Transcript Inventory Observation and Fraud Related Issues

Inventory
Observation and
Fraud Related
Issues
Dr. Donald K. McConnell Jr.
5/23/2016
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Historical Antecedents
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Physically observing inventories
was considered an extended audit
procedure prior to McKesson and
Robbins
What did auditors do?
Tests of internal purchase
transactions
 Reliance on management
representations
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McKesson and Robbins:
a Watershed Fraud
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As of late 1930s, fraud detection was
primary purpose of an audit
McKesson and Robbins received
unqualified opinion on $78 million
balance sheet
However, almost 25% of balance sheet
was fraudulent!
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$10 million of fictitious inventories
$9 million of fictitious accounts receivable
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Consequences of
McKesson and Robbins
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Led to issuance of very first
professional auditing standard
SAP 1: Extensions of Audit
Procedures (Oct. 1939), requiring:
Physical examination of inventories
 Confirmation of Accounts
Receivable
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Erosion of auditor’s fraud detection
responsibility
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Audit Procedures for
Observing Inventories
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One of first thing you’ll do as a new
auditor!
Not glamorous: buy some jeans
and boots beforehand
Client does inventory counts
General auditor responsibilities:
Make test counts
 Observe propriety of inventory
taking procedures
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Client Inventory Taking
Considerations
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Client personnel generally count
inventories 100%, unless statistical
sampling techniques used
Client may employee inventory “Count
Specialists”
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Inventory components are ideally tagged
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Considered same as if client did
inventory counts
But may enable us to limit extent of our
test counts
Tags are prenumbered
So counters count everything once, but
only once
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Client Inventory Taking
Considerations (Con.)

Client count team activities
Perpetual systems: one count,
compared to perpetuals for
agreement
 Periodic systems:
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 count
with recount by another
count team
 ideally recorded on “blind tags”
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Observing Client
Inventories: What Do
You Do?
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Obtain copy of client inventory taking
instructions:
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Record test counts
Observe the following:
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When will inventories be counted?
Where, what locations?
Inventory taking instructions
Client personnel in charge
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Counters appear to be following inventory
instructions
Record counts from many inventory
teams
Note condition of inventories for NRV
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considerations
Observing Client
Inventories: What Do
You Do? (con.)
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Which assertion is generally at greatest
risk? Why?*
Existence or occurrence
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Hence direction of test should be from
recorded entry to source item (inventory)
That is, perpetuals, or inventory
tags/count sheets to inventory item
Emphasize counts of components of
greatest dollar value to maximize dollar
coverage of total inventories
Staff auditors often arrive with list of
inventory components to find/count with
recording of counts on work paper
Spot check smaller value inventory items 9
Observing Client
Inventories: What Do
You Do? (con.)
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Auditor recorded inv. counts traced to
final client inv. listings for agreement of
quantities (Cenco Fraud)
Ideally tags not pulled till auditor okays
Client should account for all inventory
tags as used, voided, or unused
Auditor should record on work paper
numbers of tags unused or voided
To verify such tag numbers don’t end up
on final inventory listings!
Consider obtaining copies of client
inventory count sheets, if fraud risk
10
Other Inventory
Observation
Considerations
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How would you verify work in process
inventory?
Sometimes client operations are not shut
down during inventory observation*
Client may have segregated goods they
want to call “sold”
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OK, if immaterial
Make sure carefully roped off and
labeled, “Do not count!”
What if a count team(s) is/are blowing
counts? [A personal experience]
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Various Inventory Issues
(Au 331)
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Physical (periodic) inventories:
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Perpetual inventories:
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Must be taken at or near year end
Auditor must be present recording test
counts and observing procedures (Au
331.09)
If well-kept and controlled, inventory
taking/observation can be done at an
interim date
Auditor must observe (Au 331.10)
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Where Inventories Taken
at Interim
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Auditor must “roll forward” inventory
account from inventory date to year end
for reasonableness of activity:
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Gross profit tests important:
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Does purchase and sales activity appear
reasonable in stub period?
Compare by months between years
Dec (and other months) gross profit ratios
this year should be comparable to last yr.
What if gross profit ratio up compared to
last December?
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Various Inventory Issues
(Au 331) (con.)
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Client may use statistical sampling
techniques for inventories:
To avoid counting every inventory
component every year (called
“cycle counts”)
 An acceptable practice under
GAAS
 Auditor must insure stat. plan and
parameters are reasonable (Au
331.11)
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What about a First-year
Audit? (Au 331.13)
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Can sometimes give a clean opinion on
the financials, even though beginning
inventory not observed!
Must be satisfied with ending inventories
Generally requires well-controlled
perpetual inventories
Necessary alternative procedures
regarding beginning inventories:
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Tests of prior inventory transactions
Review prior test counts, trace counts to
inventory lists, do beginning inventory
price testing. [Everything as done at
year-end, other than observation.]
CRITICAL: Gross profit results are
consistent with current and prior years 15
What about a First-year
Audit? (Au 331.13) (con.)
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If auditor is not satisfied
concerning beginning inventories…
Can still often give an unqualified
opinion on the balance sheet
Usually disclaimer on earnings and
cash flows (Au 508.67)
What would opinion be in the
following year?
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Inventories In Public
Warehouses (Au 331.14)
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Generally should be confirmed with
warehousemen
If material, one or more the following
should be accomplished:
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Review/test client control procedures for
monitoring warehouseman performance
Obtain a report on internal controls of
warehouseman
Observe physical counts at warehouse
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Examples of Responses
to Identified Risks of
Material Misstatement of
Inventories per SAS 99
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Examine entity records to identify
locations or items requiring
attention during physical counts
Observe inventories at locations on
an unannounced basis
Make concurrent observations
when several inventory locations
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Inventory Fraud Risk
Responses (con.)
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Possible additional procedures
during observation:
Examine box contents
 Observe manner of stacking (e.g.
hollow squares)(Crazy Eddie’s)
 Quality of liquid substances such
as perfumes, specialty chemicals
 Specialists may be helpful in
assessing quality
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Inventory Fraud Risk
Responses (con.)
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If feasible, retain copies of client
inventory count sheets
Minimizes risk of subsequent
alteration
 Minimizes risk of inappropriate
compilation
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Consider skeptically client attempts
to subsequently add count sheets
(Doughties’s Foods)
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Inventory Fraud Risk
Responses (con.)
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Consider using computer-assisted
audit techniques to test compilation
of physical inventory counts, e.g.:
Sorting by tag numbers to test tag
controls
 Sorting by serial number to test for:
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 Possibility
of item omission
 Possibility of item duplication
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