Question

3. Article: Control Cash-Register Thievery

Based on this article what fraud is the most easiest to detect?    Most difficult?

https://www.journalofaccountancy.com/issues/2002/jun/controlcashregisterthievery.html

4. Article: Ghost Goods: How to Spot Phantom Inventory

Why does the client most likely resort to creating a phantom inventory?

https://www.journalofaccountancy.com/issues/2001/jun/ghostgoodshowtospotphantominventory.html

5. Article: Ghost Goods: How to Spot Phantom Inventory

Should the auditor consider both motive and opportunity when investigating an inventory fraud?

https://www.journalofaccountancy.com/issues/2001/jun/ghostgoodshowtospotphantominventory.html

7. The Crazy Eddie Antar fraud is discussed in the article So Thats Why Its Called a Pyramid Scheme and in Chapter 12.   What are the lessons learned by fraud examiners from this fraud?

https://www.journalofaccountancy.com/issues/2000/oct/sothatswhyitscalledapyramidscheme.html

8. When a fictitious refund is made for merchandise returned what is the problem that the fraudster must solve in order for the fraud to be undetected?

Answer 1

3. Based on Report to the Nation on Occupational Fraud and Abuse, Association of Certified Fraud Examiners, 1996 mentioned in the article, on a scale of 1 to 7, the most difficult scams to detect was extortion (2.5) and illegal gratuities (2.86). Most easiest among them to detect was cash larcency(5.04) and check tampering (4.40)

4. The following activities by auditors are suggested to spot and stop phantom inventory

Observation of physical inventory. The most reliable way to validate inventory quantity is to count it in its entirety. Even when this is done, little mistakes can allow inventory fraud to go undetected:

Management representatives follow the auditor and record the test counts. Thereafter, the client can add phony inventory to the items not tested. This will falsely increase the total inventory values.

Auditors announce when and where they will conduct their test counts. For companies with multiple inventory locations, this advance warning permits management to conceal shortages at locations which auditors will not visit.

Sometimes auditors do not take the extra step of examining packed boxes. To inflate inventory, management stacks empty boxes in the warehouse.

Analytical procedures. Ghost goods throw a company’s books out of kilter. Compared with previous periods, the cost of sales will be too low; inventory and profits will be too high. There will be other signs, too. When analyzing a company’s financial statements over time, the auditor should look for the following trends:

Inventory increasing faster than sales.

Decreasing inventory turnover.

Shipping costs decreasing as a percentage of inventory.

Inventory rising faster than total assets move up.

Falling cost of sales as a percentage of sales.

Cost of goods sold on the books not agreeing with tax returns.

A client usually resort to phantom inventory creation to serve as a mitigating factor for unrecorded liabilities. In order to lower its affect, they either try to manipulate work orders through wrong material or resource transactions thereby increasing the selling price or increase the inventory levels by manipulating the quantity.

The client’s advantage with this method is that the amount of the overstatement is buried in the overall cost of sales calculation

5. Because of the reasons cited above, it is important for the auditor to identify the motive and opportunity while investigating inventory variations.

An alert auditor can detect these schemes by any one of the analytical methods described above and also can examine the cash disbursements subsequent to the end of the period. If the auditor finds payments made directly to vendors that were not recorded in the purchase journal, he or she should investigate further.

Although any inventory item can be improperly capitalized, manufactured goods present a particular problem. Common items capitalized are selling expenses and general and administrative overhead. To detect these problems, auditors should interview manufacturing process personnel to gain an understanding of appropriate charges to inventory. Although there may be many good faith reasons to boost income by capitalizing inventory items, there also may be fraudulent ones. Usually the auditor will find that the CFO, typically at the CEO’s direction, carries out material illegal schemes. Therefore, during normal interviews with key personnel, the auditor always should ask—in a straightforward but nonaccusatory way—if anyone in the company has instructed them to inflate inventory information.

There are many ways a dishonest client can attempt to manipulate inventory. An auditor must look at the data with a different mindset, surmising not only how inventory fraud works, but why the client would resort to such improprieties in the first place.

7/

Know your client. Eddie Antar started young. By the time he was 21, Eddie had already developed a reputation in the retail industry for saying anything to make a sale; some considered him an early master of the “bait and switch” technique. Had the auditors invested the time and expense to investigate Eddie before accepting him as a client, they perhaps would have decided against conducting the Crazy Eddie’s audit. In short, they would have found that Eddie Antar was very, very risky.

Assign proper personnel. The field auditors for Crazy Eddie’s were, according to Sam Antar, young and inexperienced. This is the nature of the audit business—field work typically is assigned to less experienced personnel. Selecting the right auditors for the job, though, is critical in high-risk engagements. Less experienced personnel may be satisfactory in low-risk environments, but detecting the signs of fraud requires maturity and judgment. Therefore senior auditors, fraud examiners and/or antifraud specialists should be considered.

Be careful in inventory observations. In any merchandising concern, inventory is usually the largest single asset. And experience has shown it is the asset of choice in financial fraud cases. In the Crazy Eddie’s case, the auditors inadvertently may have contributed to the fraud by the way the inventory observations were conducted. Rather than climb over boxes in the warehouse, the auditors asked employees to assist them. Crooked employees volunteered. An employee would stand on top of a stack of television sets, for example, and call down the count to the auditors. If there were 10 sets, the worker would claim there were 25. Repeated many times, this clever trick helped to greatly increase the inventory count. The message here is obvious: If you’re supposed to verify the inventory count, then you must observe it.

Provide appropriate security to documents and computers. Crazy Eddie’s auditors were provided a company office during their examination. They had a key to lock the desk—which they kept in a box of paperclips on top of the desk in full view. After the auditors left for the day, Eddie’s cohorts would unlock the desk, increase the inventory counts on the workpapers and photocopy the altered records. Were the auditors stupid? No, just too trusting. After all, no one wants to think the client is a crook. But it happens all too often. That’s why the profession requires auditors to be skeptical.

Try to understand the relationship between the client and its principal suppliers. Crazy Eddie’s bought most of its electronics from one of three wholesalers. All three were in on the scheme to inflate Crazy Eddie’s assets. Did the suppliers know they were helping Eddie cook the books? They may have figured it out, but it’s doubtful they would have asked questions. The reason these suppliers cooperated is simple—Eddie engaged in economic extortion. If they didn’t help him with his schemes, Eddie would change suppliers. This provided them with a significant incentive to cooperate. Perhaps if the auditors had known the extent to which the suppliers were dependent on Eddie, they would have subjected those relationships to closer audit scrutiny. Admittedly, this may be difficult to do. But if the supplier ultimately is material to the financial statements, the auditor may even want to consider visiting the vendor’s operation to further assess risk. Auditors should document any such visits in the workpapers.

Consider extra risks associated with closely held businesses. Every major player in the Crazy Eddie’s case was related to Eddie Antar—and they made up the board of directors. This was a case of family conspiracy and an extreme example of the kind of damage that can be done to a closely held business when its board consists entirely of insiders who also are company officers. The familial relationship becomes important in assessing risk. There is certainly nothing wrong with family- owned and operated enterprises; they are a strong part of our economic base. But the auditor should recognize an obvious fact about human behavior in the risk equation: It is certainly easier to conspire with a family member than with someone unrelated.

Be wary of businesses that buck industry trends. While other electronic retailers were struggling to stay even, Crazy Eddie’s was enjoying double-digit growth. Eddie Antar had people believing those I-N-S-A-N-E commercials were responsible. But now we really know why Eddie was so successful—he was a fake. In other instances of financial statement chicanery, bucking industry trends has been a big red flag, too. The auditor should ask herself or himself, “In today’s competitive international business environment, why is this client doing so much better than everyone else?” If you can’t answer that question to your satisfaction, keep digging. There could be a problem.

The failure to detect Crazy Eddie’s large-scale fraud spawned seemingly endless lawsuits against those involved—some spanning a decade or more. The auditors were sued for malpractice; the principals were sued for fraud. Whatever money was made illegally is long gone—the bones of the company have been picked clean through litigation.

Antar and several of his family members ended up with criminal records. Only Eddie served time—eight years. Ironically, he now clerks in an electronics store. Other family members fared better. Relatives in on the conspiracy all received probated sentences. Both Eddie and his conspirators have millions of dollars in civil judgments against them. In sum: Other than the painful lessons learned, nothing positive for Antar and his cohorts came out of the Crazy Eddie’s case