By Terry Silver
Special to the Legal
Tax reduction through inventory manipulation is not an uncommon practice. A company desiring to reduce income tax liability can achieve this result through inventory manipulation. Because this illegal tax-reducing technique does occur, the forensic accountant, business valuator, litigator, etc., must be aware of how it works.
To illustrate how this may happen, I have included the following scenario: a company realizes an annual profit of $250,000, which produces $75,000 (estimated at 30 percent) income tax liability. The firm management decides this is more than the tax budget will bear, and so reduces ending inventory from $1.25 million to $1.1 million. The resulting impact is:
- Costs of goods sold increases by $150,000
- Net income reduces by $150,000
- Income tax reduces by (30 percent) $45,000
Additionally, the inventory asset is now understated on the company balance sheet by $150,000.
There are techniques that can be used to discover this fraud. A manipulation of inventory can be discovered via trend analysis; I recommend a five-year analysis period. Gross profit is defined as sales minus cost of goods sold. The ratio of gross profit to sales should be fairly consistent from year to year. If not, significant changes in gross profit can and should be investigated and explained. For example, the introduction of new product lines or the utilization of more efficient technology may increase gross profit. Reducing prices due to enhanced competition will reduce gross profit. Using trend analysis will identify the reason(s) for gross profit fluctuations. If the reason(s) for gross profit fluctuations cannot be identified, one must look to the possibility of inventory manipulation.
Proper accounting mandates the maintenance of beginning and ending inventory records sufficient to support inventory levels. If inventories cannot be supported by contemporaneous records, reliance on same will pose a risk. Additionally, a system that utilizes a perpetual inventory will usually indicate a higher degree of reliability.
The existence of larger adjustments to inventory, both late in the year and early in the following year, may be a sign of manipulation. Inquire about the frequency of physical counts of inventory, which should be performed at least annually. Inventory will usually be adjusted to account for differences between perpetual records and physical counts. In a well-designed and maintained inventory system, these adjustments should not be significant. Beware of large adjustments to inventories as a possible sign of manipulation.
A cross-check on the validity of the value of inventory is to review insurance coverage. When the level of insurance coverage is significantly different than the book-carrying value of the inventory, there exists a warning sign of manipulation.
The manipulation of inventory can also be used to camouflage an operating loss, i.e., turn a loss into a break-even or a profit. This is accomplished by inflating ending inventory over actual levels.
Since inventory is an asset that is more difficult to substantiate after the fact, it is often used to reduce profit (by reducing ending inventory) or increase profit (by increasing ending inventory). Consequently, the reasonableness of inventory levels must be ascertained in a forensic investigation or business valuation.
Terry Silver is a certified public accountant, certified valuation analyst and certified in financial forensics for Citrin Cooperman, an accounting, tax and business consulting firm in Philadelphia, where he is a partner with more than 33 years of experience as an accountant and auditor. He focuses his practice on business valuation and financial forensic services, expert testimony and matrimonial actions. He can be reached at email@example.com or 215-545-4800.