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Reprinted by permission of Dow Jones, Inc. via Copyright Clearance Center, Inc. Copyright © 1992 Dow Jones and Company, Inc. All Rights Reserved Worldwide.

Why do so many accountants fail to warn the public that the companies they audit are on the verge of collapse?

Increasingly, experts are blaming inventory fraud.

"When companies are desperate to stay afloat, inventory fraud is the easiest way to produce instant profits and dress up the balance sheet," says Felix Pomerantz, director of Florida International University’s Center for Accounting, Auditing and Tax Studies in Miami.

Even auditors at the top accounting firms are often fooled because they usually still count inventory the old-fashioned way, that is, by taking a very small sample of the goods and raw materials in stock and comparing the count with management’s tallies. In addition, Mr. Pomerantz says outside auditors can fail to catch inventory scams because they "either trust management too much or fear they will lose clients by being tougher."

Growing Problem

The problem is growing fast. On Friday, Comptronix Corp., for example, disclosed that inventory manipulations played a significant role in the scandal at the once-highflying Alabama electronics company.

In November, William Hebding, its chairman and chief executive, told the Comptronix board that he and two other top officers had simply, though improperly, inflated profits by putting on the books as capital assets some expenses, such as salaries and start-up costs, related to the company’s expansion. But on Friday, the company said the "fraudulent" accounting practices were started by making false entries to increase its inventory and decrease its cost of sales. Comptronix also said Mr. Hebding has been dismissed and its auditor, KMPG Peat Marwick, has resigned.

Nationwide, tough economic times have sparked a fourfold increase in inventory fraud from five years ago, says Douglas Carmichael, a professor of accounting at City University of New York’s Baruch College. Paul R. Brown, an accounting professor at New York University’s graduate school of business, adds "The recent rise in inventory fraud is one of the biggest single reason for the proliferation of accounting scandals."

Accountants Accused

Indeed, lawsuits charging accounting firms with fraud and malpractice have escalated to the point where the six biggest firms last year spent nearly $500 million—9% of their U.S. audit revenue—to defend themselves. Although auditors’ failure to spot bad loans at financial institutions gets headlines, accounting experts term inventory fraud far more pervasive.

How an audit can misfire is illustrated by the way Deloitte & Touche, the auditors of Laribee Wire Manufacturing Co., failed to realize that the New York copper-wire maker was buoying a sinking ship by creating fictitious inventories.

Laribee was plagued by huge debt—almost seven times its equity—generated by a major acquisition in 1988. Meanwhile, its sales to the troubled construction industry, its major customer for copper wire, were declining. In 1990, Laribee borrowed $130 million from six banks. The banks say they relied on the clean opinion that Deloitte & Touche gave Laribee’s financial statement for 1989, when the company reported $3 million in net income. A major portion of the loan collateral consisted of Laribee’s inventories of the copper rod used to draw wire at its six U.S. factories.

Between Warehouses

But after Laribee filed for bankruptcy-court protection in early 1991, a court-ordered investigation by other accountants, attorneys and bankruptcy specialists showed that much of Laribee’s inventory didn’t exist. Some was on the books at bloated values. Certain wire-product stocks carried at $2.20 a pound were selling at only $1.70 to $1.75 a pound.

Shipments between plants were recorded as stocks located at both plants. Some shipments never left the first plant and documentation supposedly showing they were being transferred to the second plant "appeared to be largely fictitious," the report to the court found. And 4.5 million pounds of copper rod, supposedly worth more than $5 million, that Laribee said it was keeping in two warehouses in upstate New York would have required three times the capacity of the buildings, the report said.

"It was one of the biggest inventory overstatements I’ve ever seen," say John Turbidy, the court-appointed trustee. He estimates that inventory fraud contributed $5.5 million before taxes to Laribee’s 1989 results. Absent this fraud and other accounting shenanigans, Laribee would have reported a $6.5 million loss instead of the profit, he adds. Laribee’s previous top management declines to comment.

Creating phantom inventory instantly benefits a company’s bottom line. Subtracting the current inventory of parts and raw materials from year-earlier figures shows the supply costs of producing items for sales. This cost, plus labor, is deducted from sales to help calculate profit. By inflating current inventories with phantom items, a company reduces production costs and creates phony profits.

Banks and other creditors sued Deloitte in state courts in Texas, Illinois, North Carolina and New York earlier this year for unspecified damages, charging it with malpractice and gross negligence in failing to spot the accounting manipulations at Laribee. A suit filed by Asarco Inc., a copper producer and Laribee creditor, accuses Mel Dobrichovsky, the Deloitte partner who oversaw Laribee’s audit, of fraud in missing the inventory scam and other improper audit practices.

"The auditor was either taken in or missed the obvious," Mr. Turbidy says. "Giving the auditors the benefit of the doubt, I assume that it was inexperience on their part because some who showed up at Laribee’s plants were fresh out of college. Otherwise, how could they have overlooked such blatant inventory manipulations?"

James T. Simmons, Laribee’s former vice president for operations, says a firm later merged into Deloitte sent "three to five auditors with three years or less experience to the [Camden, N.Y., and Jordan, N.Y.] plants to check inventory." He recalls: "The faces kept changing and there was little continuity." According to several Laribee employees, a standing joke at the plants was that the next outside auditor "would be fresh out of high school." Mr. Simmons adds that Mr. Dobrichovsky "never showed up at the plants" during annual inventory counts.

Mr. Dobrichovsky, who left Deloitte at the end of 1990, declines to comment. Deloitte denies any wrongdoing and says the audits "were done in accordance with professional standards."

In any event, the Laribee case isn’t unusual. Experts say many companies overvalue obsolete goods and supplies. Others create phantom items in the warehouse to augment the assets needed as loan collateral. Still others count inventory that they pretend they have ordered but that will never arrive.

In recent years, lawsuits have been filed against a lot of companies, including L.A. Gear Inc. and Digital Equipment Corp. Three class-action suits charge in federal district court in Los Angeles that L.A. Gear pumped up its inventories with "phantom sneakers," and one against Digital in federal court in San Jose, Calif., accuses it of failing to set aside reserves for obsolete inventory. L.A. Gear declines to comment, and Digital denies all the allegations.

As critics see it, unscrupulous managers can get auditors to swallow all kinds of ruses. In one case, auditors permitted company officials to follow the auditors and record where they were making test counts of inventory, Prof. Carmichael says. "Then the managers simply falsified counts for inventory that wasn’t being tested by the auditors."

In another case, the auditor spotted a barrel whose contents management had valued at thousands of dollars. Actually, the barrel was filled with floor sweepings. The auditor forced the company to subtract the false amount from inventory, Prof. Carmichael says, ‘but it never occurred to the auditor that this was an egregious example of intentional and pervasive fraud. To be that blind suggests incompetence or worse."

Prof. Carmichael adds that spotting inventory fraud requires bigger staffs than some accounting firms now have or are willing to send out to do inventory sampling. In the slow economy, the firms, facing reduced revenue growth and client demands for audit-fee concessions, have been pushing out partners and lower-level staff to cut costs. "With their jobs in peril, remaining auditors are less likely to make waves for fear of losing a client and possibly their jobs," says Howard Schilit, an associate professor of accounting at American University in Washington, D.C.

According to professional standards, outside auditors are supposed to watch carefully how company personnel count inventory and make counts themselves for a representative sample. The sample usually ranges form 5% to 10%, experts say. But current auditing standards don’t spell out the sample’s size, which depends on the auditor’s judgment, nor how the inventory should be counted, says the American Institute of Certified Public Accountants, which sets the standards.

Alan Winters, the institute’s director of auditing research, says it is difficult if not impossible for an outside auditor to spot inventory fraud "if top management is directing it."

But Mr. Pomerantz of the Florida center disagrees. "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 under the leeway of current standards nowadays are unusual," he says.

Fights over how auditors should handle inventory have figured prominently in the woes of Phar-Mor Inc., the troubled deep-discount drugstore chain based in Youngstown, Ohio. It recently took a $350 million accounting charge to cover losses resulting from an alleged swindle by some former managers, who were dismissed in August, 1992. The company’s surviving management and Coopers & Lybrand, its former outside auditor, have each filed lawsuits charging the other with negligently failing to detect inventory fraud and other financial manipulations at Phar-Mor.

The suit by Coopers, filed in a state court in Pittsburgh, contends that previous management kept items in inventory ledgers that had already been sold, maintained a secret inventory ledger and created phantom inventory at many of the chain’s stores. But a suit filed against Coopers in federal district court in Cleveland in October by Corporate Partners L.P. contends that Coopers is at fault for failing to catch the scams. Corporate Partners, which has a 17% stake in Phar-Mor, is an investment fund affiliated with Lazard Freres & Co., the investment bank.

While recent charges concerning Phar-Mor have cited the inventory-rigging problem, the Corporate Partners’ suit has far more detailed allegations. Corporate Partners contends that Coopers, in a "gross departure from generally accepted auditing standards, observed the taking of inventory at no more than five stores" and "advised Phar-Mor, in advance, of the specific stores at which Coopers would observe" the inventory counting.

Corporate Partners maintains that Phar-Mor then "refrained from making fraudulent adjustments at the five stores where it knew that the inventories would be observed . . . by Coopers. Instead, it [Phar-Mor] made its fraudulent adjustments to the inventory records of the vast majority of other stores that it knew in advance that Coopers would not review."

On June 30, 1990, the fiscal year-end, Phar-Mor’s balance sheet "falsified (and overstated) inventory by more than $50 million," the suit alleges, adding, "Coopers closed its eyes to the evidence that would have revealed the false and inflated inventory adjustments."

Eugene M. Freedman, Coopers’s current chairman, contends that the suit lacks merit because the fund’s own accountants studied Phar-Mor’s finances before it invested in Phar-Mor in 1991. He adds that the fund’s accountants spent little time discussing Phar-Mor with Coopers’s auditors. "They’re trying to shift the blame for their inadequate due diligence and judgment" to Coopers, he contends.

Phar-Mor said last August that it was the victim of a more than $400 million fraud-and-embezzlement scheme by Michael Monus, a co-founder of the company and three other executives; all were discharged soon afterward. Phar-Mor and Mr. Monus recently filed for bankruptcy-court protection. In its suit, Corporate Partners said it would have also sued the company and Mr. Monus if they hadn’t filed in bankruptcy court. Mr. Monus has declined to comment.

David McLean, Coopers’s associate general counsel, says the firm had to tell Phar-Mor managers where it was sampling inventories "because those stores had to be closed to do the count. You can’t check a huge retail operation’s inventories while the store is open."

Sometimes, however, auditors fall for the most obvious ruses.
Paul Regan, a forensic accountant in San Francisco often involved in court cases, recalls a Texas company being acquired by a California computer concern. He says the auditor test-counted two types of computer chips, finding 500 of one and 300 of the second at the acquired company. The next day, the acquired company’s controller called the auditor and told him that "an hour after you left, 1,500 more chips of the first variety and 1,000 of the second arrived in a shipment," he says. But the auditor "never checked back to see if the new chips were for real. It was a complete scam and helped the acquired company to double its reported profits," Mr. Regan says.
Discussion Questions
  1. What is inventory fraud? Give some examples.
  2. Why is inventory fraud an important problem in financial reporting?

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