The Impacts of Inventory Inflation Schemes Used to Commit Financial Statement Fraud

In the Association of Certified Fraud Examiners’ (“ACFE”) bi-annual Report to the Nations on Occupational Fraud and Abuse, the ACFE presents its findings related to the three major types of occupational fraud, which are asset misappropriation, corruption and financial statement fraud.  The most common form of fraud, in terms of frequency, reported by the ACFE is asset misappropriation, while the least common form of fraud was financial statement fraud. The interesting part of this statistic is that while financial statement fraud is the least common, when it does occur, it more often than not has the most significant financial impact.

According to the ACFE, there are two general ways to commit financial statement fraud.  Assets and/or revenue can be either understated or overstated.  While revenue recognition schemes are likely the most well-known form of financial statement fraud, there are other ways to manipulate a company’s financial position and profitability, one being inventory inflation schemes.  The essential results of inventory inflation schemes are that both profitability, including gross profit and net income, and assets, particularly current assets, are overstated. 

The reasons for fraud can be many, but a lot of times fraud results out of desperation to meet financial goals and objectives.  Consider a manufacturer with large bank loans that has found itself in the middle of a contracting economy, thus shrinking its sales.  The manufacturer might rationalize inflating inventory to pass loan covenants related to working capital or profitability ratios.  Attempts to overstate inventory could also be made to manipulate its borrowing base calculations to increase its borrowing capacity.  Consider this same manufacturer under a different scenario. Now it is looking to be acquired.  The Company might be incentivized to inflate inventory, thus reducing cost of goods sold resulting in overstated earnings before interest, taxes, depreciation and amortization (“EBITDA”), a frequent financial metric companies are bought and sold on, increasing the price of the sale.

The Securities and Exchange Commission (“SEC”) ruled on three different inventory inflation schemes that occurred in recent history.  The companies involved included Logitech International, S.A. (“Logitech”), IEC Electronics Corp (“IEC Electronics”) and Stein Mart, Inc (“Stein Mart”).  Two of the three cases resulted in fraud-related charges by the SEC while the other did not.

The issue surrounding the SEC’s enforcement action against Logitech involved Logitech not adequately writing down its inventory related to a failed product based upon its future expectations of the product.  Logitech’s forecasts at the time of the misstatement reflected two future price markdowns of the product, when only the first markdown was incorporated into the write down of inventory.

IEC Electronics was charged by the SEC for filing false statements because a subsidiary’s controller, among other things, overrode formulas in a spreadsheet used to calculate work-in-progress labor and overhead.  The results of the overridden formulas caused the subsidiary to record journal entries that inappropriately capitalized these costs when they should have been expensed. It was determined the motivation behind this scheme was the pressure to meet budgeted gross margin goals.

In the Stein Mart case, Stein Mart overstated inventory as a result of not appropriately writing down inventory for permanent price markdowns of its inventory, however no charges were filed by the SEC.  The SEC was unable to obtain sufficient evidence to prove intent to deceive, which is a requirement of fraud and determined the error occurred because of miscommunication between Stein Mart’s merchandising and accounting departments.

Whatever the reasons for fraud, the implications are far reaching and, more often than not, expensive.  It is important to understand the risks posed to you so they can be properly mitigated, and hopefully all together avoided.  Should you identify fraud, or have concerns of fraud occurring in your organization, do not hesitate to contact Schneider Downs to see how we can help you address those risks.