Special to the Legal
In recent blogs, I have been discussing red flags in financial data. Red flags are circumstances unusual in nature or deviations from customary activity. In this blog, I want to focus on one specific balance sheet item: the current asset inventory. For manufacturing and merchandising firms, inventory can be a significant balance sheet item.
In order to discuss the red flags related to inventory, it is important to understand what inventory is and how it relates to the financial statements of a business. Inventory represents goods produced or purchased for the purpose of resale. In a manufacturing situation, inventory can include raw materials, work-in-process and finished goods. Inventory in simplest terms is product a business owns but has not sold. Inventory is carried on the balance sheet at cost and is considered a current asset because it is expected to be sold in the relatively near future.
Components of Inventory
The two key components of inventory are quantity and price. While these seem to be simple concepts, the nature of inventory can cause quantity and price to be confusing. The inventory process involves purchases and sales over time. In addition, for many businesses, transfer of inventory between locations is also a regular occurrence. Depending on the accounting procedures a business utilizes, determining the goods on hand at any point in time may involve a number of procedures. For example, some companies do not track inventory movement on a transaction-by-transaction basis, but perform physical counts of inventory periodically to obtain that information.
In addition, the cost of inventory has its own complexities. Costs fluctuate over time. Further, tracking of costs, as with quantity, may not be done on a transaction-by-transaction basis, but may involve the use of accounting procedures.
Finally, inventory is connected to the balance sheet as well as the income statement. Merchandise prior to being sold is reported as inventory; however, when merchandise is sold, the cost of the items sold is reported on the income statement as “cost of goods sold.”
As a result, analyzing red flags related to inventory involves two general areas: theft of inventory and financial statement fraud involving the inventory account.
Theft of Inventory
Theft of inventory is more often than not done by an employee or group of employees and involves actual physical loss of inventory. Inventory is taken for personal use or for resale. For most businesses, the loss of inventory by employee theft is the largest component of inventory shrinkage. Inventory shrinkage includes physical loss of inventory related to a variety of events, including theft, bookkeeping errors and damage.
Examples of red flags related to inventory theft include unexplained inventory variances, missing documentation, particularly related to the receiving and shipping processes, unexplained credits and write-offs to inventory.
Those who want to defraud a company via theft of inventory often use more than one scheme when manipulating inventory. For example, they create fictitious purchase orders, alter inventory physical counts and use journal entries to artificially inflate the inventory account.
Overstatement of Inventory
Overstatement of inventory is a common financial statement fraud. To illustrate this concept, consider the income statement equation. The income statement provides information on a business’ profitability. The formula: Revenues minus expenses equals net profit or net loss. In a simple world, if expenses are lower, profitability is improved. Inventory is connected to the expense (i.e., cost of goods sold). When inventory is sold, the corresponding cost is taken as an expense on the income statement. Therefore, when ending inventory is overstated, the costs for the period are understated and result in reporting higher profit. Conversely, at times, companies may understate inventory, as there are motivations to show lower profit in a particular period.
Red flags to consider include inventory values that do not change or minimally change from period to period and gross profit percentages that remain consistent period to period.
To better understand inventory, consider comparing the inventory and cost of goods sold accounts from period to period to help identify areas of potential concern and areas that need to be considered in more detail. In addition, using ratio analysis can also help identify trends and patterns as well as variances that should be questioned and discussed.
Colleen S. Vallen is a partner in Citrin Cooperman Philadelphia’s valuation and forensic services group. An expert in the field of forensic and investigative accounting, she focuses her attention on forensic and fraud investigations, the preparation of financial damage analysis and litigation support. She is also highly experienced in the analysis, investigation and review of financial documents, as well as case planning and management, financial and economic analysis, expert report preparation, oral presentation of findings and assistance with discovery, interrogatories and depositions. She can be reached at firstname.lastname@example.org or 215-545-4800.