichange iorders. i iThese idocuments ishow ithose iparts ibeing ireplaced iby idifferent iones, ias iwell ias iwhen ithe ichangeover iis ischeduled ito itake iplace. i iYou ican ithen isearch ithe iinventory idatabase ito isee ihow imany iof ithe iparts ibeing ireplaced iare istill iin istock, iwhich ican ithen ibe itotaled, iyielding ianother ivariation ion ithe iamount iof iobsolete iinventory ion ihand.

A ifinal isource iof iinformation iis ithe ipreceding iperiod’s iobsolete iinventory ireport. iThe iaccounting istaff ishould ikeep itrack iof ithese iitems iand inotify imanagement iof ithose ifor iwhich ithere iis ino idisposition iactivity.

In iorder ito imake iany iof ithese ireview isystems iwork, iit iis inecessary ito icreate ipolicies iand iprocedures ias iwell ias iongoing ischeduled ireview idates. i iBy idoing iso, ithere iis ia istrong ilikelihood ithat iobsolescence ireviews iwill ibecome ia iregular ipart iof ia icompany’s iactivities. i iIn iparticular, iconsider ia iBoard-mandated ipolicy ito iconduct iat ileast iquarterly iobsolescence ireviews, iwhich igives imanagement ian iopportunity ito ilocate iitems ibefore ithey ibecome itoo iold ito ibe idisposed iof iat ia ireasonable iprice. i iAnother iBoard ipolicy ishould istate ithat imanagement iwill iactively iseek iout iand idispose iof iwork-in-process ior ifinished igoods iwith ian iunacceptable iquality ilevel. i iBy idoing iso, igoods iare ikept ifrom ibeing istored iin ithe iwarehouse iin ithe ifirst iplace.