Inventory and Cost of Goods
Sold Fraud
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
Identifying Inventory and Cost of
Goods Sold Fraud Exposures
 One of the easiest ways to identify fraud exposures is
to diagram the various kinds of transactions that can
occur related to inventory and cost of goods sold. For
many companies, that diagram might be similar to the
following example
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
Inventory and Cost of Goods Sold Fraud
1. Purchase Inventory
Return
Goods?
Yes
2. Return good to supplier
No
Take
Discount?
Yes
3. Pay within discount period
No
4. Pay vendor without
discount
Sell
Inventory?
Yes
5. Inventory is sold
No
Yes
Inventory is
obsolete?
6. Write down inventory
No
Inventory
counted?
No
7. Inventory quantities are estimated
8. Inventory quantities
are counted
9. Inventory costs are
determined
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
Matrix for Identifying Inventory Fraud
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
Identifying Inventory and Cost of Goods
Sold Analytical Fraud Symptoms
 With inventory and cost of goods sold, some of the most
common analytical financial statement fraud symptoms
are
 Reported “Inventory” balances or ratios that appear




too high
Reported “Cost of Goods Sold” balances or ratios that
appear too low
Reported “Purchase Returns” that appear too high
Reported “Purchase Discounts” that appear too high
Reported “Purchases” that appear too low for
inventory levels
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
 Decreasing inventory turnover.
 Decreasing shipping costs as a percentage of inventory.
 Increased shipping costs at or near end of period.
 Significant inventory returns after the end of the
period.
 Cost of Goods Sold on books not agreeing with tax
returns.
 Decreasing cost of sales as a percentage of sales.
Identifying Inventory and Cost of Goods Sold
Accounting or Documentary Symptoms
 With inventory and cost of goods sold, some of the most
common accounting or documentary symptoms are:
 Inventory and cost of goods sold transactions not recorded
in a complete or timely manner or improperly recorded as
to amount, accounting period, classification, or entity
policy
 Unsupported or unauthorized inventory and cost-ofgoods-sold-related transactions
 Last minute inventory and cost of goods sold adjustments
by the entity that significantly improve financial results
 Missing documents related to inventory and cost of goods
sold
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
 Unavailability of other than photocopied
documents to support inventory and/or cost of
goods sold transactions when documents in
original form are supposed to exist.
• Unusual or suspicious-looking purchase orders,
invoices, shipping documents, and/or receiving
documents.
 Cost of goods sold related accounting records
(purchases, sales, cash payments, etc.) that do not
balance.
 Unusual discrepancies between the entity's
inventory and/or cost of goods sold records and
corroborating evidence (such as inventory
counts).
• Differences between inventory counts and
inventory records, especially systematic
differences.
 Differences between receiving reports and inventory actually received.
 Inventory items not actually received.
 Differences between purchase orders, purchase invoices, receiving







records, and inventory records.
Purchases from suppliers not approved on vendor list or with no EIN
numbers.
Missing inventory when performing inventory counts.
Duplicate purchase orders or invoice numbers.
Vendors not listed in Dunn and Bradstreet or Telephone Directories.
Adjusting entries that have increased inventory over time.
Large reversing entries to inventory accounts after the end of the
period.
"Accidental" sales to customers that are later reversed.
Identifying Inventory and Cost of
Goods Sold Control Symptoms
 With inventory and cost of goods sold, some of the most
common control symptoms are:
 Management override of significant internal control




activities related to purchases, inventory, and/or cost
of goods sold
New, unusual, or large vendors that appear not to have
gone through the regular vendor-approval process
Weaknesses in the inventory counting process
Inventory that cannot be easily physically inspected
Unclear or ineffective cutoff procedures
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
 Inclusions in inventory of merchandise already sold for
which purchases are not recorded.
 Inventory that appears to not have been used for some
time, or inventory that is stored in an unusual
location.
 Excessive intercompany movement of inventory with
little or no controls or documentation.
 Material inventory write-offs after the end of the
period.
Identifying Inventory and Cost of Goods Sold
Behavioral or Verbal Symptoms
 With inventory and cost of goods sold, some of the
most common behavioral or verbal symptoms are:
 Inconsistent, vague, or implausible responses from
management or employees arising from inventorypurchase- or cost-of-goods-sold-related inquiries or
analytical procedures
 Denied access to facilities, employees, records,
customers, vendors, or others from whom inventoryand cost-of-goods-sold-related evidence might be
sought
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
• Undue time pressures imposed by management to
resolve contentious or complex inventory and/or cost
of goods sold related issues.
• Unusual delays by the entity in providing inventory
and/or cost of goods sold related, requested
information.
• Untrue or questionable responses by management to
inventory and/or cost of goods sold or other queries
made by auditors.
• Suspicious behavior or responses from members of
management when asked about inventory and/or cost
of goods sold related transactions, vendors, or
accounts.
Actively Searching for Inventory/Cost of Goods
Sold Analytical Symptoms
Analyzing Financial
Balances and
Relationships within
Financial Statements
Comparing Financial
Statement Amounts or
Relationships with Non
financial Statement
Information
Look for unusual changes
in inventory and cost of
goods sold account
balances from period to
period (trends).
Compare financial results
and trends of the
company with those of
similar firms in the same
industry, or with industry
averages.
Look for unusual changes
in inventory and cost of
goods sold relationships
from period to period.
Compare recorded
amounts in the financial
statements with
nonfinancial statement
amounts
Focusing on Changes in Recorded
Balances From Period to Period
 Usually the least effective method is to focus on
changes in the actual financial statement numbers
 A very similar method is to study the Statement of
Cash Flows
 The best method is to perform horizontal analysis
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
Focusing on Changes in Relationships
From Period to Period
 Calculate inventory and cost of goods sold-related
ratios and examine how the ratios change from one
period to the next
 Convert the financial statements to common-size
statements and use vertical analysis to examine the
percentage change from period to period
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
 Comparing Financial Statement Amounts with
the Assets They Are Supposed to Represent or
with Nonfinancial Statement Factors
Actively Searching for “Accounting and
Documentary” Symptoms
 Actively searching for accounting and documentary
symptoms involves examining samples from a
population or using query programs to search for
attributes that, if existed, would signal the possibility
of fraud
 Discovery sampling, or “stop and go” sampling, is an
easy and effective statistical sampling technique
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
 While sampling may make sense when looking for inventory
documentary or accounting symptoms, computers have made it
possible, and even easier and faster, to search for documentary
symptoms.
 The approach to using queries would be as follows:
 Identify the fraud scheme (e.g., under-record purchases, over-count
inventory, etc.).
 Identify the fraud symptoms that would exist if these fraud schemes
were being perpetrated.
 Query various databases to determine if the fraud symptoms exist.
 Follow up on the symptoms observed.
Actively Searching for
“Control” Symptoms
 Because inventory frauds, like revenue-related frauds,
are so easy to perpetrate, it is important that a good
control environment and control procedures be in
place
 Where controls are weak, or can be easily overridden, a
missing control or an observance of an override
represents a fraud symptom, not just a control
weakness. As such, it should be pursued with the same
vigilance as any other “fraud symptom”
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
Actively Searching for “Behavioral or
Verbal” and “Lifestyle” Symptoms
 Lifestyle symptoms are usually not very effective in
helping you find inventory-related financial statement
fraud because financial statement fraud usually does
not benefit the perpetrators directly
 Searching for behavioral and verbal symptoms can be
very fruitful
 Ask questions that go beyond simple inquiries and
watching closely for inconsistencies and changes in
response or behavior can be powerful tools for
detecting fraud
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
Actively Searching for “Tips and
Complaints” Symptoms
 Because of its physical characteristics, inventory must
be shipped into a firm, handled while in the firm, and
shipped out of the firm when sold. All this movement
means that people must be involved in managing the
physical flow of inventory. Talk to those people
 Communicate directly with vendors and try to
determine their relationships with the company
Copyright 2014-2015 AICPA Unauthorized copying
prohibited
SAS 99 and its predecessor, SAS 82, provide guidance about how an auditor
should follow up on inventory fraud symptoms. With respect to inventoryspecific guidance, the standards suggest that an auditor may want to consider
doing the following:
 Visit locations or perform certain tests on a surprise or unannounced
basis; for example, observing inventory at locations where auditor
attendance has not been previously announced.
 Count inventories at a close to year-end date.
 Alter the audit approach in the current year. For example, contact
major customers or suppliers (both verbally and in writing), send
confirmation requests to specific parties within an organization, and/or
seek more and different information.
 Perform a detailed review of the entity's quarter-end or year-end
adjusting entries and investigate any entries that appear unusual as to
the nature or amount.
• For significant and unusual transactions, particularly those
occurring at or near year-end, investigate (a) the possibility of
related parties and (b) the sources of financial resources
supporting the transactions.
• Perform substantive analytical procedures at a detailed level.
For example, compare sales and cost of sales by location and
line of business to auditor-developed expectations.
• Engage the work of a specialist if deemed appropriate. For
example, in the Royal Dutch/Shell case previously discussed, it
was difficult for auditors to properly value the proven reserves.
However, the audit firm could engage an engineering firm to
make estimates of the value of the proven reserves.
• If the auditor has a concern about the risk of material
misstatement due to fraud in the inventory area, it may be
particularly important that the entity counts are conducted at all
locations subject to count on the same date.
• Furthermore, it may also be appropriate for the auditor to apply
additional procedures during the observation of the count – for
example, examining more rigorously the contents of boxed items,
the manner in which the goods are stacked or labeled, and the
quality of liquid substances such as perfumes or specialty
chemicals.
• Finally, additional testing of count sheets, tags or other records, or
the retention of copies may be warranted to minimize the risk of
subsequent alteration or inappropriate compilation.
If, after taking these and other steps, the auditor feels that inventory may
be misstated and could be material, the auditor should take appropriate
action from the following alternatives:
 Consider the implications for other aspects of the audit.
 Discuss the matter and the approach to further investigation with an
appropriate level of management at least one level above those
suspected to be involved, and with senior management.
 Attempt to obtain additional evidential matter to determine whatever
material fraud has occurred or is likely to have occurred and, if so, its
effect on the financial statements and the auditor's report thereon.
 If appropriate, suggest that the client consult with legal counsel.
 Consider withdrawing from the engagement and communicate the
reasons for withdrawal to the audit committee or others with
equivalent authority and responsibility.
Following up on
Symptoms Observed
 If you are an auditor, follow AU-C 240 guidelines for
suspected inventory fraud. For SEC clients, always
consult your legal counsel
 If you are a fraud investigator, if conditions or
circumstances warrant, you should proceed with a
fraud investigation
Copyright 2014-2015 AICPA Unauthorized copying
prohibited