Famous Inventory Fraud Cases and Their Red Flags

Inventory fraud is the deliberate misrepresentation of inventory values in a company’s financial records. For businesses in retail, manufacturing, and distribution, inventory is often the largest asset on their balance sheet. Misstating its value can significantly warp perceptions of a company’s financial stability. This fraud misleads investors, creditors, and management, creating a false image of profitability that can precede a financial collapse.

Common Inventory Fraud Schemes

Inventory fraud schemes fall into two main categories: overstatement and understatement, with overstatement being far more common. The primary goal of overstating inventory is to inflate the value of a company’s assets and its net income. This deception makes a company appear more profitable and financially sound than it actually is.

One direct method of overstating inventory is the creation of fictitious inventory. This involves fabricating records for goods that do not exist. These “phantom” items are supported by falsified documents like bogus purchase orders or receiving reports, which artificially inflate inventory counts and the company’s assets on the balance sheet. This manipulation reduces the cost of goods sold on the income statement, leading to a higher reported gross profit.

Another prevalent technique is improper inventory valuation. Companies might intentionally fail to write down the value of obsolete, slow-moving, or damaged goods. Accounting rules require inventory to be valued at the lower of its original cost or its net realizable value—the estimated selling price less any costs to complete and sell the goods. By ignoring these valuation rules, a company can carry inventory on its books at an inflated value, which again boosts reported assets and profits.

The physical counting process itself is also a target for manipulation. Fraudsters may deliberately falsify count sheets, include empty boxes in the tally, or count goods that the company does not legally own, such as items held on consignment. These actions lead to an overstatement of the quantity of inventory on hand, which inflates the inventory value on financial statements.

Cut-off manipulation is a more subtle but equally effective scheme. This involves playing with the timing of transactions around the end of an accounting period. For instance, a company might record sales from the current period in the subsequent period while keeping the sold items in the current period’s inventory count. This inflates inventory and defers revenue, distorting the financial results of both periods.

While less common, inventory understatement schemes are used to conceal theft or to reduce tax liabilities. In these cases, perfectly good inventory might be written off as scrap or damaged goods, allowing it to be removed from the premises. A company might fail to record incoming inventory, which is then stolen. By understating inventory, a company increases its cost of goods sold, which lowers its reported net income and tax obligations.

Motivations Driving Inventory Fraud

The reasons behind inventory fraud are often rooted in intense financial pressure. Management may be driven to meet or exceed the earnings expectations set by market analysts, investors, or lenders. Achieving these targets can be directly linked to substantial personal rewards, such as executive bonuses and stock options. Failing to meet these expectations could trigger violations of loan covenants, which might lead to immediate debt repayment demands or financial consequences.

Another motivation is the desire to conceal theft. Employees with access to physical inventory may steal goods for personal use or resale. To cover their tracks, they might manipulate inventory records to match the lower physical count, a practice often referred to as “inventory shrinkage fraud.”

Tax evasion is a primary driver for inventory fraud in privately held companies. By intentionally understating inventory, a business can increase its cost of goods sold, which in turn reduces its reported profits. This lower profitability figure results in a smaller income tax liability.

The manipulation of inventory figures can be motivated by a desire to manage market perception. A company might overstate its inventory to project an image of robust health and growth. This can be a strategic move to attract new investors, secure more favorable credit terms from suppliers, or to maintain a strong competitive position in the marketplace.

Indicators of Potential Inventory Fraud

Several analytical red flags can be identified by reviewing a company’s financial statements:

• Inventory that is growing at a significantly faster rate than sales.
• A decreasing inventory turnover ratio, which measures how quickly a company sells and replaces its inventory.
• An unusually high or inconsistent gross margin percentage compared to industry peers.
• Sudden and unexplained changes in the cost of goods sold as a percentage of sales.
• Changing inventory valuation methods without a clear business reason.

Beyond financial analysis, there are operational and physical indicators of potential inventory fraud:

• Poor physical security over inventory storage areas, which can create opportunities for theft.
• Significant discrepancies that repeatedly surface during physical inventory counts.
• The use of unusual or poorly supported journal entries to adjust inventory accounts.
• Shipping and receiving records that do not reconcile with the perpetual inventory records.
• Management consistently overriding internal controls related to inventory.
• Frequent customer complaints about missing or under-packed goods.

Notable Historical Cases

One example of inventory fraud is the case of Phar-Mor, a discount drug store chain that collapsed in the early 1990s. The company engaged in a massive fraud scheme that involved significantly overstating inventory and understating costs to conceal huge losses. The motivation was to fuel aggressive expansion and project an image of growth. The fraud was eventually uncovered, but not before the company had overstated its inventory by hundreds of millions of dollars, leading to its bankruptcy.

The case of Crazy Eddie, a consumer electronics chain, illustrates both overstatement and understatement of inventory. In its early years as a private company, Crazy Eddie’s management systematically understated inventory to skim cash and evade taxes. After going public, the scheme was reversed, and the company began to overstate inventory to inflate its earnings and stock price. This fraud was eventually exposed when new owners took over and discovered a massive inventory shortfall.

The McKesson & Robbins scandal of the 1930s is a case that led to significant changes in auditing standards. The company’s top executives created a fictitious foreign subsidiary to perpetrate the fraud. They used fake purchase orders and invoices to create the illusion of a massive inventory of crude drugs that did not exist. The fraud went undetected for years and highlighted the need for auditors to physically inspect inventory and confirm accounts receivable.