Count On Experts to Reduce Inventory Fraud

Many businesses depend on inventory to survive. But inventory items — from raw materials used to manufacture products to finished goods marked for sale — have a way of disappearing from worksites. The good news is that timely detection and prevention measures can help prevent inventory fraud and its financial repercussions.

Small stakes
Inventory fraud generally involves either 1) the theft of physical inventory items for resale or personal use or 2) misstatement of inventory. Most schemes fall on the smaller end of the scale, such as returned goods schemes in which dishonest people return merchandise after using it or thieves return stolen merchandise for cash.

Collusion between delivery and receiving staff is also common. For example, a delivery person might skim some of the items from a shipment, while a colluding receiving clerk signs for more items than are received. Then the skimmed items are diverted for sale to other parties, and the proceeds are split between the perpetrators. Similarly, an employee might order excess goods, such as building materials or auto parts. These excess items might be shipped to the business and removed by the perpetrator or shipped directly to the perpetrator’s home.

Scrap sales present another opportunity for inventory theft. Sales of scrap typically aren’t controlled, and scrap inventory generally isn’t closely tracked. So it’s relatively easy for fraud perpetrators to underreport scrap sales revenue.

Bigger fish
Inventory fraud can occur even in the absence of stolen inventory. For example, one type of financial statement scheme overstates ending inventory balances to lower cost of sales and inflate profits. This artificially boosts the company’s overall performance and reflects well on management. Those who commit financial statement fraud to reduce taxable income, on the other hand, might understate ending inventory balances to increase cost of sales and deflate taxable income.

Embezzlers abuse inventory accounts, too. Because these accounts usually aren’t reconciled until the end of an annual period, and often have large balances, embezzled funds can easily be buried in the inventory ledger. At the end of the period, cost of sales, like other expense accounts, is closed out to retained earnings (meaning the account is zeroed out, with the expenses reflected in aggregate in retained earnings).

On the trail
Fortunately, employees who have circumvented internal controls to commit inventory fraud leave trails for fraud experts to follow. For example, experts look for inventory that might have been declared “received” but was removed before a stock receipt actually occurred. They also seek evidence of “phantom” inventory, such as falsified purchase orders, doctored shipping and receiving reports, and inflated inventory counts.
Other red flags that ending inventory might be overstated or misappropriated include:

  • Discrepancies among related invoices, purchase orders and payment records,
  • Inventory balances that increase more quickly than sales,
  • Shipping costs that are dropping as a percentage of inventory,
  • Significant increases in the days of inventory,
  • Vendor lists that include companies that do not have websites or are not found in the phone book,
  • Signs of database or system manipulation, and
  • Large adjustments after physical inventory counts.

Unusual journal entries may also appear in the inventory ledger. For example, an entry might be made for a physical count adjustment during a period that no inventory count had been conducted.

The presence of one or more of these signs doesn’t necessarily prove that fraud is occurring. An expert will seek additional evidence and interview potential suspects and witnesses to confirm — or disprove — suspicions.

Cutting crime
Businesses with extensive or expensive inventory are especially vulnerable to inventory fraud and should adhere to rigorous controls. These include securing storage areas, installing video surveillance and alarms, running background checks on employees, verifying new vendors and performing random inventory counts.
Businesses that have fallen victim to inventory fraud may want to further restrict access to inventory and computerized inventory records. Such companies should also look into implementing better procedures for documenting and tracking inventory.

Slow drip
Inventory fraud is like a slow drip from a leaky faucet. The losses may seem insignificant at first, but they gradually add up and can lead to major, costly damage down the road.

Sidebar: Hotlines can help
Occupational fraud perpetrators often overestimate their proficiency at covering up inventory theft. In many cases, co-workers know — or at least suspect — that something illegal is going on. However, employees generally are reluctant to “rat out” colleagues by going directly to management. Here’s where an anonymous fraud hotline can help.

Over the years, the Association of Certified Fraud Examiners (ACFE) has consistently found that the presence of a reporting hotline substantially increases fraud detection. In fact, more than 42% of the frauds examined in a recent ACFE study were discovered thanks to tips. To help ensure this detection method is effective, the ACFE advises organizations to make their hotlines available not only to employees but also to vendors, customers and shareholders. Businesses might also want to consider offering rewards for whistleblowing.

© 2015