Spotting inventory frauds – Guide for Auditors

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The most reliable way to validate inventory quantity is to count it in its entirety. Many auditors make sure that the inventory is counted at-least once in a year. Inventory count is generally the part of the audit plan of most of the audit firms. At the end of the year, many banks eagerly wait for the Inventory verification reports on the big borrowers from the independent auditors as the part of annual compliance. However, in-spite of inventory counts, little mistakes can allow inventory frauds to go undetected.

Auditors may download a free handbook on inventory audits

One of my professional colleague explained me some very interesting techniques. Many of us test the huge piles of inventory items on sample basis and one of the representatives generally the stores in-charge accompany us to the locations of the inventory. Once the inventory count is done, non counted inventory counts are adjusted to match the book balance with the physical balances.

My colleague further explains that “few inventory items were shifted in front of me to another location when i declared that I would check 100% of the inventory items. These shifted items were dumped on the same premises at a location far away from my place of verification. Later when i reached that location, the same item was shown to me. I counted the same item twice, but since i made some chalk marks on those metal components, i could easily track that company is producing the same item twice.”

My colleague went on explaining me a simple case of a retail mall where he was asked to perform the inventory count. Inventory items were stacked in piles in the godown of the retail mall. When my friend went on counting the packed boxes at the helm of the piles he found that there were empty boxes piled at the upper end of the stacks. This was done to adjust the inventory according to the books.

Why Inventory frauds

Research conducted by the Indiaforensic center of Studies on the ” Early Warning Signals of Corporate frauds” cited that the inventory is the most popular tool for not only comitting the financial statement frauds but also to steal money from business. This report further stated that during the recessionary times the businesses adjust the inventories for two reasons

  1. To maintain the profitability by inflating the value of the stocks
  2. To maintain the working capital limits with the banks by adjusting the stock counts.

Warning Signals of Inventory Frauds

Here is a small guide which may help the auditors in planning their inventory audits. Its a free tool available on the web. Sometimes the auditors can see the warnings signals of the inventory frauds on the books of accounts and here are the red flags of the inventory frauds.

  • Inventory increasing faster than sales.
  • Decreasing inventory turnover.
  • Shipping costs decreasing as a percentage of inventory.
  • Value on the books not matching with the stock statements submitted to the Bankers.
  • Inventory rising faster than total assets.
  • Falling cost of sales as a percentage of sales.
  • Cost of goods sold on the books not agreeing with tax returns.