Detecting Inventory Fraud

Today lets look at an ethical question.  Consider an auditor who has a large client in danger of being lost due to fee competition.  (i.e., a competitor has agreed to provide an audit for a lower fee.)  Is it ethical for this auditor to cut back on the number of hours devoted to auditing the inventory account so that the client can be charged a lower fee?  Lets look at the following scenarios before we answer the question.

It is a well known fact that inventory fraud is a way companies can easily dress up the balance sheet and produce instant profits.  There have been many famous frauds that involved the creation of fabricated inventories.  Some examples would be; Laribee Wire Manufacturing Co. who filed for bankruptcy, at which time it was discovered that much of Laribee’s reported inventory did not exist.  Similar situations have occurred with Phar Mor, the Youngstown Drugstore chain, Miniscribe, Crazy Eddie’s, and Regina Vacuum Cleaners.  L.A. Gear and Digital Equipment Corporation were also cited in lawsuits filed by investors who lost money relying on financial statements prepared by an auditor that claimed overstatements of inventory.

The Wall Street Journal (December 14, 1992) reported that “auditors at even the top accounting firms are often fooled by falsified inventories….outside auditors can fail to catch inventory scams because they either trust management too much or fear they will lose clients by being tougher….spotting inventory fraud requires bigger staffs than some accounting firms….are willing to send out to do the inventory audits….If auditors were more skeptical of management claims, particularly in bad times, they would look at a far greater portion of the inventory in certain instances and do more surprise audits, which….nowadays are unusual.”

Auditors do face intense competition for clients, and audit fees have been reduced significantly in recent years to accommodate this competitive environment.  Accordingly there can be much pressure to reduce the number of audit hours to help control audit costs and maintain profit levels.  This is why inventory frauds can occur and can be very difficult to uncover.