The Fraud Audit: Responding to the Risk of Fraud in Core Business Systems by Leonard W. Vona Copyright 2011 John Wiley & Sons, Inc.

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1 The Fraud Audit: Responding to the Risk of Fraud in Core Business Systems by Leonard W. Vona Copyright 2011 John Wiley Sons, Inc. DAPPENDIX Fraud Audit Program: Inventory INVENTORY CONCEALMENT TECHNIQUES False counts. The management team records improper counts. If this procedure is performed, it is most likely to occur on inventory perceived less likely to be counted or with a planned reason for the false count. In this way, the auditor will view the false count as an intentional error versus an intentional plan to misstate the inventory. The auditor needs to ensure that management has no record of the test counts. Fictitious inventory. Management will use their business environment to create the illusion of inventory by placing empty boxes in the warehouse or creating a reason why inventory cannot be physically inspected. The reasons will vary; however, the intent is always the same. Management will need to inhibit the auditor s ability to physically inspect the item. In this scheme the item does not exist, the item is incomplete, or some item will be represented as the inventory. 339

2 340 Appendix D Partially fictitious inventory. The auditor is presented some item to provide the illusion that the inventory does exist. Oftentimes the inventory item will be of a technical nature, which makes it difficult to understand whether the item is in fact a true item. False certifications. In this scheme, management creates documents certifying inventory balances, alters the original documents, provides copies of documents or draft documents, or has the outside expert provide false documents supporting the inventory item. Inventory stored at remote locations, independent warehouses, engineering estimates, ore and minerals, and percentage of completion are the type of items that are susceptible to this fraud scheme. Alteration of inventory counts after the physical counts. The key for management is to know the auditor s test counts. This has occurred through recording the auditor s test counts or obtaining the information after the auditor has completed his or her test counts. Multiple locations. Inventory at locations not being counted is moved to the planned locations to hide the overstatement of inventory. Timing issues. With the receipt of inventory at year-end, either through hiding purchases, in-transit goods, title transfer of inventory, sales returns, and recording the sales without inventory update. Hiding the slow-moving inventory. The inventory or sales reports will be altered in some manner to indicate inventory movement. Management may create fictitious sales to indicate the product is moving. The sold inventory then could be used as part of a false count scheme. The scheme may also be as simple as false explanations from management. Improper cost assigned to the inventory. How this occurs will depend on the nature of the inventory item. The key is to have a sufficient knowledge of the business. Data Mining Strategies Compare the beginning inventory balances to the ending inventory balances. The auditor should be looking for changes consistent with the fraud theory of over- or understatement of inventory. Compare unit purchases to unit sales. The auditor should correlate the variances to the change in the inventory. The procedure should be performed on the lowest data element possible. Compare dollar purchases to dollar sales.

3 Appendix D 341 Compute the number of inventory locations (bins) prior to the physical count. Compare beginning inventory to the ending inventory for new or deleted items. Compare inventory balances before and after the physical counts. Identify the largest physical counts. For multiple locations, compare total beginning inventory to total ending inventory. For those locations experiencing deviations consistent with fraud theory, perform searches on the inventory items. Determine which inventory items have had stock outages during the year. Through inquiry with the sales force, determine which items have had stock outages during the year. Compare inventory balances at the end of the third quarter to the inventory balances at the end of the year. Identify inventory variances by stock item. Examine internal sales forecasts for sales projections consistent with representations on inventory movement. Examine inventory tags for evidence of changes. Examine inventory tags for evidence of tags being included or excluded. Compare the number of inventory tags to the number of inventory locations. Establish an inventory variance percentage and examine those inventory items exceeding the range. Compute inventory items by square footage of the warehouse. Compare beginning and ending square footage calculations. Perform inventory counts at locations not known to management. Based on the data analysis, the auditor may need to determine additional procedures to determine the reasonability of the data analysis results. Fictitious inventory. Management will use their business environment to create the illusion of inventory by placing empty boxes in the

4 342 Appendix D warehouse or creating a reason why inventory cannot be physically inspected. The reasons will vary; however, the intent is always the same. Management will need to inhibit the auditor s ability to physically inspect the item. In this scheme, the item does not exist, the item is incomplete, or some item will be represented as the inventory. The data analysis performed for the false count will also provide information for the fictitious inventory scheme. The inventory item needs to be critically examined to ensure the physical existence of the item. Perform a test to ensure the item functions consistent with the sales catalogs. Consider the use of an outside expert to validate the item. Develop a logic test to determine the reasonability of the inventory amount. Partially fictitious inventory. The auditor is presented some item to provide the illusion that the inventory does exist. Oftentimes the inventory item will be of a technical nature, which makes it difficult to understand whether the item is in fact a true item. The data analysis performed for the false count will also provide information for the fictitious inventory scheme. The inventory item needs to be critically examined to ensure the physical existence of the item. Perform a test to ensure the item functions consistent with the sales catalogs. Consider the use of an outside expert to validate the item. False certifications. In this scheme management create documents certifying inventory balances, alter the original documents, provide copies of

5 Appendix D 343 documents or draft documents, or have the outside expert provide false documents supporting the inventory item. Inventory stored at remote locations, independent warehouses, engineering estimates, ore and minerals, and percentage of completion are the type of items that are susceptible to this fraud scheme. The data analysis performed for the false count will also provide information for the fictitious inventory scheme for items of a unit nature. The documents should be critically examined to ensure the documents are original and not altered. Confirm directly with the source the authenticity of the documents. Confirm the valid existence of the source or the outside expert. Perform an onsite inspection of the inventory. Confirm existence of the inventory at the location with some other source within the company. Interview operations staff as to their knowledge of the inventory amount. Review vendor invoices to ensure cost elements of the project have reasonably have occurred. Alteration of inventory counts after the physical counts. The key for management is to know the auditor s test counts. This has occurred through recording the auditor s test counts or obtaining the information after the auditor has completed his or her test counts. The data analysis performed for the false count will also provide information for the fictitious inventory scheme. Prior to the physical inventory, obtain a report or data file on the inventory balances prior to the physical count. Compare retained copy of inventory report to final physical inventory report.

6 344 Appendix D Multiple locations. Inventory at locations not being counted is moved to the planned locations to hide the overstatement of inventory. Search for inventory transfer between operating locations. Consider conducting an unannounced physical inventory count. Prior to the inventory, examine shipping documents, transfer documents, or other source documents indicating transfers. Interview operating management at inventory locations to determine if any unusual inventory movement occurred in around the time of the physical inventory. Timing issues. Search for discrepancies with the receipt of inventory at yearend, either through hiding purchases, in transit goods, title transfer of inventory, sales returns, and recording the sales without inventory update. Search for inventory transfer between operating locations. Search for purchases recorded after year-end. Match shipping documents to inventory movement. Examine purchase returns and credits for indicators of false purchases. For purchases recorded after year-end, examine the shipping documents to ascertain date of receipt. Examine shipping records after year-end for evidence of fraud. Hiding the slow-moving inventory. The inventory or sales reports will be altered in some manner to indicate inventory movement. Management may create fictitious sales to indicate the product is moving. The sold inventory then could be used as part of a false count scheme. The scheme may also be as simple as false explanations from management. Compute sales history by units and dollars by inventory item. Compare sales history for a minimum of one year.

7 Appendix D 345 Compute inventory from the previous quarter and compare to ending inventory. Search for ship-to addresses that are company-owned property. Search for sales with no commissions. Search for returns with no adjustment to a sales representative. Perform interviews with sales management to validate explanations regarding the marketability of inventory. Misstatement regarding the marketability of the inventory. The key is to provide the auditor with explanations or documents that indicate pending or future sales. The procedures would be the same as hiding slow moving inventory. Confirm explanations with sources outside the financial area. Improper Cost Assigned to the Inventory. How this occurs will depend on the nature of the inventory item. The key is to have a sufficient knowledge of the business. Search for updates to cost items in the last quarter. Compare last quarter cost element to year-end cost elements. Match cost elements to original supporting documentation. Confirm that cost composition elements correlate to operation blueprints or other like plans. Compare ending unit costs to beginning unit costs. The lowest component cost possible will provide the best results. Journal entries at year-end. I call this the easy approach. The management team alters the inventory balance through journal entries. The key is the documentation supporting the entry, the volume of entries, and whether the entries appear to be part of the normal course of business.

8 346 Appendix D Search for year-end journal entries affecting ending inventory. Search for year-end journal entries transferring inventory from locations. Validate the explanations provided. Determine if similar entries are made during the year or prior years. Alteration of year-end inventory reports. The auditor will match the yearend inventory report to the financial statements. The key to the concealment technique is to have the all reports provide the same erroneous calculations or totals. The nature of the scheme does not lend itself to a specific data analysis. Recalculate the inventory report.