Fools More Auditors
A Quick Way to Pad Profits, It Is Often Revealed Only When Concern Collapses
A Barrel Full of Sweepings
By LEE BERTON
Staff Reporter of THE WALL STREET JOURNAL
December 14, 1992
Why do so many accountants fail to warn the public that the companies they audit are on the verge of collapse?
Increasingly, experts are blaming inventory fraud.
"When companies are desperate to stay afloat, inventory fraud is the easiest way to produce instant profits and dress up the balance sheet," says Felix Pomerantz, director of Florida International University's Center for Accounting, Auditing and Tax Studies in Miami."
Even auditors at the top accounting firms are often fooled because they usually still count inventory the old-fashioned way, that is, by taking a very small sample of the goods and raw materials in stock and comparing the count with management's tallies. In addition, Mr. Pomerantz says, outside auditors can fail to catch inventory scams because they "either trust management too much or fear they will lose clients by being tougher."
The problem is growing fast. On Friday, Comptronix Corp., for example, disclosed that inventory manipulations played a significant role in the scandal at the once-highflying Alabama electronics company.
In November, William Hebding, its chairman and chief executive, told the Comptronix board that he and two other top officers had simply, though improperly, inflated profits by putting on the books as capital assets some expenses, such as salaries and start-up costs, related to the company's expansion. But on Friday, the company said the "fraudulent" accounting practices were started by making false entries to increase its inventory and decrease its cost of sales. Comptronix also said Mr. Hebding has been dismissed and its auditor, KPMG Peat Marwick, has resigned.
Nationwide, tough economic times have sparked a fourfold increase in inventory fraud from five years ago, says Douglas Carmichael, a professor of accounting at City University of New York's Baruch College. Paul R. Brown, an accounting professor at New York University's graduate school of business, adds: "The recent rise in inventory fraud is one of the biggest single reasons for the proliferation of accounting scandals."
Indeed, lawsuits charging accounting firms with fraud and malpractice have escalated to the point where the six biggest firms last year spent nearly $500 million - 9% of their U.S. audit revenue - to defend themselves. Although auditors' failure to spot bad loans at financial institutions gets headlines, accounting experts term inventory fraud far more pervasive.
How an audit can misfire is illustrated by the way Deloitte & Touche, the auditors of Laribee Wire Manufacturing Co., failed to realize that the New York copper-wire maker was buoying a sinking ship by creating fictitious inventories.
Laribee was plagued by huge debt - almost seven times its equity - generated by a major acquisition in 1988. Meanwhile, its sales to the troubled construction industry, its major customer for copper wire, were declining. In 1990, Laribee borrowed $130 million from six banks. The banks say they relied on the clean opinion that Deloitte &Touche gave Laribee's financial statement for 1989, when the company reported $3 million in net income. A major portion of the loan collateral consisted of Laribee's inventories of the copper rod used to draw wire at its six U.S. factories.
But after Laribee filed for bankruptcy-court protection in early 1991, a court-ordered investigation by other accountants, attorneys and bankruptcy specialists showed that much of Laribee's inventory didn't exist. Some was on the books at bloated values. Certain wire-product stocks carried at $2.20 a pound were selling at only $1.70 to $1.75 a pound.