Inventory inflation schemes come in many flavors

As I've pointed out in previous columns, revenue recognition schemes are the most common form of financial reporting fraud because companies sometimes take desperate measures to meet their revenue and earnings goals. But revenue recognition isn't the only avenue for artificially enhancing the appearance of financial health.

In this edition, I'll examine some recent cases involving improper accounting for inventory resulting in overstated assets. As with so many of the companies in the cases I profile, the players in two of the three cases were motivated primarily by a desire to meet published or internal goals for gross profit.

Each case is affected by the requirement in generally accepted accounting principles that inventory be carried in the financial statements at the lower of 1) its cost or 2) the value at which it could be sold.

Logitech

Logitech International, S.A. is a Swiss company that manufactures and sells peripherals for computers and electronic devices. In April, Logitech was the subject of an enforcement action for fraudulently accounting for the write-down of a failed product in its fiscal year 2011 financial statements. (Its fiscal year ended March 31, 2011.) [See the Securities and Exchange Commission (SEC) order.]

A device called Revue, which Logitech launched in October 2010 for $299 each, is the focal point of the ruling. Revue connected to televisions for internet usage and video streaming. From the beginning, Revue sales lagged well behind internal forecasts. As early as December 2010, Logitech directed its contract manufacturer to cease production of Revue and not to ship 26,000 finished units. However, despite sales at only 40 percent of forecasts the company didn't record an adjustment to reduce the carrying value of inventory at Dec. 31, 2010 (the third quarter of fiscal 2011).

In January 2011, Logitech planned to sell off all remaining components awaiting assembly and to reduce the product's retail price to $249 and $199 in the first and second quarters of 2012, respectively. The company didn't share these plans with Logitech's external auditor.

In the fourth quarter (March 31, 2011) sales of the product further tanked to just 30 percent of forecast. Retailers were selling Revue at a pace of 1,000 units a week, but Logitech had more than 163,000 finished units on hand in its U.S. distribution centers and another 52,000 of finished and work-in-progress (WIP) units in Asia.

Despite several internal communications acknowledging the need for a write-down of the inventory, Logitech indicated in its initial year-end analysis for the audit that an adjustment wasn't necessary. The auditor, however, reminded the company of the importance of considering future pricing assumptions in the analysis. Logitech then told the auditor it planned to reduce the price to $249 and calculated a $2.2 million write-down in inventory. However, the company didn't tell the auditor about the second planned price reduction to $199; if it had, it would've had to increase the $2.2 million adjustment.

Logitech also failed to analyze $11 million of excess component inventory, but the auditor noted the omission. In response, Logitech produced an analysis, which concluded that it should make a $1.1 million adjustment. However, it based this analysis on the false assertion that the company would build another 79,000 Revue units, which meant the adjustment should have been larger.

Logitech's CFO and acting controller at the time both knew that the two analyses and adjustments were incorrect; the first omitted consideration of the second price reduction and they based the second on assumptions they knew to be false. Logitech's VP of global sourcing even referred to any plans to build out the remaining components as "far fetched." He further explained that efforts to sell off the unused components hadn't been successful; the company sold the most valuable components at 40 to 50 cents on the dollar. He said that Logitech should assume a sales price of 25 cents on the dollar for the remaining inventory.

IEC Electronics

A June enforcement action charged IEC Electronics Corp. with filing false statements for 2012 and the first quarter of 2013 because the controller at a now-former subsidiary, Southern California Braiding (SCB), made false entries into a WIP spreadsheet used to prepare the financial statements. (See the SEC order.) SCB consolidated its accounts into IEC's financial statements, which rendered them inaccurate.

IEC manufactures circuit cards, cable and wire harnesses, and sheet metal components that can withstand harsh environments. The company primarily serves the medical, aerospace, defense, industrial and transportation industries. Prior to its acquisition by IEC in 2010, SCB had been privately held and, apparently, never had a good system of internal controls. SCB took the actions described in the enforcement proceeding in order to meet budgeted gross profit margins.

SCB's inventory consisted primarily of raw materials and WIP because it normally would immediately ship finished products to fulfill customer orders.

The inventory overstatement at SCB comprised four separate actions. First, the amount of labor SCB capitalized into WIP was inflated. WIP consisted of labor, materials and overhead. Materials and overhead were properly tracked and accounted for. But labor was estimated. Initially, four weeks' worth of labor was capitalized into WIP at the end of each quarter (in 2011). In 2012, however, SCB's controller began gradually increasing the number of weeks of labor included in WIP.

By early 2013, SCB included 13 weeks of labor in WIP. It didn't perform a proper analysis of the percentage of completion of WIP at the end of each quarter. However, during 2012 and 2013, SCB took approximately six weeks to assemble/manufacture a product and, on average, a product in WIP was about 25 percent complete at the end of each quarter. This means that at the end of each quarter, 1 ½ weeks of labor generally should've been included in WIP, not 13.

The second manner in which inventory was inflated was through the false entries into the WIP spreadsheet. The spreadsheet included formulas designed to calculate certain elements of labor and overhead. But SCB's controller overrode the formulas in two quarters of 2012 and replaced the results of the formulas with higher amounts. These entries appear to have been made in an effort to meet budgeted gross margins.

In the fourth quarter of 2012, SCB's controller carried out the third method of inflating inventory. In this case, the controller included materials in WIP that had already been used for an SCB customer on two job orders. This resulted in an understatement of cost of goods sold for materials relating to these two orders.

The fourth method of inflating inventory stemmed from a discrepancy in finished goods inventory from the time IEC acquired SCB. The controller, at the direction of the former executive vice president of IEC, simply transferred the missing finished goods inventory to WIP rather than writing it off to cost of goods sold, which would've reduced gross profit. The controller made the mistake of documenting some of this by email; at one point he told the executive vice president that the external auditors "haven't seen" the missing finished goods transferred into WIP.

The ruling concluded that IEC violated; the controller aided, abetted and caused; and the executive vice president caused IEC's violations of Section 10(b) of the Securities Exchange Act of 1934, which prohibits fraudulent conduct in connection with the purchase or sale of securities.

Stein Mart

A September 2015 ruling explains how Stein Mart Inc., a national apparel retailer, inflated its reported inventory by failing to properly account for price discounts, which the company referred to as "markdowns." (See the SEC's order.) Stein Mart used three types of markdowns: temporary [or point of sale (POS)], permanent, and "Perm POS" markdowns.

Temporary markdowns are for limited periods of time — usually associated with a holiday such as a Fourth of July weekend sale. Stein Mart often referred to permanent markdowns as "hardmarks" because it altered the original price tags by crossing out the old prices and replacing them with reduced prices. Unlike with temporary markdowns, prices under permanent markdowns never revert back to their original amounts.

Perm POS markdowns were also permanent in nature. They differed from hardmarks only in that the price tags weren't changed. Instead, store signage reflected the price reduction, and this merchandise was physically segregated from all other inventory in the store.

Stein Mart didn't record any accounting adjustments reducing inventory for temporary markdowns at the time of the sale because the plan was for prices to revert back to the higher level after the sale. If a sales price was lower than the cost reflected in the accounting records, the loss would be recorded at the time of the sale. But since hardmarks were permanent in nature, Stein Mart reduced the book value of inventory, if necessary, at the time of the markdown.

The inventory inflation occurred in the Perm POS items. Stein Mart didn't record any reduction in value for these items until it sold the items. But like the hardmarks, price reductions should've resulted in accounting adjustments at the time of the markdown.

Unlike the first two cases, the Stein Mart case didn't include charges of fraud, which indicates that the SEC didn't discover any clear signs of intentional manipulation. Rather, the SEC characterized the restatement of the company's financial statements that resulted from discovery of the inventory overstatement as an accounting error. The ruling notes that the company's merchandising department, which made the markdown decisions, wasn't aware of the accounting implications of the Perm POS designation, so the company's accounting department wasn't informed — an internal control deficiency. Stein Mart's CFO only became aware of the existence of Perm POS markdowns in the summer of 2011 — two years after becoming CFO — and disclosure to and discussions with the external auditor didn't occur until 2012. Stein Mart issued restated financial statements to correct these errors in May 2013.

Different methods, same goals

These cases illustrate many different methods to accomplish the exact same goals: inflating inventory and reducing cost of goods sold. These cases represent only a small sampling of plentiful techniques.

The cases also provide for another good comparison of the factors that play a role in determining whether charges of fraud are brought or a misstatement is attributed to an unintentional error. (For more along these lines, see my column Proving intent proves to be tricky in the March/April 2015 edition of Fraud Magazine.)

In the Logitech and IEC cases, we see clear signs that the personnel responsible for the preparation of the financial statements knew that what they were doing conflicted with the company's stated policies and generally accepted accounting principles. But in the Stein Mart case, all signs pointed towards breakdowns in communication that resulted in an accounting department that was unaware of factors that led to the overstated inventory.

I'm always looking for recent cases and news involving alleged financial reporting fraud around the globe. Email me your links, news or information on public reports of alleged fraud.

Regent Emeritus Gerry Zack, CFE, CPA, CIA, is a managing director in the Global Forensics practice of BDO Consulting, at which he provides fraud risk advisory and investigation services. He's an ACFE faculty member and was also the 2015 chair of the ACFE Board of Regents. His email address is: gzack@bdo.com.