Case Study: Organization Creates Bogus Inventory to Secure Loans
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GUEST BLOGGER
Mohit Jain, CFE, CA
A few years ago, I worked a bogus inventory case. The organization in question had various branches across the country. The accounting books for all of these branches were centrally maintained at the organization’s headquarters. To organize their books by branch, they created a corresponding profit center in the accounting software. So for Branch X, organization created Profit Center X.
While finalizing the end-of-year accounts, an auditor identified that the organization had only five physical branches, but six profit centers existed in the accounting software. This didn’t seem right to the auditor, so he dug deeper, looking for the reason why there was a difference in the number of profit centers versus the actual branches.
How the auditor identified the bogus profit center
During his review of the annual reports of previous years, the auditor noted that the organization had disclosed five working branches at different locations.
The auditor also noticed a list of pending work on the desk of one of the account executive officers. While the auditor reviewed the work pending list, he noted that certain accounting entries were pending for all the branches. Nestled into these work pending items, there was an exhaustive list of accounting entries that were separately classified under branch head “D.”
Upon further investigation of the suspicious “D” section in the work pending list, the auditor was verbally informed that these entries were directed from the management and had no supporting documentation. Analysis of these “D” in accordance with the Statutory Accounting Principles (SAP) led the auditor to identify a bogus profit center, which was used solely for creating bogus inventory over the course of many years. The purpose of this bogus inventory was to secure loans from the bank.
The organization took various loans from banks by pledging its inventory as collateral. Using the bogus inventory listed in the nonexistent profit center, the organization was able to secure loans that they didn’t actually qualify for.
5 ways to identify bogus inventory in the books (and the red flags to look out for)
1. Review purchases or sales from related parties or subsidiaries.
Purchases or sales are not made at arm’s length price.
The quality of material is compromised.
There is no exchange of material between related parties, only accounting entries passed in the books.
Adjustment entries related to a sale or purchase are made at the end of the year with the related party.
2. Match the inventory details submitted to the banks with the actual inventory in the books.
Bogus inventory items are added to the inventory list.
Low-value inventory items are shown at a higher price.
Scrap material or low-quality material is shown as inventory.
3. Substantiate purchases of material at year end.
Despite adequate material in the stock and no foreseen sales, a huge quantity of inventory is purchased.
Purchases from bogus companies having the same or similar details as an existing vendor (address, Tax no., contact no, etc.).
4. There are recurring purchases of low quality inventory from a single vendor and its continual write-off.
There is a recurring purchase of low-quality material that eventually leads to an increase in the inventory, which is ultimately used to secure a loan.
Bad or obsolete items are mixed with good inventory.
5. Organization favors a particular vendor despite exponentially high price or low quality as compared to others in the market.
Favoring a particular vendor could lead to adjustment of sale or purchase entries.
Inventory from the favoring vendor results in a higher cost of inventory as compared to other vendors.
To my fellow auditors, don’t be afraid to question the norm
From this investigation, I learned that sometimes a fraud can be identified from the simplest of methods, and at times the fraud is right there, transparent and clear. However, due to the monotonous use of the same techniques, it manages to escape notice. An auditor should always keep the attitude of professional skepticism, which includes a questioning mind, an alertness to conditions that may indicate possible misstatements and a critical assessment of audit evidence.
In the above case, if the auditor would have ignored or overlooked the additional profit center as a clerical error, it would have led to a continued fraud practice of obtaining loans from the banks. Instead, he questioned and dug deeper, and, ultimately, stopped a years-long fraud from continuing.
Mohit Jain, CFE, CA, is the owner of a Chartered Accountancy Firm whose areas of expertise includes forensic audit, fraud investigation, fraud risk assessment as well as other fraud-related areas. The firm works with clients from a variety of fields including real estate, hospitality, financial institutions and more.
