Financial Controls for Inventory
By Mike Morley, CPA

Inventory is easily manipulated. It can be hidden, stolen, or simply forgotten. Weak controls in this area can pose a serious risk of material misstatements on the company’s financial statements.

Creating financial controls for inventory begins with determining accountability. Defining and documenting exactly who is responsible for inventory is not quite as easy as it sounds.

Inventory doesn't start out as inventory. It starts out as a purchase order, becomes an order to the supplier, a received shipment, can be stored, in a manufacturing environment it becomes work in process, is prepared for shipment, and delivered to the customer. At every stage different people are responsible for this asset called inventory. Each stage follows a different process, or series of processes to accomplish the tasks assigned to them.

Each of these processes should be documented and evaluated in terms of what the risks are of producing an error on the financial statements. For example, the original decision to purchase the inventory often stems from a customer order that is usually handled by the sales group. Documenting the process of receiving a customer order is the first step in assessing the risk of accepting and filling the order. The sales group hands it off to purchasing who will proceed with finding and securing the necessary materials, which may pose some risk if it cannot be done in time or if the items are not of sufficient quality.

Inventory Valuation

Writing off obsolete inventory can be a significant expense and is an area where the potential for fraud is great. Write-offs of inventory were common when they appeared as one-time charges during the high-tech boom years. These one-time charges were used to even out the profit figures over several quarters so that investors could be fooled into thinking the company was on a steady climb to more profits. For example, if profits were not good for a given quarter, companies would wait for a good quarter to take the write-offs and call them a one-time charge. This gave the false impression that profits were on a steady climb.

On the other hand, carrying inventory at an over-inflated value can lead to understated expenses and overstated profits, which is another area with tremendous potential for fraud. Every step in the process, including approvals for write-downs, should be documented. Employees, such as purchasing managers, who have a vested interest in not writing down inventory because it would highlight their poor buying decisions, should not be the people responsible for writing off obsolete inventory. At the very least, the write-off needs to be approved by finance.

When companies are looking for financing, the lender will often request that the inventory be used as collateral for the loan and that the amount of the ongoing financing be tied to the level of inventory. Usually, there will be a covenant that the loan must be paid down if the inventory value falls. Companies make themselves look better by not writing down obsolete inventory. Financial controls that eliminate this risk will help to ensure that the company abides by its loan covenants.

Valuations require good market information, including competitor prices, to correctly reflect the value of inventory in the financial statements. Controls need to verify the information on which the valuation is based. They also must be able to catch any attempted fraud by employees trying to cover theft of inventory.

To limit the likelihood of fraud, supervision of inventory counts should be completely out of the hands of the people who are responsible for the inventory.

A Sale That Is Not a Sale

“Channel Stuffing” which is the practice of invoicing customers at month-end, recognizing the sale, and then issuing a credit for the return of the goods to the supplier after month-end was a widespread practice during the high-tech boom. Companies benefited from this game by inflating sales figures and reporting their investment in inventory as lower than it actually was. It was bad for investors and banks because not only did it produce a false income statement and balance sheet, but also the cash flow relied upon by investors and lenders did not exist. The Accounts Receivable reported from the non-existent sale would never be turned into cash. Only a credit note would be issued. Reduced cash meant a reduced ability to pay dividends or accounts payable. The inventory going back and forth eventually became obsolete and a significant write-down would be taken in some future quarter.

It is virtually certain that the company executives were well aware of the fraud that was taking place but either chose to ignore it or actually encouraged the practice. Since in the days before Sarbanes-Oxley they did not have to personally certify the financial statements and attest to the effectiveness of their company’s financial controls the personal risk to them was insignificant compared to the potential gains in the company’s stock price.

Mike Morley is a Certified Public Accountant who holds the top credit designations in the U.S., Canada, and the U.K. Mike is the author of “Sarbanes-Oxley Simplified,” which is an easy-to-read explanation of the requirements of the U.S. legislation that makes CEO's & CFO's personally responsible for the accuracy of their company's financial statements.

If you are interested in learning how to analyse financial statements quickly and easily, Mike will be teaching a one-day seminar on Advanced Financial Statement Analysis in Mississauga on July 16. For more information call 416-275-1278 or go to www.mikemorley.com