Inventory manipulations have played a key role in countless frauds. Back in the 1990s, executives at drugstore chain Phar-Mor manipulated the company’s financial statements in order to hide approximately $500 million in losses. Their strategy included overstating inventory balances at individual stores, shifting inventory between locations and overstating unit prices. Managers also played a role in the fraud by stocking shelves at locations they knew financial statement auditors would visit, leaving shelves bare at unaudited locations.
CPAs have learned from past fraud cases like this one and have beefed up inventory auditing procedures as a result. Multi-location audits typically involve the following techniques to evaluate inventory:
1. Reviewing the inventory manual
Before venturing into the field to view inventory in person, your auditors will request a copy of the company’s inventory manual. This helps them understand the policies and procedures you use to manage inventory. Throughout the audit, auditors will compare the company’s inventory records against the manual for discrepancies and exceptions.
2. Conducting in-depth analytical procedures at each location
In order to safeguard against bloated inventory balances, your auditors will review the company’s accounting records. This helps them understand the process to allocate and assign inventory units and costs to individual locations. It includes verifying that the balances and associated value conform to U.S. Generally Accepted Accounting Principles (GAAP).
3. Counting inventory
Depending on the size of your company’s inventory, the auditor may conduct independent inventory counts or observe physical inventory counts that are conducted in-house or by third parties. As part of the inventory observation process, your auditor team may randomly select a sample of items and verify that those items are included in the inventory count. Alternatively, the auditor may select an item that appears in the inventory count and then attempt to locate that item in the company’s stores. At the conclusion of the physical count, the auditor may also perform statistical sampling to test the accuracy of the physical inventory count.
4. Analyzing general ledger entries
The perpetrators of the Phar-Mor fraud periodically made fictitious journal entries to the general ledger to allocate losses to the individual stores. So, auditors have learned to pay close attention to large or suspicious journal entries that reallocate losses or manipulate inventory balances. If anomalies are detected in general ledger transactions, your auditor will ask for documentation and detailed explanations from management regarding the purpose of the entry.
While the scope and depth of inventory auditing procedures depend on a number of factors, including the number of locations you operate, you can be assured that auditors will pay close attention to the inventory account. For more information about what to expect as auditors review your inventory balances or if you need assistance with your company’s audit, call us at 818-334-8623 or click here to contact us.