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    PharmCo's Overstated Inventories

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    Identify the operational and behavioral issues in the following case

    A new internal auditor discovers that her company is falsifying inventories—and selling expired medications. When she refuses to ignore her findings, she receives a reprimand. As the family breadwinner, how can she uphold her professional ethics and protect her job?
    The Problem
    It was a late fall afternoon. My conscience was overcome with guilt for not having done everything I possibly could to correct pervasive financial misstatements at the Fortune 500 pharmaceutical retail company where I worked—PharmCo.
    I took a break from the dull task of reviewing construction invoices for a new distribution facility on the West Coast. Even though this was yielding great results, the issue at hand was more imperative. I had discovered that PharmCo was overstating inventory by millions of dollars.
    One question kept running through my mind: "How can I protect myself and satisfy my responsibilities as a CPA? My family relies on me for the income to keep the household running. I have two children in daycare and the majority of my husband's income goes toward his law school debt. I have to consider all the factors."
    I quietly went to the human resources department to ask to see my personnel records. I scoured my personnel record for any hint of the reprimand I was told I had received for refusing to sign what I deemed to be a fraudulent audit report to the external auditors, which concealed millions of dollars of overstatements in PharmCo's financials. To my surprise, there was no reprimand in my files.
    However, I did find a sheet of paper with a list of percentages on it, which was dated on my first day of employment with PharmCo. "What do these percentages represent?" I asked the personnel director.
    "The numbers are scores from a personality profile you took on your first day," he replied enthusiastically. He leaned forward in his chair and excitedly said, "Your ranking for integrity is phenomenally high, in the 98th percentile!"
    Upon hearing the word "integrity" I struggled not to reveal my thoughts. I had come to HR to see if the reprimand I received from my internal audit management was an "official" document or was just a ruse to scare me into silence. It seemed that fate had brought me here to check my files, and then led me to hear independent confirmation that I was someone who did the right thing. At the same time, it was clear that internal audit management was just manipulating me to keep me silent about the accounting issues I uncovered during my inventory observations. Further this new information just confirmed to me that my management could be cavalier in their handling of me without regard to corporate rules or legal rules of handling employees. Thus, I did not confront my management. I was already looking for another job and I felt isolated from the rest of the corporation. As for the response I got from the Sr. VP with whom I revealed the information about the overstatement of inventory, via e-mail, it was a courteous "Thank you for the information"... I kept a copy of this e-mail!
    The Background
    The PharmCo internal audit management team consisted of Tom, the director of internal audit, and Marsha, a CPA, the audit manager. Just a few days earlier they had put me on probationary status. This meant that I was not to be assigned any audits that the management felt were not right for me, plus I had to provide a detailed account of all my time. I interpreted this to mean that I was not to be assigned any audits that would uncover findings that would embarrass the company. This would allow the internal audit department to continue to be management's ally without uncovering controversial accounting activities, as I had done. At the same time, since I had to record all my activities, the internal audit department was assured that I would not pursue anything beyond the limited scope I was given.
    Just a week earlier, Tom, the director, had told me that I would have to sign the misleading report on the inventory... or else. It was clear that termination loomed if I stood up for the ethics of the CPA profession. I knew Tom had wanted me to quit rather than follow my ethics and expose the inventory overstatement in the internal audit report to the external auditors and to senior management.
    My Beginnings at PharmCo
    When I started at PharmCo, as the newest internal auditor, I was assigned the mundane task of completing the external auditor's ten-store inventory observations. The external auditors wrote the respective audit program to be executed, which afforded the internal audit personnel the flexibility to select which store inventories to observe as well as which items to recount to ensure the counters' accuracy.
    The home office was located in the East. I was to select surrounding states to perform the observations to get adequate coverage to satisfy the external auditors. Given the training I had received in my previous job with a large international accounting firm, I was well versed on the procedures necessary to complete the audit program prepared by the external auditors.
    Based on the schedule provided by the store inventory department, numerous stores' inventory counts were being performed during the following week in New Jersey, so I jumped on this opportunity to get the counts completed timely. One store was in Northern New Jersey, so I stayed overnight at a nearby hotel in order to get to the store before it opened. Since the other inventory observation was in Southern New Jersey, this gave me the evening of the first inventory to travel to that store's location.
    All the inventory observations were broken into two segments, one for the store merchandise and the other for a separate pharmaceutical area. The initial store counts were contracted out to a retail inventory company whose responsibility was to perform inventory counts for all items at a store's location, which were then sent back to the home office for processing.
    I zealously started on the store inventory area. The store merchandise took up the most space, but the pharmaceutical area inventory represented the higher dollar amount. The counting crew that was consistently assigned to the pharmaceutical area was familiar with the merchandise and proper counting procedures, so I gave them adequate time to complete several areas before I rechecked their counts. It was my responsibility to randomly select merchandise to count and check against the counters' totals, getting a full explanation for any discrepancies, which I could record as a potential finding subject to review by internal audit department management. Alternatively, I had the authority to ask the counters to correct their counts.
    Counting was the most tedious part of the job, while preparation and understanding procedures was the most taxing. Counting what others had already counted had never been a problem in my prior experience with the accounting firm, as there is usually a logical explanation for any discrepancies. My counting proceeded without incident, with typical minor questions about a number of store merchandise counts that were off by one or two items. Then I started my recounts behind the pharmaceutical counter.
    I selected an open vial to check against the number of pills listed by the counters. I anticipated no problems, as the store's inventory was proceeding smoothly.
    Rattling a vial, it was obvious that it contained only one pill. However, on the counters' lists, it was represented as being half full. That would translate to 250 pills. I knew that this overstatement of inventory must be recorded as a finding in my audit report. I felt a sense of accomplishment for finding this item, but later events would dampen my excitement. Upon further review of the inventory list for the pharmacy area, I noted that no items were listed as less than half full. "What are your guidelines for counting items in open vials?" I asked one of the counting crew.
    "We do not record any item as less than 50% full," she told me, looking somewhat concerned. "We record items to the nearest 10% for amounts we deem to be greater than 50% full." It was obvious I had a finding for my report. If the counters took the trouble to record items to the nearest 10% when they were more than half full, they could make the same effort for items that were less than half full. The counters' figures were fed to the home office for use in producing financials at the end of the day. With such a massive amount of pharmacy inventory at PharmCo stores, I estimated that the numbers could be off in the millions in New Jersey because of this deceptive counting technique.
    To make matters worse, I found that PharmCo was selling expired children's cold and flu medications to the public. I determined, with help from the district manager, that the company was shipping expired cold and flu medications to stores up and down the Eastern seaboard for resale. "Sue," Jim, the district manager, told me when he called, "I found the same lines of expired merchandise in two other store locations this week. They had just arrived from the distribution center in Maryland!" Jim and I concluded that the distribution center was where the expired merchandise had originated. I knew that having this merchandise on the books overstated inventories by millions of dollars and left PharmCo open to subsequent liability. After questioning the manufacturers about expired medications, I was relieved to find that although there were no harmful effects from taking them, the medicine would be useless for treating fevers in children.
    I felt a great sense of responsibility, even beyond my professional duties, as I have young children of my own and would want them to have the best medicine when they need it. I was appalled that a company could sell expired products that parents would rely on.
    Unfortunately, doing the right thing got me into a great deal of trouble. After returning to the home office and writing up my audit reports, I received a written review from Marsha, the internal audit manager, asking me to remove my findings about the overestimation of the physical inventories and the sale of expired children's medications to consumers.
    I compliantly removed the findings but went to Tom, the director, to discuss my reservations. "I truly feel that this audit finding should remain in the report," I told him. "Not only is there a potential liability to PharmCo, but millions of dollars of obsolete inventory will be inappropriately reflected in the financials." "Marsha is right," Tom replied curtly. "Just remove the findings." His hardened look signaled an end to the conversation.
    I retorted, "I believe the findings are valid and should remain in the audit report. I refuse to sign an audit report that does not enumerate these extraordinary findings. Ethically, it is my responsibility to report misstatements and potential liability to the company."
    "Just drop it!" Tom told me.
    After my refusal to sign the report, I got the written reprimand from Tom and Marsha for insubordination. Although I was very shaken when I received the reprimand, I now knew the reprimand had been a ruse.
    Since I could not stop the sale of expired medicines in the retail stores through the proper channels, I visited three local stores near PharmCo headquarters and personally pulled the expired products from the shelves to present to the attending pharmacists. I hoped that these pharmacists could work within the PharmCo system to have the distribution center stop shipping expired merchandise to the stores for resale.

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    Solution Preview

    The organization outsourced the inventory counting of standard inventory within the store. The entire inventory process was maintained and handled by the outsourced company. The inventory audit report was sent to back to the corporate office for review. The reason for this inventory count was outsourced because of the lower cost to the company.

    The pharmaceutical area inventory count was handled internally because of the high dollar value of the pharmaceutical ...

    Solution Summary

    The following posting helps identify operational and behavioral issues in a case regarding a company's inventories.