The Hard Close - A Great Revealer of Many Issues
As this month is the time most of you get ready for a hard close in September or for those who dont and are interested a close to find any concerns before the year end close. This allows a comfort level to the year end close process and gives some breathing room for you to review for mistakes odd aging items and goods held for sale or other items.Related Item:
The "Hard Close" - A Great Revealer of Many Issues
The "Hard Close" - A Great Revealer of Many IssuesBy Carl Ashton
Inventory counts are a very important part of the hard close. With this in mind companies lose some percentage of their total revenue to fraud every year to shrink, waste and to their own employees.
Lax internal controls are ALWAYS the culprit. These schemes often begin with an intentional "accident"(not keying in a parts bill or writing an invoice by hand "offline") or anonymous small-scale theft. These are simply tests, designed to illuminate the terrain and provoke a company's response for evaluation by the planner. Then the plan develops, most often targeting one of the following areas:
Accounts Payable can deliver kited or forged checks, kickbacks, rigged bids, transfers to fictitious payees and even paychecks to ghost employees.
Accounts Receivable can permit lapping - the ongoing replacement of stolen receipts with subsequent thefts.
Expense accounts can hide inflated - or invented - costs for travel, entertainment, supplies or seminars.
Inventory is vulnerable to direct theft, diversion, overstatement, understatement, quality substitution, false weights and measures, short shipments or false valuation.
After the crime, a means of escape may be needed, depending on the chances of detection. If discovery is unlikely, perpetrators lie low; otherwise, they resign before the game is up. When I was in Automotive the biggest sign was a non matching parts bill showing up on the invoice and that manager was asked what type of car and the invoice number these parts were on due to the fact that either the P.O. number on the bill did not match or their was not a P.O. number on the bill. Then the manager would be called on the issue and the next day or two days later this happens. A 9 am call that the store was closed from one of the employees that the manager panicked and quit. Another was receiving a handwritten or "offline" invoice for services rendered and then upon review finding that an invoice was not ever entered in the system, now the customer wanted warranty service at another location "oops" that manager was caught in the act.
Some great examples are especially in, manufacturing process involves complex costing systems with many employees and large volumes of production make inventory kiting particularly difficult to detect and prevent. The most attractive inventory is the small and portable, very valuable, or easy to sell type. Common inventory fraud by employees includes direct theft; good inventory scrapped for sale and sold sales refund schemes, unauthorized outbound shipments and manipulation to conceal other frauds.
In manufacturing and retail, the largest expense for most firms is usually cost of goods sold. A dishonest manager may try to inflate inventory in order to misrepresent operational performance and earnings. To do so, managers must manipulate either physical quantities or the values associated with them. And the means of doing so a common one is to place empty boxes in a warehouse, bricks packaged as parts, tags altered after a count (same part, lesser quality higher quality returned for a refund), multiple counts of the same items, rigged barter transactions and bulk sales, are limited only by imagination.
Understatement of inventory can serve a purpose, too. Minimizing stock-on-hand can be attractive to business owners who want to evade taxes or minimize their assets in anticipation of penalties arising from business or personal legal proceedings.
The basic tools for uncovering inventory fraud are tests for quantities, compilation and valuation.
· Review of payables and receivables aging, after the fact review of expense reports.
· Testing quantities by physical count. In normal times a company may employ various means to validate its inventory, including cycle counts or continuous updates, but a fraud investigation often requires a full physical count.
· In these circumstances the company should consider a swap of managers or internal auditors form other divisions or business units if this was a daily role for them.
· In any case, auditors must carefully guard the integrity of the count, and perform it outside the view of employees, if possible, and with strict controls over count sheets and tags, used or unused. The counters should examine inventory contents, with tests for purity and grade if appropriate. And the counters should inspect records for goods received and shipped near the date of the inventory to see if they were properly included.
· Testing inventory compilation. Opportunities for manipulation arise between the counting and pricing of inventory, particularly when counts of the same items at various locations are aggregated into one list. An effective investigation requires inspection not just of the final list, but of every facet that preceded it.
· Testing inventory valuation. Auditors should confirm that vendor invoices support the stated value of inventory on hand. If a company uses dollar-value, last-in first-out (LIFO) accounting, auditors should be alert to the manipulation of LIFO pools to inflate ending inventory. In an average-cost system, slow-moving items deserve particular scrutiny, which may require purchase and sales documents from several years.
· Improperly valued items demand an explanation. Auditors should learn why they exist, and not be deterred by evasive responses or complex pricing formulas.
A manufacturing or distribution company, whose core business do not posses an internal audit team, may need help when it faces the costly and complex challenges of inventory fraud.
Some early warning signs of inventory fraud include:
Unexpected shortages or fluctuations in inventory accounts
Large adjustments to counts after a physical inventory
Significant increases in cost of goods sold
Significant decreases in gross margins
Unusual or late journal entries
Lack of timely compilation for an event such as purchase of additional space, inventory blow out event that is avoided, or write-offs of units once an event is communicated.
Accounting staff not taking vacations.
Effective analysis can expose these symptoms. Three asset ratios in particular, age of inventory, gross profit margins and inventory turnover.
These are revealing and should be reviewed in detail regularly and perhaps monthly or at least every quarter. However, these symptoms don't necessarily indicate fraud, because inventory is an area that's particularly susceptible to faulty record-keeping.
Best practices to curb this are:
· Setup of water tight internal controls.
· More than one signature needed in authorization and continual review of payables, inventory write-offs, and aging review for receivables amounts outstanding emphasis on why.
· Daily Bank reconciliation, bank deposit matching.
· Multiple reviews of journal entries, continuous review of the signals for significant changes in earnings or reduction in Cost of goods sold.
· Review of aging after being charged in a sales or franchise tax audit, usually finds lack of tax certificates or improper accounting of the accounts in question. These usually lead to non productive employee or an employee testing the waters for further exploitation.
· Have "all" checks been deposited in the bank listed on a deposit slip and reconciled to the bank account?
Staying on top of these issues should keep you free and clear of any concerns with the Hard close and feeling that the "house" is in order for the year end close and year end audits.
Carl Ashton MBA, CMA is a Consultant / Interim CFO / Controller for Acsys Inc and a member of the Gerson Lehman group of Subject matter experts. Also writes for Service Business Solution LLC A South East Accounting Firm, Franchise Accounting Solution LLC (A Franchisee only Division of Service Business Solutions), Corporate Payment Solution LLC (Electronic payment and Payroll Division of Service Business Solutions)
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