Inventory, as the major component of a merchandising company, plays a major role in the teaching of first year accounting students. While these students learn about cost flow assumptions and the recording of inventory on the books, they learn very little about the problem of a thing such as inventory fraud. As the teaching of ethics becomes more important on all academic levels, we feel that it is essential that time be taken for subjects such as these right from the beginning.


To be successful when teaching inventory fraud to first year accounting students, the legal and professional consequences should be included to round out the fundamental theories. As in learning any concept, the aspect of learning fundamental principles can be very basic. However, by introducing real-world perspectives through structured class analyses, we will be able to inspire enthusiastic student classroom participation.


We accomplish this in several stages. First, we prepare students for class discussion with a group homework assignment. To achieve this, students will be assigned groups not larger than six-students per group. The groups should be provided with a case under a page in length for students to prepare over a weekend. The case should focus on material in the student’s accounting book (all of which now have ethical challenges built in to the material (and/or handouts if provided). It is important that the case contain fact patterns that discuss each area of the subject matter. There should be questions at the conclusion of the case requiring the students to think about the different aspects of the case, for example:

• A complete definition of inventory and inventory fraud.
• An understanding why inventory fraud exists.
• An understanding of the symptoms of fraud.
• An understanding of effective inventory control.
• The legal and professional consequences of inventory fraud.
  

To ensure that the material is reviewed, students should be informed that they would be quizzed on the case at the beginning of the Monday class. The quiz should be designed simply to ensure that they put in sufficient effort in the weekend preparation of the case and are ready to participate in the classes that will cover the topic. In addition, each group will also be required to turn in their typed answers to the case at the beginning of class. Each group should retain individual copies to use in the discussion.


Second, students will be required to re-state the facts for the discussion. Prior to the start of the restatement of facts, we will utilize a technique called "warm-calling." We identify a student to be asked the first question. This can be done on a volunteer basis or as a direct request. Unlike "cold-calling", it allows students to prepare for the discussion.


A student is then called on to recite the facts and begins the discussion. This refreshes the case in the minds of the students. After the student begins restating the facts, they are interrupted and a different student is called on to continue. This process is repeated until all the facts are sufficiently stated. For example, John starts, after he relates a few facts he is interrupted and Sue is called on to continue. Openly calling on students in this manner until all the facts are completely stated will keep the class involved and promote participation. Different students are called-on at various times during the case discussion and are required to explain their answers to ensure answers are understood.


After the restating of the facts, the student "warm-called" earlier should now be requested to answer the first question. This student should be required to provide a broad definition of inventory fraud. The faculty member could then introduce students to the "Statements of Auditing Standards," by mentioning SAS No. 53, Auditors Responsibility to Detect and Report Errors and Irregularities (AU Sec. 316). This discusses the notion that auditors consider inventory fraud as a form of management fraud.

At this point in the discussion students should be required to cite several examples of fraudulent acts. Below are some examples:

• Moving or valuing non existent inventories and adjusting related accounts prior to an auditors’ physical count
• Reporting obsolete inventory higher than market value
• Overstating stage of completion of work-in-process
• Overpricing inventory¹
  

Third, current real world examples are introduced into the class to expose them to what is going on in the real world. Cases, such as Compaq Computer, Kendall Square Research, McKesson & Robbins and Phar-Mor can be discussed to demonstrate how inventory fraud is used in the real world and the many varieties of it, as well as its consequences. After discussing the cases, students can then be asked to list symptoms of fraud. (Exhibit II) (As you can tell proper preparation from students is essential.)


Fourth, we discuss how to establish a sound internal inventory control. Listed below is the order of the topics for discussion. Students are required to give complete definitions & examples from the case for each area listed.

• The separate functions of purchasing, receiving, storing, issuing, processing, and shipping. (definitions & examples of each)
• The cost accounting system & the perpetual inventory records.
• Ongoing internal audit review.
• Independent audit (only to validate internal controls)
• Examine the difference between book & physical.
  
• Items not to include in physical count. (stoppage, consigned out inventory, etc.)²
  

Lastly, students should identify the consequences of inventory fraud. These consequences may be legal, professional or financial. Legal consequences of misrepresenting inventory can result in criminal prosecution with fines and imprisonment being imposed upon those involved. Professional consequences are often less severe resulting, possibly in the loss of professional certification, your job and so on. The most devastating results could be financial. The restating of inventories and thereby net income, earnings per share, etc., often resulting in tremendous losses in the stock value, shareholder lawsuits, investors pulling out and the ultimate consequence, going out of business.

Students should be encouraged to learn ethical concepts early. Taking a few class periods in an introductory accounting course to discuss a concept such as inventory fraud is an excellent way to achieve this goal. Considering the importance of inventory to introductory accounting and all areas of accounting thereafter, financial, managerial, tax, etc. such time would be well spent. It would also give the students a break from the debits and credits of introductory accounting and give them an entirely different perspective on the subject. Hopefully it would create an enthusiasm in many of them, making them want to stay with accounting.


Exhibit I
Lesson Plan

1. Prepare students for class discussion.
   • Divide students into groups not greater than 6 students per group.
   • One page case to given over the weekend.
   • Case should cover material in the book (or in handouts if provided).
   • Case should contain questions concerning:
     1. A complete definition of inventory fraud.
     2. Several examples of inventory fraud.
     3. How to detect and protect from inventory fraud.
     4. Legal and professional consequences of inventory fraud.
   • Notify students of quiz for next class period.
2. Begin class discussion set-up.
   • Give quiz.
   • Re-state facts for case.
3. Begin discussing questions to case using class discussion technique.
   
   • A complete definition of inventory and inventory fraud.
   • An understanding why inventory fraud exists.
   • An understanding of symptoms of fraud.
   • An understanding of effective inventory control.
   • The legal and professional consequences of inventory fraud.
4. Discuss consequences of committing inventory fraud.

• Who would probably commit inventory fraud?
• Discuss legal consequences of individual committing inventory fraud.
• Discuss professional consequences of individual committing inventory fraud.
  

Exhibit II
Symptoms of Inventory Fraud

• Missing documents.
  
• Second Endorsements on checks.
  
• Unusual endorsements on checks.
  
• Unexplained adjustments to inventory balances.
  
• Stale items in bank reconciliations.
  
• Old outstanding checks.
  
• Customer complaints.
  
• Unusual patterns in deposits in Transit.
  
• Employees who exceed the scope of their responsibilities.
  
• An unusual reduction in, or less of, a regular customer’s business.
  
• Absentee ownership of a small business.
  
• An employee who appears to be living beyond his means.
  
• Open-ended contracts with suppliers.
  
• An unusual increase in purchases by a customer during a brief period.
  

Source: Whittington & Pany, Principles of Auditing, 11th Edition, 1995.

¹ Boyd and Robinson, "Accountable Actions: The Legal Implications of Inventory Fraud," Journal of Business Issues, September 1996, p. 57.


² Whittington and Pany, Principles of Auditing, 11th Edition, 1995.