Inventory Fraud:Don’t Be Left Scratching Your Head

The Benefits of Internet Research In the Area of Inventory Fraud and Fraud Auditing

by Jennifer Duvall

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

 

All of the business failures she mentioned had significant common  denominators. Most common was the fact they all had overstated inventory by playing games/manipulating inventory. The games these retailers engaged in are not new. They have existed for decades in the retail industry. Additionally, shrinkage is normally the vehicle of choice used to manipulate the inventory, for a variety of reasons. Shrinkage has traditionally been regarded as a reduction of book inventory caused by theft. Since no one can substantiate how much is stolen from a retailer each year, shrink becomes a convenient vehicle to manage earnings, cover-up operational sins and commit fraud. Jennifer hit on some very crucial and interesting issues, but stopped short in her analysis by stating corporations had found ways of to circumvent the auditors. The auditors at Phar-Mor and most recently Rite Aid were not "circumvented". Rather, in performances that would rival Claude Rains in Casablanca, they attempted to distance themselves from management stating publicly they were "Shocked! Shocked! to find accounting irregularities existing within the Company." These irregularities don't just suddenly develop in a company. They go on for years. In many instances for decades.
 
She indicated there were more than two dozen major retail companies forced to file bankruptcy. My research indicates there have been over 200 retail business failures in the past decade alone. While incidents of financial shenanigans clearly exist across industry boundaries, I believe they are more prevalent in the retail industry. Obviously, that statement begs the question: Why? There is one inescapable cause: the way retailers account for their inventory, especially inventory shrinkage. Until an industry standard is developed, senior management will continue to be tempted to use shrinkage as a means to artificially manage (puff-up) earnings and commit fraud.

Traditional efforts to analyze the likely performance of a retail company are usually based upon financial metrics that are, by their nature, an aged account of what a retail company is reporting to the financial community and the shareholders. As we have seen over the past decade, it is simply too easy to manipulate those numbers. Furthermore, shrinkage, and specifically the "retail inventory method" contribute to the financials being an unreliable snapshot of what is really happening within a retail company. All too often, the largest retail business failures have surprised Wall Street. Deep-seated problems in countless retail companies did not first appear in the company's financials or by the auditors. Rather, they were revealed in horrific news media accounts that provided graphic details regarding abusive and convoluted business practices. Therefore, the focus of my research has been on those business practices. These adverse practice would appear to suddenly erode shareholder value overnight. However, according to my research over the past seven years, and actual case work providing litigation support and investigative services to the Big Five, the Internal Revenue Service, the Securities and Exchange Commission and shareholders indicate these practice have been at work for years. Accordingly, my emphasis is on identifying what I call the "soft indicators" of a troubled retailer.
 
These soft indicators are contrary business practices that eventually become so pr evasive and deeply ingrained in the culture of a retail business, they inevitably cause it to fail. While my indicators are nothing more than empirical observations, I believe I can teach anyone to notice these telltale signs of a troubled retailer in-the-making. Each year I speak to accounting graduate students at the Whittemore School of Business and Economics at the University of New Hampshire in an effort to better prepare these folks for what they will  ultimately encounter.
 
Furthermore, Jennifer fails to mention or distinguish the difference between a business failure and an abused business. When senior management abuses the businesses they have been entrusted to manage, they signal to all of the other employees that type of behavior is perfectly acceptable. She mentions Revco in her article. I was retained by the new management of Revco the week before they filed for bankruptcy protection and remained with the troubled Company until they emerged from Chapter 11 nearly five years later. The engagement involved investigating matters of impropriety, including the sources of mysterious margin erosion, identifying those responsible and recruiting new management.
 
The investigation phase began with one of the many subsidiary businesses Revco had, a payroll company that had been created to handle the needs of the Company and its other subsidiaries. The investigation revealed that paychecks were being produce for hundreds of "ghost employees". That investigation eventually led to various other subsidiary businesses and the parent Company, Revco D.S. Graft and corruption had permeated throughout the entire organization. The departments most vulnerable to graft and corruption in a retail business are Construction, Transportation, Real Estate and the Buying office. I noticed the rents Revco was paying in the North and South Carolina market area were greater than in other market areas. I went to work attempting to learn as much as I could about the landlord who owned most of the leases. For a long time, all I could find about the landlord was that it was a business entity which had been set up as an obscure limited trust arrangement. The only real name I could produce was the name of the managing partner of the trust. Carefully concealed in almost every transaction involving this trust was any disclosure about who the members were. After months of investigation that involved combing through hundreds of court documents in North Carolina I found a personal guarantee from a local bank which contained all the members' signatures. Astonishingly, I notice the last name of every member of the trust matched the last name of the Regional Vice President of Real Estate for Revco. This guy had leased approximately 800 store locations form his own wife and children! The managing partner was his father-in-law.
 
The Learning Experience:
  1. Many troubled retail companies are abused businesses. When a business has been abused by its previous management, fraud and theft-prone environments are created the permeate the entire organization/culture.
  2. Yake & Associates, Inc. has been involved in many retail reorganizations. Without exception, where non-core business entities exist, so does abuse. Furthermore, in almost every engagement we have found employees setting up their own "creative severance arrangements".
  3. In a troubled retail business, the inventory has very little perceived value to the employees. Therefore, employee theft activities normally escalate, thereby diminishing recoveries available to the creditors.
 
This is really going further than I think you wanted, or than I intended. Would you like to discuss this matter in greater detail?

Regards, Tom Yake

 

Other Helpful Internet Sites:

Arthur Andersen LLP

http://www.arthurandersen.com/

 
Coopers and Lybrand LLP

http://www.colybrand.com/
 

Deloitte and Touche LLP

http://www.dttus.com/
 

Ernst and Young LLP

http://www.ey.com/
 

KPMG LLP

http://www.us.kpmg.com/
 

Price Waterhouse LLP

http://www.pw.com/
 

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

http://www.acfe.org/
 

Certified Public Accountant

http://www.ais-cpa.com/

Certified Management Accountant http://userwww.sfsu.edu/~kdanko/cma.htm

Certified Internal Auditor

http://www.rutgers.edu/Accounting/raw/iia/certreq.htm

Certified Fraud Examiner

http://www.acfe.org/program.html

The Securities and Exchange Commission

http://www.sec.gov/

Forensic Accountants http://www.bus.lsu.edu/accounting/faculty/lcrumbley/forensic.htm

Sherlock Holmes and Forensic Accounting http://acct.tamu.edu/kratchman/holmes.htm

  



Some Fraud Stuff Home Page

Larry Crumbley's Home Page

Forensic Accountants in Literature


Last updated: 29 October 1997