Inventory fraud. During the past several years, more than two dozen major retail companies have been forced to file for bankruptcy due to inventory fraud. These include such seemingly profitable stores as Revco Drug Stores, Crazy Eddie Electronics, Leslie Fay Women’s Apparel, and Macy’s Department Stores. How did these companies fall from reaping high profits and expansion to filing for bankruptcy for protection from their creditors? They all were greatly affected by inventory fraud. This is one of the most common areas of theft by employees and method of financial statement manipulation by management.
The manner in which these corporations have allegedly circumvented auditors varies, but there are four major methods of inventory fraud: theft of assets, misappropriation of assets, scrap sales, and embezzlement. These examples emphasize the need for the auditor to plan and control inventory audits carefully. They also demonstrate the need to use supplementary resources to research recent trends in inventory fraud and how to detect the fraud as well as to research the company being audited.
One of these sources should be the Internet. The Internet provides practically up to the minute information on any topic imaginable and many search engines are available to locate the information a fraud auditor will need quickly and easily. The Internet allows fraud auditors the ability to do a more thorough job in a much shorter period of time, saving time and money for both the auditors and the corporation.
During the 1980s, a fraud of enormous magnitude with a cost exceeding $1 billion was perpetrated with relative simplicity in the 300 store deep-discount drug and merchandise chain of Phar-Mor. It had to close several stores when the fraud first broke, but there are still stores around. One of the major reasons for the failure was a massive inventory fraud that went undetected for several years by the auditors. Perhaps if the auditors had utilized the Internet in the manner which follows, Phar-Mor would still be in operation today.
Many resources can be found simply by utilizing a search engine. For example, if a search is performed with the word "fraud," thousands of useful web sites are identified. One resource that is found is a page entitled "Twenty Ways to Detect Fraud" located at "http://getzoff.com/business_fraud/20_questions.htm". This page lists twenty different symptoms of various fraudulent activities and what the possible sources of these symptoms may be. The page lists among its symptoms, the general ledger being out of balance, inventory shortages in excess of normal shrinkage, increased levels of scrap, and post office boxes that are used as shipping addresses. These are all activities that are associated with inventory fraud. Had the Phar-Mor auditors been aware of these symptoms, then perhaps the fraud would have been detected sooner and the investors would have saved thousands of dollars.
The most obvious resource is the Securities and Exchange Commission Home Page located at "http://www.sec.gov./". From this database, auditors have access to all the required filings of all public corporations. The auditors can perform industry analysis and ratio analysis of accounts such as inventory, sales, and purchases. This data can then be compared to Phar-Mor’s accounts to determine if they are within range of the industry averages. If they are not, then further research should be performed to determine what is causing the difference.
Yake & Associates, Inc., located at "http://www.yake.com/", is a 25-year-old investigative service for the accounting profession which specializes in retail businesses. They have developed a detailed methodology to identify retail companies headed for financial disaster. If Phar-Mor’s auditors had visited this section of the home page at "http://www.yake.com/methodology/body.html", they might have learned that it is necessary to profile executive performance in past positions, to research senior management in order to determine if there has been a pattern of condoning or participating in inventory manipulation, and to determine if the company’s structure is designed to enhance or avoid accountability.
Another section of the Yake & Associates, Inc., home page is the company newsletter located at "http://www.yake.com/sentry/body.html". This month’s newsletter details various activities of business abuse, including inventory fraud and excessive shrinkage. In addition to giving an analysis of these topics, perhaps more importantly, the paper relates personal experiences with fraud.
Fraud auditing can only be ‘taught’ to a certain extent; after this point is reached, it becomes a self-learned skill. The auditor may know all the ways that fraud is perpetrated and all the tricks used to cover up the fraud, but the auditor should become familiar with the ways that actual companies commit fraud. The more personal experience the auditor has with fraud, the more developed his instinct will become. One way to supplement this instinct is through ‘shared training.’ In this way, one auditor’s personal experience becomes the almost-personal experience of another auditor.
Another Internet site that will aid in this shared training is located at "http://www.herring.com/mag/issue22/crime.html". This site, among other things, profiles the perpetrators of white-collar criminals and details how they succeed at their fraud. The site also lists several methods of how a company may protect itself from fraud. In the case of Phar-Mor, these defenses may have also served as red flags to the auditors as Phar-Mor had not instituted many of them into their workplace. They include policies of knowing your employees and your vendors, segregation of core duties, and periodic internal audits. In fact, the highly profitable Phar-Mor Corporation did not even have an internal audit department until the external auditors insisted that one be instituted. It was soon after this that an internal auditor who discovered the inventory fraud and blew the whistle to the external auditors.
It is almost certain that the internal auditor of Phar-Mor had visited "http://www.bus.lsu.edu/accounting/faculty/lcrumbley/forensic.htm". This is an excellent site to discover the nuances of forensic accounting and fraud detection. This site gives the finer points of fraud auditing in the context of shared training and literature. Several real-life examples of how fraud was detected, including how forensic accountants were the people who finally were able to put Al Capone in jail after law enforcement officials had failed. These examples are accompanied by a plethora of books one can read in order to gain knowledge almost subliminally.
Inventory fraud is one of the most damaging types of fraudulent activity that can go on in a corporation due to the value of the inventory and its far-reaching effects on the financial statements and investors. It has brought down multi-million dollar corporations with ease. Committing fraud does not require unusually high intellect. However, it is usually committed by knowledgeable people ~ people who know how to circumvent the system by knowing how to capitalize on the weaknesses in the business. Fraud auditors now can use the Internet to research corporations and fraudulent activities in order to detect these weaknesses and the frauds that may be linked to them. In addition to all of the sites listed in this article, below are seventeen other Internet sites that fraud auditors will find beneficial in their work. The Internet gives auditors the ability to stop inventory fraud and not to be left scratching their heads wondering what happened.
Comments from Tom Yake
Arthur Andersen LLP
Coopers and Lybrand LLP
Deloitte and Touche LLP
Ernst and Young LLP
Price Waterhouse LLP
American Institute of Certified Public Accountants http://www.aicpa.orh/index.htm
Institute of Management Accountants http://www.rutgers.edu/Accounting/raw/ima/ima.htm
The Institute of Internal Auditors http://www.rutgers.edu/Accounting/raw/iia/welcome.htm
Association of Certified Fraud Examiners
Certified Public Accountant
Certified Management Accountant http://userwww.sfsu.edu/~kdanko/cma.htm
Certified Internal Auditor
Certified Fraud Examiner
The Securities and Exchange Commission
Forensic Accountants http://www.bus.lsu.edu/accounting/faculty/lcrumbley/forensic.htm
Sherlock Holmes and Forensic Accounting http://acct.tamu.edu/kratchman/holmes.htm
Larry Crumbley's Home Page
Forensic Accountants in Literature
Last updated: 29 October 1997