Specific Fraud Risk Area Inventory-Accounts Payable-Payroll | Auditing and Attestation | CPA Exam

IN this video, I discuss fraud risk risk as it relates to inventory and accounts payable.
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Inventory Fraud Risks

Inventory is often the largest account on many companies’ balance sheets, and auditors often find it difficult to verify the existence and valuation of inventories. As a result, inventory is susceptible to manipulation by managers who want to achieve certain financial reporting objectives. Because it is also usually readily saleable, inventory is also susceptible to misappropriation.

Fraudulent Financial Reporting Risk for Inventory
Fictitious inventory has been at the center of several major cases of fraudulent financial reporting. Many large companies have varied and extensive inventory in multiple locations, making it relatively easy for the company to add fictitious inventory to accounting records.

While auditors are required to verify the existence of physical inventories, audit testing is done on a sample basis, and not all locations with inventory are typically tested. In some cases involving fictitious inventories, auditors informed the client in advance which inventory locations were to be tested. As a result, it was relatively easy for the client to transfer inventories to the locations being tested.

Warning Signs of Inventory Fraud
Similar to deceptions involving accounts receivable, many potential warning signals or symptoms point to inventory fraud. Analytical procedures are one useful technique for detecting inventory fraud.

Analytical Procedures

Analytical procedures, especially gross margin percentage and inventory turnover, often help uncover inventory fraud. Fictitious inventory understates cost of goods sold and overstates the gross margin percentage. Fictitious inventory also lowers inventory turnover. Table 10-5 is an example of the effects of fictitious inventory on inventory turnover based on the Crazy Eddie fraud. Note that the gross profit percentage did not signal the existence of fictitious inventories, but the significant decrease in inventory turnover was a sign of fictitious inventories.

Purchases and Accounts Payable Fraud Risks

Cases of fraudulent financial reporting involving accounts payable are relatively common although less frequent than frauds involving inventory or accounts receivable. The deliberate understatement of accounts payable generally results in an understatement of purchases and cost of goods sold and an overstatement of net income. Significant misappropriations involving purchases can also occur in the form of payments to fictitious vendors, as well as kickbacks and other illegal arrangements with suppliers.
Fraudulent Financial Reporting Risk for Accounts Payable
Companies may engage in deliberate attempts to understate accounts payable and overstate income. This can be accomplished by not recording accounts payable until the subsequent period or by recording fictitious reductions to accounts payable.

All purchases received before the end of the year should be recorded as liabilities. This is relatively easy to verify if the company accounts for prenumbered receiving reports. However, if the receiving reports are not prenumbered or the company deliberately omits receiving reports from the accounting records, it may be difficult for the auditor to verify whether all liabilities have been recorded. In such cases, analytical evidence, such as unusual changes in ratios, may signal that accounts payable are understated.

Companies often have complex arrangements with suppliers that result in reductions to accounts payable for advertising credits and other allowances. These arrangements are often not as well documented as acquisition transactions. Some companies have used fictitious reductions to accounts payable to overstate net income. Therefore, auditors should read agreements with suppliers when amounts are material and make sure the financial statements reflect the substance of the agreements.