Occupational Fraud schemes fall into three primary categories consisting of asset misappropriation, corruption, and financial statement fraud. Asset misappropriation cases involve an employee stealing or misusing the employing organization’s resources. This is by far the most common category of occupational fraud, occurring in 89% of the cases reviewed in the ACFE’s Report to Nations. These cases also tend to cause the lowest median loss, at USD 120,000 per case. Asset misappropriation schemes include both the theft of company assets, such as cash, and the misuse and theft of company assets, such as inventory. Inventory fraud involves the theft of physical inventory items and the misstatement of inventory records on a company’s financial statements.
Inventory fraud can take various forms, but some common types include:
1. Fake Inventory Counts: Manipulating physical inventory counts to reflect more or less inventory than actually exists. This can involve either inflating or deflating the count to misrepresent the true value of inventory. By doing this an employee can easily steal the inventory as it never appeared in the inventory count. Warning signs consist of suspicious entries in the inventory system, a sudden increase in the cost of goods sold percentage while sales remain the same or discrepancies in recorded inventory counts compared to physical inventory.
2. Phantom Inventory: Similar to fake inventory counts “Phantom inventory” involves creating fictitious inventory records for products that do not actually exist. This can be performed by unsupported journal entries, inflated inventory count sheets, bogus shipping/receiving reports and fake purchase orders. This can artificially inflate the value of the inventory on the balance sheet.
3. Underreporting Inventory: Intentionally underreporting the quantity or value of inventory on hand to reduce tax liabilities, maintain inventory balances for debt covenants or inflate profitability metrics. Similar to phantom inventory, underreporting inventory is the opposite of phantom inventory where instead of inflating inventory it deflates the inventory value.
4. Concealed Theft: Employees stealing inventory and covering it up by altering records to make it appear as if the inventory was lost due to damage, spoilage, or other legitimate reasons. On the contrary unconcealed theft is when inventory is stolen, and the loss is not recorded created discrepancies in inventory records.
5. Inventory Lapping:Consists of manipulating the recording of sales transactions to conceal the theft of inventory. This typically involves delaying the recording of sales to cover up missing inventory and then using the next payment to cover up the previous one.
6. Vendor Collusion: Colluding with vendors to create false purchase orders or invoices for inventory that was never received, allowing for the misappropriation of funds.
7. Channel Stuffing: Deliberately sending excess inventory to distributors or retailers then they can sell, recording these shipments as sales to artificially boost sales figures, revenue, or market share. This can mislead investors and inflate the company’s financial performance.
8. Obsolete Inventory Manipulation: Another way similar to unauthorized write-offs are abused is by deliberately misclassifying obsolete or slow-moving inventory as active inventory to avoid write-offs or impairment charges.
9. Bill and Hold Schemes: Falsely recording sales of inventory that has not yet been shipped to customers, thereby inflating revenue figures. This can be used to manipulate financial statements and deceive investors about the company’s performance. It can also be used to ship inventory to different locations, including third-party warehouses.
To prevent and detect inventory fraud, here are ten tips for implementing appropriate controls:
1. Enforce Clear Policies and Procedures: Develop and enforce written policies and procedures for inventory management, including guidelines for receiving, storing, and recording inventory transactions.
2. Train Employees: Provide training to employees on inventory control procedures, including recognizing signs of inventory fraud and reporting suspicious activities.
3. Encourage Whistleblowing:Establish channels for employees to report suspected inventory fraud confidentially and without fear of retaliation. Fostering a culture of ethics and integrity within the organization will also help employees report unethical behavior they may see.
4. Conduct Background Checks: Screen employees thoroughly before hiring, particularly for positions involving access to inventory or financial records.
5. Implement Segregation of Duties: Ensure that responsibilities for inventory management, receiving, recording, and reconciliation are divided among different employees to prevent collusion.
6. Authorization and Approval Processes: Require managerial approval for significant inventory-related transactions to prevent unauthorized adjustments.
7. Perform Regular Physical Inventory Counts: Conduct periodic physical counts of inventory and reconcile the results with the recorded quantities to identify discrepancies promptly. This should be performed throughout the year rather than relying solely on annual inventory counts.
8. Use Inventory Tracking Systems: Implement inventory management software that record all inventory transactions and tracking systems such as barcodes and RFID technology. This will help provide audit trails for review and reconciliation as well as improve accuracy in tracking inventory movements and reduce human error.
9. Implement Access Controls: Limit access to inventory storage areas and computer systems containing inventory records to authorized personnel only.
10. Conduct Regular Audits: Perform regular internal audits of inventory processes and records to identify any irregularities or discrepancies. This would be a good time to monitor vendor relationships to verify the legitimacy of vendors including the review of invoices and purchases for accuracy and consistency. External audits should also be considered by engaging external audits to perform periodic reviews of inventory processes and controls.
By implementing these controls and practices, businesses can reduce the risk of inventory fraud and safeguard their assets effectively. Regular monitoring and adaptation of controls in response to changing risks are also essential for maintaining effective fraud prevention measures.
Stay Tuned
This is article is a part of our “Leader’s Guide to Fraud Prevention” series, designed to provide ongoing guidance on simple, effective actions leadership can take to prevent fraud, waste, and abuse. Future articles will explore everything from emerging fraud trends to critical risk areas like cybersecurity, as well as entity-wide recommendations for strengthening controls. By making a few strategic improvements to your fraud prevention environment, your organization can build a stronger foundation for long-term financial success.
Missed the other articles of the series? Check them out here:
- Risk Mitigation Starts with You | The Bonadio Group
- Fraud Facts & Misconceptions | The Bonadio Group
- How to Protect Your Business from Cash Fraud | The Bonadio Group
- Payroll Fraud: Understanding the Schemes Involved | The Bonadio Group
- Cash Disbursement Fraud Schemes and How to Prevent | The Bonadio Group
- Expense Reimbursement Fraud: Understanding the Risks | The Bonadio Group
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
