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Inventory Fraud a Costly Loss

Manufacturing | Distribution | Retail Practice
03.01.2017 | IMA Newsletter
The numbers from the Association of Certified Fraud Examiners (ACFE) tell the story: Manufacturing ranks third in terms of the frequency of fraud cases among all U.S. companies, and the median loss of the fraud for manufacturers is $194,000 (as compared to $120,000 for all U.S. companies). These estimates include only direct monetary losses and do not take into account lost productivity, loss of employee morale, and the potential loss of confidence from customers. These astonishing findings were published by the ACFE in its 2016 Report to the Nations on Occupational Fraud and Abuse.

The ACFE reports that the most common frauds committed against manufacturers fall into three categories:

  • Corruption, including bribery, illegal gratuities, and extortion;
  • Billing scams, such as submitting invoices for fictitious goods or services, inflated invoices, or invoices for personal purchases; and
  • Noncash theft, i.e., the theft of inventory, equipment, and supplies.

Twenty-five percent of the fraud cases committed against manufacturers involve inflated claims for expense reimbursement. This fraud, which is relatively easy to commit and hard to detect, is often the gateway to bolder, more sophisticated, and more damaging fraud schemes.

In most cases, fraud is carried out by an employee, often considered a “member of the family” and lasts for an average of 18 months before detection according to the ACFE. The key to mitigating the risk of fraud is to have strong internal controls in place.

Watch For the Red Flags

All too often, red flags are overlooked or simply ignored: An employee begins to live beyond his/her means, citing reasons for new-found wealth, such as inheritance or investments. The employee may exhibit other changes in behavior, which can be an indication of financial pressure, family pressure, or addiction. He/she may refuse to take vacation or sick leave, so no one can check his/her work.  These warning signs are often missed within organizations that lack good, or even basic, internal controls, such as the segregation of duties in certain areas.

Other red flags in the purchasing and inventory area, according to a report published by the New York Office of the State Comptroller, include:

  • An increasing number of complaints about your products or services;
  • An increase in purchasing inventory but no increase in sales;
  • Abnormal inventory shrinkage;
  • Lack of physical security over your inventory;
  • Charges without accompanying shipping documents;
  • Payments to vendors who are not on an approved vendor list;
  • High volume of purchases from new vendors;
  • Purchases that bypass your normal procedures;
  • Vendors with no physical addresses;
  • Vendor addresses that match employee addresses;
  • Excess inventory and inventory that is slow to turn over; and
  • Purchasing agents who choose to pick-up payments rather than have payments mailed.

Whatever the reason, fraud is basically the perfect storm of opportunity, pressure, and rationalization:

  • Opportunity, the chance to solve a problem in secret by violating a trust.
  • Pressure to meet deadlines, performance goals, or other financial obligations.
  • Rationalization. Fraudsters reconcile their behavior with rationalizations that may go something like this: “I will pay this money back.” “I can’t afford to lose everything.” “I deserve this item.” “I should be paid more.” “No one will be hurt.” “No one will even notice.”

Know Your Inventory Fraud Risk Profile

Some companies are more at risk for inventory fraud than others. Obviously, service companies with minimal inventory on hand bear little risk of inventory embezzlement; instead, it’s more common among retailers, manufacturers/distributors, and contractors. In general, higher-value inventory items, such as electronics or jewelry, and smaller items that fit into pockets, purses, or backpacks, tend to be more attractive to thieves.

Inventory theft typically occurs in one of the four following ways, according to the GIA Trading Group, an international trade facilitator:

  • Simple larceny, which is the theft of parts, materials, tools, or other company property.
  • Asset requisition and transfers, which allows for the theft of inventory during the move between locations.
  • Purchasing and receiving schemes, which involves the deliberate falsification of incoming shipment records.
  • False shipment of inventory. The inventory is actually sent to a bogus individual or company and then resold.

Sometimes, the inventory account is just a convenient place to hide financial misstatement ploys, such as skimming or bogus sales. Thousands of journal entries are typically made to the inventory account, and it’s closed out to cost of sales each year. Thieves with access to the accounting systems can therefore bury their scams in the inventory account. As a result, manufacturers or other victim-organizations often write-off discrepancies between the computerized perpetual inventory records and physical inventory counts as external pilferage, obsolescence or errors—oblivious to the fact that it’s due to intentional manipulation of the accounting systems.

Monitor Inventory Metrics

If an organization’s year-end inventory counts aren’t adding up, it’s essential for management to not just write off the discrepancy, as a cost of doing business, but to investigate why. This can be accomplished by computing various inventory ratios, including:

  • Days in inventory (average inventory divided by annual cost of sales times 365 days);
  • Gross margin (sales minus cost of sales) as a percentage of sales;
  • Inventory as a percentage of total assets;
  • Returns as a percentage of annual sales; and
  • Shipping costs as a percentage of sales.

These metrics should be consistent over time and comparable to industry benchmarks. If there are sudden changes, immediate action to determine the cause and to resolve the issue should be taken.

Catch Fraud Early

With that median duration—from inception to detection of a fraud scam—of 18 months, many victims are unaware that inventory balances are inaccurate until they’ve accrued substantial losses. Diligent managers know the signs of inventory fraud and can identify anomalies early if certain controls are put into place.

So what are some best practices organizations can implement in order to deter inventory fraud? The following list provides some guidance on industry practices that may appear to be common sense, but are surprisingly absent from many organizations’ offices and/or warehouses.

  • Carefully pre-screen potential new employees. Check references and run background checks.
  • Closely supervise unloading and loading procedures during the receiving and shipping operations.
  • Conduct frequent cycle counts and investigate variances.
  • Secure inventory storage areas with locks, cameras, and/or alarms during non-working hours. Inventory loss can occur throughout the day, but it often occurs after-hours.
  • Install security cameras throughout your operation, including parking lots and building entrances, in the interest of protecting your employees and your inventory.

Putting these measures into place cannot guarantee that you will never be the victim of inventory fraud. These measures, however, can go a long way to deterring a potential thief from both inside and outside of your organization.  Organizations that suspect fraud and require assistance to identify the cause and/or implement internal controls to reduce their risk should contact their trusted advisors and/or reach out to a Berdon representative for guidance.

Questions? Contact your Berdon advisor. Berdon LLP, New York Accountants