Inventory Observation and Fraud Related Issues

1. Inventory Observation and Fraud Related Issues Dr. Donald K. McConnell Jr.

2. Historical Antecedents • Physically observing inventories was considered an extended audit procedure prior to McKesson and Robbins • What did auditors do? • Tests of internal purchase transactions • Reliance on management representations

3. McKesson and Robbins: a Watershed Fraud • As of late 1930s, fraud detection was primary purpose of an audit • McKesson and Robbins received unqualified opinion on $78 million balance sheet • However, almost 25% of balance sheet was fraudulent! • $10 million of fictitious inventories • $9 million of fictitious accounts receivable

4. Consequences of McKesson and Robbins • Led to issuance of very first professional auditing standard • SAP 1: Extensions of Audit Procedures (Oct. 1939), requiring: • Physical examination of inventories • Confirmation of Accounts Receivable • Erosion of auditor’s fraud detection responsibility

5. Audit Procedures for Observing Inventories • One of first thing you’ll do as a new auditor! • Not glamorous: buy some jeans and boots beforehand • Client does inventory counts • General auditor responsibilities: • Make test counts • Observe propriety of inventory taking procedures

6. Client Inventory Taking Considerations • Client personnel generally count inventories 100%, unless statistical sampling techniques used • Client may employee inventory “Count Specialists” • Considered same as if client did inventory counts • But may enable us to limit extent of our test counts • Inventory components are ideally tagged • Tags are prenumbered • So counters count everything once, but only once

7. Client Inventory Taking Considerations (Con.) • Client count team activities • Perpetual systems: one count, compared to perpetuals for agreement • Periodic systems: • count with recount by another count team • ideally recorded on “blind tags”

8. Observing Client Inventories: What Do You Do? • Obtain copy of client inventory taking instructions: • When will inventories be counted? • Where, what locations? • Inventory taking instructions • Client personnel in charge • Record test counts • Observe the following: • Counters appear to be following inventory instructions • Record counts from many inventory teams • Note condition of inventories for NRV considerations

9. Observing Client Inventories: What Do You Do? (con.) • Which assertion is generally at greatest risk? Why?* • Existence or occurrence • Hence direction of test should be from recorded entry to source item (inventory) • That is, perpetuals, or inventory tags/count sheets to inventory item • Emphasize counts of components of greatest dollar value to maximize dollar coverage of total inventories • Staff auditors often arrive with list of inventory components to find/count with recording of counts on work paper • Spot check smaller value inventory items

10. Observing Client Inventories: What Do You Do? (con.) • Auditor recorded inv. counts traced to final client inv. listings for agreement of quantities (Cenco Fraud) • Ideally tags not pulled till auditor okays • Client should account for all inventory tags as used, voided, or unused • Auditor should record on work paper numbers of tags unused or voided • To verify such tag numbers don’t end up on final inventory listings! • Consider obtaining copies of client inventory count sheets, if fraud risk

11. Other Inventory Observation Considerations • How would you verify work in process inventory? • Sometimes client operations are not shut down during inventory observation* • Client may have segregated goods they want to call “sold” • OK, if immaterial • Make sure carefully roped off and labeled, “Do not count!” • What if a count team(s) is/are blowing counts? [A personal experience]

12. Various Inventory Issues (Au 331) • Physical (periodic) inventories: • Must be taken at or near year end • Auditor must be present recording test counts and observing procedures (Au 331.09) • Perpetual inventories: • If well-kept and controlled, inventory taking/observation can be done at an interim date • Auditor must observe (Au 331.10)

13. Where Inventories Taken at Interim • Auditor must “roll forward” inventory account from inventory date to year end for reasonableness of activity: • Does purchase and sales activity appear reasonable in stub period? • Gross profit tests important: • Compare by months between years • Dec (and other months) gross profit ratios this year should be comparable to last yr. • What if gross profit ratio up compared to last December?

14. Various Inventory Issues (Au 331) (con.) • Client may use statistical sampling techniques for inventories: • To avoid counting every inventory component every year (called “cycle counts”) • An acceptable practice under GAAS • Auditor must insure stat. plan and parameters are reasonable (Au 331.11)

15. What about a First-year Audit? (Au 331.13) • Can sometimes give a clean opinion on the financials, even though beginning inventory not observed! • Must be satisfied with ending inventories • Generally requires well-controlled perpetual inventories • Necessary alternative procedures regarding beginning inventories: • Tests of prior inventory transactions • Review prior test counts, trace counts to inventory lists, do beginning inventory price testing. [Everything as done at year-end, other than observation.] • CRITICAL: Gross profit results are consistent with current and prior years

16. What about a First-year Audit? (Au 331.13) (con.) • If auditor is not satisfied concerning beginning inventories… • Can still often give an unqualified opinion on the balance sheet • Usually disclaimer on earnings and cash flows (Au 508.67) • What would opinion be in the following year?

17. Inventories In Public Warehouses (Au 331.14) • Generally should be confirmed with warehousemen • If material, one or more the following should be accomplished: • Review/test client control procedures for monitoring warehouseman performance • Obtain a report on internal controls of warehouseman • Observe physical counts at warehouse

18. Examples of Responses to Identified Risks of Material Misstatement of Inventories per SAS 99 • Examine entity records to identify locations or items requiring attention during physical counts • Observe inventories at locations on an unannounced basis • Make concurrent observations when several inventory locations

19. Inventory Fraud Risk Responses (con.) • Possible additional procedures during observation: • Examine box contents • Observe manner of stacking (e.g. hollow squares)(Crazy Eddie’s) • Quality of liquid substances such as perfumes, specialty chemicals • Specialists may be helpful in assessing quality

20. Inventory Fraud Risk Responses (con.) • If feasible, retain copies of client inventory count sheets • Minimizes risk of subsequent alteration • Minimizes risk of inappropriate compilation • Consider skeptically client attempts to subsequently add count sheets (Doughties’s Foods)

21. Inventory Fraud Risk Responses (con.) • Consider using computer-assisted audit techniques to test compilation of physical inventory counts, e.g.: • Sorting by tag numbers to test tag controls • Sorting by serial number to test for: • Possibility of item omission • Possibility of item duplication