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Inventory Manipulation What You See Is Not Always What You Get

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Whether speaking, chatting or testifying, I am frequently asked the following questions about debtors' financial statements:

  • What can the estate expect to realize upon "monetization" of one asset or another?
  • What will be the estate's exposure to a particular class of claims? And the classic:
  • Was the debtor solvent on the date of the transfer(s)?

The precise answer to these questions requires extensive analysis, due diligence and, on occasion, utilization of other professionals in addition to the accountant performing the work. After explaining this to the client, colleague or just plain curious, I am likely to provide some guidance in analyzing the numbers on a "back of the envelope" basis. As you can imagine, this type of approach to number crunching is necessarily fraught with generalities although industry-specific data and expertise may prove helpful.

For purposes of this article, I have chosen to highlight some of the inventory-related issues affecting financial statement preparers and users. This is an area in which I have spent untold hours investigating and about which I have an equal number of stories to tell. A focused topic such as this will also allow me to explore other areas of the balance sheets in future articles.

Let the Good Times Roll!

Manufacturers, wholesalers and retailers frequently have inventory as a significant, if not the largest, asset on their balance sheet. When the economic environment is tough and performance tougher, inventory manipulation creates a credible illusion of improved performance and an enhanced balance sheet. Luckily, during good times, owners and managers must only consider the following end-of-year quandary: how do I show the best capitalization to assure my company continued good credit standing vs. how do I pay the least taxes possible?

How can an accountant combat such cavalier attitudes and obtain some degree of assurance that appropriate information is being reported on the financials as well as on the tax returns? To understand the problem we must first define it. Accounting Research Bulletin No. 43 Chapter 4, "Inventory Pricing," Statement 1 defines inventory as items of tangible personal property that are (1) held for sale in the ordinary course of business; (2) in the process of production for such sale; or (3) to be currently consumed in the production of goods or services to be available for sale.

Given the responsibility of documenting the existence of the above, the accountant should apply §331.09 to §331.13 of Statement on Auditing Standards (SAS) No. 1, which discuss the evidentiary standard that should be attained. These sections of SAS No. 1 do not define the auditor's responsibility for quality of inventory. However, the third standard of field work requires the auditor to obtain sufficient competent evidentiary matter regarding inventory quality in connection with determining whether the inventories are presented in accordance with generally accepted accounting principles (GAAP).

While the accountant steadfastly attempts to prove the existence of the inventory, as well as arrive at a good approximation of its value, Uncle Sam will not be denied his due. While preparing the client's tax return, Treasury Regulation §1.471-2(c) states that: "the taxpayer is permitted to value the goods at bona fide selling prices less direct cost of disposition." This method of valuation requires an actual "offer for sale" that must be made within 30 days after the inventory date. Thus, obsolete inventory items cannot be written off without being scrapped or offered for sale. At this juncture the perpetual predicament facing the accountant is how to explain to the client that you are reducing inventory for financial statement purposes due to necessary valuation reserves but, except under the most stringent of circumstances, no corresponding reduction in tax burden will be realized for the reserve taken.

Even the method of recording inventory for tax purposes is dictated as in Treasury Regulation §1.471-2(a), whereby it is decreed that a sound inventory method is one that must conform to the best accounting practice in the trade or business and clearly reflects income. The phrase "best accounting practice in the industry" appears to be synonymous with GAAP. See Thor Power Tool Company v. Commissioner [79-1 USTC ¶9139], 439 U.S. 522, 532. (1979). Treasury Regulation §1.446-1(a)(2) states that an accounting method "which reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly reflecting income."

Ordinarily, the independent accountant cannot spend exhaustive time or the client's money validating the existence, pricing, movement and quality of every item of inventory. Even if fees were of no consequence, the intent of the client or circumstances beyond anyone's control could cause a material misstatement. During relatively good times the accountant must rely upon sophisticated random sampling models and other statistically acceptable methodologies in order to overcome the potential conflict that exists between impartial financial statement and tax return preparation when juxtaposed against the client's wishes.

Oh, What a Tangled Web We Weave

All too frequently in distressed situations, a debtor's perceived need to improve balance sheets and earnings, or to appear to achieve budgets, or the ability to compare favorably to certain financial indices, may be so compelling as to supercede sound judgment. It is for this and other reasons that accountants have been attempting to close the "expectation gap" between the public's perception of the meaning of financial information and the auditor's understanding of, and requirements for, producing financial statements.

An accountant must be eternally vigilant in less-than-ideal situations, economic or otherwise. SAS No. 53 states that, "the auditor's responsibility to detect and report errors and irregularities" requires an auditor to assess the risk that errors or irregularities may cause financial statements to contain material misstatements.

Here are some of the well-known cases that have made national headlines:

  • Laribee Wire Manufacturing Corp.: Most of this wire manufacturer's inventory used as loan collateral was nonexistent and the inventory that did exist was overpriced. Shipments between plants were recorded as stock located at both plants. Transferring documentation was fictitious. Inventory in off-site warehouses was three times the capacity of the buildings.
  • Digital Equipment Corp.: This electronics firm's obsolete inventory was never marked down to market value. The company was sued for failing to set aside reserves for obsolete inventory.
  • Phar-Mor Drugs: This deep-discount, retail drugstore chain overstated its inventory by more than $50 million. Items already sold were never deleted from inventory ledgers. Phantom inventory was maintained on the books of many of the stores. Auditors notified management in advance the stores that were to be physically test counted. Ultimately a $350 million accounting charge needed to be taken due to alleged fraud by former management.

Equally frightening are some lesser-known real life exploits. Some creative themes of note are as follows:

  • "Someone else's inventory" is where a friend or accomplice will loan merchandise to a debtor during the physical counting.
  • "Multiday counting" affords the debtor the time and luxury of moving his own goods to other locations while unsuspecting auditors travel to and from.
  • "Third-party verification" is similar to the first ploy, but distance, cost or some other acceptable reason lulls the auditor into a false sense of security. Believing that the documents received in support of the existence of the inventory are sufficient evidence for reporting purposes, the auditor is unaware that the documents have been fabricated.
  • "Returned goods, bill-and-hold and damaged goods" are frequently used by debtors to augment their inventory values. Testing procedures will often bring many problems to light, but part-time inventory counting services and junior accountants are no match for sophisticated and determined debtor management.

Conclusion

The means of inventory fraud are as varied as the companies that seek this illegal activity. Had management owned up to its responsibilities and taken the write-downs when appropriate, then inventory would be sold off in a more timely fashion. The cash generated would then go to more beneficial areas, such as operational improvements, replenishment of good inventories or weathering any temporary storm.

The fact that many companies offer incentives to management based on positive economic results remains a dilemma. This useful tool is one of the cornerstones of capitalism and will not soon be abandoned regardless of the misguided few who abuse it.

Auditors and readers of financial statements need to be aware of industry trends and credibility of management, and have a keen understanding of underlying factors effecting their clients, investments, etc. Only then will the odds slightly improve relative to finding inventory valuation problems.

Journal Date: 
Wednesday, March 1, 2000

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