Inventory and Cost of Goods Sold Fraud Copyright AICPA Unauthorized copying prohibited

Identifying Inventory and Cost of Goods Sold Fraud Exposures One of the easiest ways to identify fraud exposures is to diagram the various kinds of transactions that can occur related to inventory and cost of goods sold. For many companies, that diagram might be similar to the following example Copyright AICPA Unauthorized copying prohibited

Inventory and Cost of Goods Sold Fraud Copyright AICPA Unauthorized copying prohibited

Matrix for Identifying Inventory Fraud Copyright AICPA Unauthorized copying prohibited

Identifying Inventory and Cost of Goods Sold Analytical Fraud Symptoms With inventory and cost of goods sold, some of the most common analytical financial statement fraud symptoms are Reported “Inventory” balances or ratios that appear too high Reported “Cost of Goods Sold” balances or ratios that appear too low Reported “Purchase Returns” that appear too high Reported “Purchase Discounts” that appear too high Reported “Purchases” that appear too low for inventory levels Copyright AICPA Unauthorized copying prohibited

Decreasing inventory turnover. Decreasing shipping costs as a percentage of inventory. Increased shipping costs at or near end of period. Significant inventory returns after the end of the period. Cost of Goods Sold on books not agreeing with tax returns. Decreasing cost of sales as a percentage of sales.

Identifying Inventory and Cost of Goods Sold Accounting or Documentary Symptoms With inventory and cost of goods sold, some of the most common accounting or documentary symptoms are: Inventory and cost of goods sold transactions not recorded in a complete or timely manner or improperly recorded as to amount, accounting period, classification, or entity policy Unsupported or unauthorized inventory and cost-of- goods-sold-related transactions Last minute inventory and cost of goods sold adjustments by the entity that significantly improve financial results Missing documents related to inventory and cost of goods sold Copyright AICPA Unauthorized copying prohibited

 Unavailability of other than photocopied documents to support inventory and/or cost of goods sold transactions when documents in original form are supposed to exist. Unusual or suspicious-looking purchase orders, invoices, shipping documents, and/or receiving documents.  Cost of goods sold related accounting records (purchases, sales, cash payments, etc.) that do not balance.  Unusual discrepancies between the entity's inventory and/or cost of goods sold records and corroborating evidence (such as inventory counts). Differences between inventory counts and inventory records, especially systematic differences.

Differences between receiving reports and inventory actually received. Inventory items not actually received. Differences between purchase orders, purchase invoices, receiving records, and inventory records. Purchases from suppliers not approved on vendor list or with no EIN numbers. Missing inventory when performing inventory counts. Duplicate purchase orders or invoice numbers. Vendors not listed in Dunn and Bradstreet or Telephone Directories. Adjusting entries that have increased inventory over time. Large reversing entries to inventory accounts after the end of the period. "Accidental" sales to customers that are later reversed.

Identifying Inventory and Cost of Goods Sold Control Symptoms With inventory and cost of goods sold, some of the most common control symptoms are: Management override of significant internal control activities related to purchases, inventory, and/or cost of goods sold New, unusual, or large vendors that appear not to have gone through the regular vendor-approval process Weaknesses in the inventory counting process Inventory that cannot be easily physically inspected Unclear or ineffective cutoff procedures Copyright AICPA Unauthorized copying prohibited

Inclusions in inventory of merchandise already sold for which purchases are not recorded. Inventory that appears to not have been used for some time, or inventory that is stored in an unusual location. Excessive intercompany movement of inventory with little or no controls or documentation. Material inventory write-offs after the end of the period.

Identifying Inventory and Cost of Goods Sold Behavioral or Verbal Symptoms With inventory and cost of goods sold, some of the most common behavioral or verbal symptoms are: Inconsistent, vague, or implausible responses from management or employees arising from inventory- purchase- or cost-of-goods-sold-related inquiries or analytical procedures Denied access to facilities, employees, records, customers, vendors, or others from whom inventory- and cost-of-goods-sold-related evidence might be sought Copyright AICPA Unauthorized copying prohibited

Undue time pressures imposed by management to resolve contentious or complex inventory and/or cost of goods sold related issues. Unusual delays by the entity in providing inventory and/or cost of goods sold related, requested information. Untrue or questionable responses by management to inventory and/or cost of goods sold or other queries made by auditors. Suspicious behavior or responses from members of management when asked about inventory and/or cost of goods sold related transactions, vendors, or accounts.

Actively Searching for Inventory/Cost of Goods Sold Analytical Symptoms Analyzing Financial Balances and Relationships within Financial Statements Look for unusual changes in inventory and cost of goods sold account balances from period to period (trends). Look for unusual changes in inventory and cost of goods sold relationships from period to period. Comparing Financial Statement Amounts or Relationships with Non financial Statement Information Compare financial results and trends of the company with those of similar firms in the same industry, or with industry averages. Compare recorded amounts in the financial statements with nonfinancial statement amounts

Focusing on Changes in Recorded Balances From Period to Period Usually the least effective method is to focus on changes in the actual financial statement numbers A very similar method is to study the Statement of Cash Flows The best method is to perform horizontal analysis Copyright AICPA Unauthorized copying prohibited

Focusing on Changes in Relationships From Period to Period Calculate inventory and cost of goods sold-related ratios and examine how the ratios change from one period to the next Convert the financial statements to common-size statements and use vertical analysis to examine the percentage change from period to period Copyright AICPA Unauthorized copying prohibited

Comparing Financial Statement Amounts with the Assets They Are Supposed to Represent or with Nonfinancial Statement Factors

Actively Searching for “Accounting and Documentary” Symptoms Actively searching for accounting and documentary symptoms involves examining samples from a population or using query programs to search for attributes that, if existed, would signal the possibility of fraud Discovery sampling, or “stop and go” sampling, is an easy and effective statistical sampling technique Copyright AICPA Unauthorized copying prohibited

While sampling may make sense when looking for inventory documentary or accounting symptoms, computers have made it possible, and even easier and faster, to search for documentary symptoms. The approach to using queries would be as follows: Identify the fraud scheme (e.g., under-record purchases, over-count inventory, etc.). Identify the fraud symptoms that would exist if these fraud schemes were being perpetrated. Query various databases to determine if the fraud symptoms exist. Follow up on the symptoms observed.

Actively Searching for “Control” Symptoms Because inventory frauds, like revenue-related frauds, are so easy to perpetrate, it is important that a good control environment and control procedures be in place Where controls are weak, or can be easily overridden, a missing control or an observance of an override represents a fraud symptom, not just a control weakness. As such, it should be pursued with the same vigilance as any other “fraud symptom” Copyright AICPA Unauthorized copying prohibited

Actively Searching for “Behavioral or Verbal” and “Lifestyle” Symptoms Lifestyle symptoms are usually not very effective in helping you find inventory-related financial statement fraud because financial statement fraud usually does not benefit the perpetrators directly Searching for behavioral and verbal symptoms can be very fruitful Ask questions that go beyond simple inquiries and watching closely for inconsistencies and changes in response or behavior can be powerful tools for detecting fraud Copyright AICPA Unauthorized copying prohibited

Actively Searching for “Tips and Complaints” Symptoms Because of its physical characteristics, inventory must be shipped into a firm, handled while in the firm, and shipped out of the firm when sold. All this movement means that people must be involved in managing the physical flow of inventory. Talk to those people Communicate directly with vendors and try to determine their relationships with the company Copyright AICPA Unauthorized copying prohibited

SAS 99 and its predecessor, SAS 82, provide guidance about how an auditor should follow up on inventory fraud symptoms. With respect to inventory- specific guidance, the standards suggest that an auditor may want to consider doing the following: Visit locations or perform certain tests on a surprise or unannounced basis; for example, observing inventory at locations where auditor attendance has not been previously announced. Count inventories at a close to year-end date. Alter the audit approach in the current year. For example, contact major customers or suppliers (both verbally and in writing), send confirmation requests to specific parties within an organization, and/or seek more and different information. Perform a detailed review of the entity's quarter-end or year-end adjusting entries and investigate any entries that appear unusual as to the nature or amount.

For significant and unusual transactions, particularly those occurring at or near year-end, investigate (a) the possibility of related parties and (b) the sources of financial resources supporting the transactions. Perform substantive analytical procedures at a detailed level. For example, compare sales and cost of sales by location and line of business to auditor-developed expectations. Engage the work of a specialist if deemed appropriate. For example, in the Royal Dutch/Shell case previously discussed, it was difficult for auditors to properly value the proven reserves. However, the audit firm could engage an engineering firm to make estimates of the value of the proven reserves.

If the auditor has a concern about the risk of material misstatement due to fraud in the inventory area, it may be particularly important that the entity counts are conducted at all locations subject to count on the same date. Furthermore, it may also be appropriate for the auditor to apply additional procedures during the observation of the count – for example, examining more rigorously the contents of boxed items, the manner in which the goods are stacked or labeled, and the quality of liquid substances such as perfumes or specialty chemicals. Finally, additional testing of count sheets, tags or other records, or the retention of copies may be warranted to minimize the risk of subsequent alteration or inappropriate compilation.

If, after taking these and other steps, the auditor feels that inventory may be misstated and could be material, the auditor should take appropriate action from the following alternatives: Consider the implications for other aspects of the audit. Discuss the matter and the approach to further investigation with an appropriate level of management at least one level above those suspected to be involved, and with senior management. Attempt to obtain additional evidential matter to determine whatever material fraud has occurred or is likely to have occurred and, if so, its effect on the financial statements and the auditor's report thereon. If appropriate, suggest that the client consult with legal counsel. Consider withdrawing from the engagement and communicate the reasons for withdrawal to the audit committee or others with equivalent authority and responsibility.

Following up on Symptoms Observed If you are an auditor, follow AU-C 240 guidelines for suspected inventory fraud. For SEC clients, always consult your legal counsel If you are a fraud investigator, if conditions or circumstances warrant, you should proceed with a fraud investigation Copyright AICPA Unauthorized copying prohibited