Introduction

Generic Definition : “Items, goods, merchandise, and materials held by a business for selling in
the market to earn a profit.”

Manufacturing inventory : Besides finished goods, also includes raw materials used in
production and the semi-finished goods in the warehouse or on the factory floor.

Service inventory : Intangible inventory - no physical stock. Hence including steps involved
before completing a sale

Takeaways :
i) An asset, tangible or intangible,
ii) An asset that can be realized for revenue generation or has a value for exchange, or
iii) An asset which is in process but is meant for sale in the market
 Types of Inventory

1. Raw materials - All items processed to make the final product. (only in manufacturing process)

2. Work in Progress Inventory - Completely processed, but yet to be sent for sale

3. Finished goods - Final items, ready for sale in market

4. MRO inventory - Maintenance Repairing and Operating supplies (manufacturing industry)

5. Buffer inventory - a.k.a safety stock, inventory to cushion impact of unexpected shocks

6. Cycle inventory - quantity of inventory that a business can sell and replenish according to plan

7. Decoupling inventory - consists of items which are kept in reserve to be processed by another machine

8. Transit inventory - items that are being moved from one location to another
 What exactly is Inventory Fraud?

There are 2 types of Inventory Frauds:-

Employee Theft :

▪ Physical Loss of the inventory without any invoice generation or receipt generation.
This type is more common in retail setting

▪ Employee steals business inventory for personal use, such as consumer goods that
are small and easy to hide

▪ Some employees also steal inventory for resale, which can happen in any number of
ways, from receiving clerks to night-crew stockers
 What exactly is Inventory Fraud?

Financial Inventory Fraud

Cost of Goods Sold = Opening Inventory + Purchased Inventory - Closing

Inventory

● Overstatement of Inventory: Cost of Goods sold is calculated by subtracting the

increase in inventory from purchases. Therefore, overstating ending inventory
(increase in inventory) understates cost of goods sold and has the effect of
reporting higher profit

● Understatement of Inventory: Alternatively, management is sometimes

motivated to report lower profit in order to limit the amount of taxes. In this case,
understating inventory accomplishes the overstatement of cost of goods sold and,
as a result low net income
 Common Fraud Techniques

▪ Fake Sales: Companies create fake purchase orders and invoices

▪ Skimming items from a customer’s order of sale

▪ Creating false journal entry to account for goods that are stolen

▪ Creating phony inventory to boost a company’s value

 Reasons for committing Inventory Frauds

▪ Personal financial pressures or addiction may entice an employee to steal inventory or

overstate it

▪ Employees and executives who feel unfairly treated like he or she feels underpaid,
underappreciated or overworked by an owner

▪ Given an opportunity to commit fraud is typically related to internal controls like if there
exist improper checks and balances

▪ Company attempting to obtain financing secured by inventory

Symptoms of Inventory Related Fraud
● Removal of inventory from storage for resale or personal use and the warning signs include
missing packing slips and sales receipts, employees living above their means, complaints from
customers about lost goods, spikes in the number of damaged goods and sharp drops in sales
● The signs of possible financial statement fraud include stagnant inventory balances for several
consecutive accounting periods and inventory balances rising faster than sales
● Determine if the inventory turnover -- which is the ratio of the cost of goods sold to inventory
shows sudden changes or if it's significantly different from industry trends
● Check if the cost of goods sold on the company's books is different from the tax returns
● Spot unusual trends in certain financial ratios involving inventory

Days in inventory (average inventory divided by annual cost of sales times 365 days)
Gross margin (sales minus cost of sales) as a percentage of sales
Inventory as a percentage of total assets
Returns as a percentage of annual sales
Shipping costs as a percentage of sales
 Famous Inventory Frauds

Two famous inventory frauds are -

● Mckesson & Robbins - Drug and Chemical Maker

● The Equity Funding Corporation of America (EFCA)

 Mckesson & Robbins(1937)

● Adelphia Pharmaceutical Manufacturing Company was used by Philip Musica as a front to sell the goods
in Illegal Market. He assumed the name Frank D Costa.
● Mckesson and Robbins was a drug and chemical company which was bought by Musica in 1925 with
assumed name F Donald Coaster
● The goods are hair tonic and other products with high alcohol content
● They have a demand in illegal market which are sold as liquor to the customers
● Musica brought his three brothers with assumed names to help him in doing the illegal business by
placing two of them within the company and one outside
● They would generate fake sales documents and pay sales commissions to shell companies under their
control
● In 1937 treasurer Julian Thomson discovered the shell company is fake and alerted the authorities about
the fraud.
● Total of $19 Million fictitious inventory was discovered in balance sheets which is $285 million in current
dollars
● All of this transactions occurred even with Price Water House Coopers worked as their auditors
● Reforms: Inclusion of independent audit committee and auditors need to verify the inventory personally
 Equity funding Corporation of America(1973)

● Equity funding Corporation of America is a los angeles based financial conglomerate.It is one of top 10
insurance company in US
● They would sell a package of mutual funds and life insurance to the customers
● Their strategy was to sell mutual fund to the customer who would borrow money with the security of
mutual fund and use that money to purchase life insurance
● They convinced the customers that the money from the mutual fund can be used to pay the premium of
insurance
● But EFCA was not able to generate money and want to compete in the market. To meet the deadline of
reporting and to impress the customers, they have filled the fictitious transactions in the financial
statements
● The fraud multiplied over the years and was estimated at $2 billion dollars
● It was a classical case of insider trading where the people of wall street are aware of the fraud from a
very long time
 Prevention of Inventory Fraud
▪ Segregation of duties: Employees involved in production process should not involved in shipment process

▪ Production Yield Analysis: The difference between actual output and standard output based on the standard inputs
of labor and capital. A regular analysis will help

▪ Management reporting process: A lack of structured reporting process can lead to such frauds go undetected.
Detailed reviews of quarterly meeting can help mitigate the risks

▪ Surprise Stock Count: Predictable methods can be eluded. A random surprise visit will help to gauge the actual
picture

▪ Automated Production Process: Manual processes have high areas to commit fraud. Integration of production
process with automated inventory control system can help

▪ Stringent policies and auditing methods : As seen in Mckesson & Robbins, independent auditing is imperative to
reduce these frauds

▪ Awareness : To reduce financial inventory frauds like EFCA, people must increase their knowledge about the risks of
buying financial services
Thank You!