In his book “Accounting Irregularities and Financial Fraud: A Corporate Governance Guide,” Michael R. Young discusses the primary characteristics of fraudulent reporting. Young states that fraud does not start with intentional dishonesty but in a certain environment when two conditions exist. The first is an “aggressive target of financial performance”. The second is a realization that the inability to meet this target would be viewed as failure. Simply put, “fraudulent financial reporting starts with pressure.” Young further states that most financial fraud begins with gray areas of financial reporting such as revenue recording issues and expand over time.
Taking the above discussion into account, it is readily apparent how a distressed company can ride the slippery slope into fraud. This is especially true as it relates to the most important thing facing a distressed company, the availability of working capital.
- When accounts receivable slows down due to customer lateness or non-payment, the company can suffer serious cash flow problems with the inability to meet large expenses such as payroll.
- When inventory doesn’t move, the company is unable to recoup costs through sales.
- With enough time, inventory can become obsolete.
To solve its cash flow problems, the company may begin to engage in fraudulent activity to maintain (or obtain) short-term (asset-based) financing to meet its obligations.
Accounts Receivable Fraud
The most prevalent form of financial statement fraud is the improper recording of revenue. This usually manifests itself in the form of recorded fictitious revenue or the recording of sales (and related accounts receivable) in the wrong time period to inflate revenue, commissions, bonuses, or other monetary income. This second method is known as premature revenue recognition. While these methods are similar fictitious revenue schemes, premature revenue frauds can be much more complicated than the simple recording of bogus revenue. What follows are two ways in which this fraud is perpetuated:
- Fraudulently inflating the value of accounts receivable. Companies set up “allowance” accounts to cover those receivables that ultimately become uncollectable and must be written off. When the company writes off these receivables at their actual value, it results in a decrease of receivables, current short-term assets, and net income.
This process can be manipulated by falsely underestimating the uncollectable portion of receivables, thus inflating total receivables and maintaining uncollectable receivables on the books as current assets. Further, a credit issued to a customer could be hidden without decreasing the accounts receivable. This is accomplished by simply maintaining the receivable on the books to inflate total sales revenue, but hiding the credit memo to avoid having to adjust receivables down.
For example, a customer receives $500 worth of goods. The supplier will record the $500. Sales and receivables increase by $500. The customer then returns half of the goods for faulty parts and demands a 50% refund. To avoid having to record the loss on sales, the supplier issues a credit memo to the customer’s account but does not take the $250 portion of the sale (or related $250 portion of accounts receivable) off the books. This fraudulent recording of earnings will be detected only if the receivable ages to the point of becoming uncollectable and written off, or if an experienced professional uncovers the $250 discrepancy between sales and written-off receivables.
A second example is found when a company uses bad debt to falsify earnings. One high-profile example of this occurred with HealthSouth, the large healthcare company that was prosecuted for massive financial fraud in the early 2000′s. The accounts receivable portion of this fraud was detailed in an article by accounting professors Leonard G. Weld, Ph.D., Peter M. Bergevin, Ph.D., and Lorraine Magrath, Ph.D. in the October 2004 issue of CPA Journal.
The article explains that a review of credit sales is often sufficient to detect fraudulent earnings claims but such an investigation will require a review of all company accounts related to net accounts receivable. According to the article, the large percentage of receivables reported by HealthSouth as uncollectable is not surprising in light of the healthcare industry’s high level of bad debts. However, HealthSouth’s write-offs of bad debts where highly volatile throughout the 1990s when compared with industry averages. According to the company’s filings with the SEC, HealthSouth’s 1999 bad debt expense rose to nearly 9 percent of annual sales as compared with about 3 percent in 1998.
According to the authors of the article, “annual write-offs for uncollectible receivables lacked any consistency whatsoever.” “Moreover, the amount of the accounts written off in any given year did not correlate with the allowance established for them… [The figures show] that HealthSouth used bad debt reserves to manipulate earnings. This lack of correlation could be an indirect indicator of abusive earnings management and reserves that are not correlated with balance sheet items. Company officials have decided to replenish the balance in the allowance account for bad debts…in a classic cookie jar ploy.”
A “cookie jar ploy” is when an account is created with an ambiguous name such as “miscellaneous items” or similar term and is used for hiding cash in the event that it is needed to manipulate earnings figures or otherwise falsify accounting records.
Even the suggestion of inventory fraud can be a scary experience for any company owner or lender. In fact, the list of inventory manipulations that companies have committed over the past 50 years reads like a suspense thriller: McKesson and Robbins, Crazy Eddie, Phar-Mor, the Salad oil debacle, Equity Funding.
Generally, determining the value of inventory involves the analysis of two areas: quantity and price. Determining the amount of inventory on hand can prove difficult since products are constantly being rotated on and off the shelves or transferred to other facilities. Calculating the unit cost of inventory can also pose a challenge because the result can depend on the valuation method used (e.g. FIFO or LIFO, average cost, etc.). Each method can result in significantly different inventory values. As a result, inventory is often an attractive asset category for fraud.
The pressured environment within distressed companies may lead to the use of a combination of methods to commit inventory fraud: fictitious inventory, manipulation of inventory counts, failure to record purchases, and fraudulent inventory capitalization. Each method has the same goal of fraudulently inflating inventory values.
The most obvious method of creating fictitious inventory is to create records for products that do not exist such as undocumented journal entries, inflated inventory counts, fake shipping and receiving records, and invented purchase orders. Since it is difficult for auditors to spot such fake documents, they usually rely on other means to validate the value of inventory on hand.
- Observation of physical inventory. The most reliable method to value inventory is to count it. Even so, small mistakes can permit fraud to remain undetected.
- Management staff follows the auditor and makes notes regarding the counts. After the auditor leaves, the company can add fake inventory to the items not counted. This will artificially inflate the total inventory value.
- Auditors announce when they will visit. For those companies with several locations, this advance notice permits management to conceal any inventory shortages at those locations that the auditors may not visit.
- The auditor may not examine packed boxes. To inflate inventory, management stacks empty boxes in the warehouse.
Phantom inventory sets a company’s books off kilter. As compared with previous periods, the cost of sales will be too low with profits too high. Other signs include:
- Inventory is increasing faster than sales are being generated.
- Inventory turnover is slowing.
- Shipping costs are decreasing as a percentage of inventory on hand.
- Inventory is growing faster than total assets.
- Decreasing cost of sales as a percentage of total sales.
- The cost of goods as shown in company records does not match with what is stated on tax returns.
Manipulation of Inventory Counts
Auditors rely heavily on physical inventory counts so it is important to take and accurately document test counts. Some incidents of fraud occur when the company alters the auditor’s notes after work hours.
As an example, suppose a company receives a large shipment of inventory days before a bank auditor is set to visit and hides all the documentation relating to the receipt of this merchandise. During the physical inventory count, employees count the merchandise that the auditor then tests. In this scenario, physical inventory will be inflated by the amount of the unrecorded liability (secreted invoices). The benefit to the company is that the amount of overstatement is hidden from the cost of sales (COGS) calculation. An astute analyst can pick this up by reviewing the cash disbursements for the period in question. Should the analyst find payments to vendors that are not offset by purchase journal entries, further investigation will be warranted.
Although in theory any inventory can be fraudulently capitalized (held as an asset when it should be expensed), manufactured goods present a particular challenge. Common items of capitalization include selling expenses and general and administrative overhead costs.
A crisis manager experienced in fraud detection can look at inventory counts knowing how inventory fraud tends to work and why a particular company may be motivated to engage in such behavior. In almost all cases, the answer is that management (at various levels) is feeling intense pressure to meet financial obligations. A crisis manager who evaluates both motive and opportunity to commit inventory fraud will almost always end up catching the phantom.
Nat Wasserstein, JD,MBA, CFE